CHRG-111shrg52619--96 Mr. Dugan," Senator, as I said before, we certainly did have some institutions that were engaged in subprime lending, and what I said also is that it is a relatively smaller share of overall subprime lending in the home market and what you see. It was roughly ten to 15 percent of all subprime loans in 2005 and 2006, even though we have a much larger share of the mortgage market. I think you will find that of the providers of those loans, the foreclosure rates were lower and were somewhat better underwritten, even though there were problem loans, and I don't deny that at all, and I would say that, historically, the commercial banks, both State and national, were much more heavily intensively regulating and supervising loans, including subprime loans. We had had a very bad experience 10 years ago or so with subprime credit cards, and as a result, we were not viewed as a particularly hospitable place to conduct subprime lending business. So even with organizations that were complex bank holding companies, they tended to do their subprime lending in holding company affiliates rather than in the bank or in the subsidiary of the bank where we regulated them. We did have some, but it turned out it was a much smaller percentage of the overall system than the subprime loans that were actually done. Senator Menendez. Well, subprimes is one thing. The Alternate As is another. Let me ask you this. How many examiners, on-site examiners, did you recently have at Bank of America, at Citi, at Wachovia, at Wells? " CHRG-111hhrg52406--209 Mr. Bachus," I am talking about the subprime mortgages, where it is just restricted to that. I sort of associate you all with subprime lending, but you are actually on all sorts of credit--with the Center for Responsible Lending. Ms. Keest. I am sorry. " CHRG-111shrg57319--39 Mr. Melby," That is correct. Senator Levin. Now, specialty lending is what Washington Mutual called its subprime operations after it abolished Long Beach as a separate entity and took over the subprime lending function itself, right? " fcic_final_report_full--115 COMMISSION CONCLUSIONS ON CHAPTER 6 The Commission concludes that there was untrammeled growth in risky mort- gages. Unsustainable, toxic loans polluted the financial system and fueled the housing bubble. Subprime lending was supported in significant ways by major financial insti- tutions. Some firms, such as Citigroup, Lehman Brothers, and Morgan Stanley, acquired subprime lenders. In addition, major financial institutions facilitated the growth in subprime mortgage–lending companies with lines of credit, securitiza- tion, purchase guarantees and other mechanisms. Regulators failed to rein in risky home mortgage lending. In particular, the Federal Reserve failed to meet its statutory obligation to establish and maintain prudent mortgage lending standards and to protect against predatory lending. CHRG-111shrg56376--74 Mr. Dugan," Yes, but the bank itself was subject to the uniform Federal standards of the National Bank Act, and was not subject to California law. They did not do their subprime lending that caused a number of problems in the bank. Senator Reed. Just to be clear, the subprime lending was in an entity that was subject to California law. " CHRG-110shrg46629--101 Chairman Bernanke," That is correct. Senator Bennett. And not all subprime lending is predatory. " CHRG-111hhrg55814--438 Mr. Bachus," What about subprime lending? Do you think it was regulated, or-- " Mr. Watt," [presiding] I-- " CHRG-111hhrg52406--210 Mr. Bachus," I said I associate you all with subprime lending just because of the last few years, but you are actually concerned with all sorts of lending practices. Ms. Keest. Certainly. We work on credit cards. We work on payday loans, and we are affiliated with the financial institution that does mortgage lending, small business lending and that has retail credit union operations. " CHRG-111hhrg54868--72 Mr. Dugan," Okay. I will give you a couple of examples, and then I will also say that a bunch of the practices, the very worst subprime mortgage lending, was not occurring inside national banks or State banks for that matter. It was in unregulated State entities where the States were in charge of them. And the numbers show that. In terms of the things that we have leaned on people, payday lending was something where the payday lenders tried to get ahold of national banking franchises to run payday lending operations in them, and we stopped it. We stopped them from so-called renting the national bank charter to do that. I mentioned subprime lending and credit cards, where we saw a number of abuses that caused real problems. Both on the consumer protection side and the safety and soundness side, we came down very hard on it, and we essentially ended that practice for the monoline stand-alone subprime lenders in the credit card business. I can provide you other examples and specific cases and would be happy to do that for the record. Mr. Miller of North Carolina. My time is nearly up. " fcic_final_report_full--469 One of the many myths about the financial crisis is that Wall Street banks led the way into subprime lending and the GSEs followed. The Commission majority’s report adopts this idea as a way of explaining why Fannie and Freddie acquired so many NTMs. This notion simply does not align with the facts. Not only were Wall Street institutions small factors in the subprime PMBS market, but well before 2002 Fannie and Freddie were much bigger players than the entire PMBS market in the business of acquiring NTM and other subprime loans. Table 7, page 504, shows that Fannie and Freddie had already acquired at least $701 billion in NTMs by 2001. Obviously, the GSEs did not have to follow anyone into NTM or subprime lending; they were already the dominant players in that market before 2002. Table 7 also shows that in 2002, when the entire PMBS market was $134 billion, Fannie and Freddie acquired $206 billion in whole subprime mortgages and $368 billion in other NTMs, demonstrating again that the GSEs were no strangers to risky lending well before the PMBS market began to develop. Further evidence about which firms were first into subprime or NTM lending is provided by Fannie’s 2002 10-K. This disclosure document reports that 14 percent of Fannie’s credit obligations (either in portfolio or guaranteed) had FICO credit scores below 660 as of December 31, 2000, 16 percent at the end of 2001 and 17 percent at the end of 2002. 31 So Fannie and Freddie were active and major buyers of subprime loans in years when the PMBS market had total issuances of only $55 billion (2000) and $94 billion (2001). In other words, it would be more accurate to say that Wall Street followed Fannie and Freddie into subprime lending rather than vice versa. At the same time, the GSEs’ purchases of subprime whole loans throughout the 1990s stimulated the growth of the subprime lending industry, which ultimately became the mainstay of the subprime PMBS market in the 2000s. 2005 was the biggest year for PMBS subprime issuances, and Ameriquest ($54 billion) and Countrywide ($38 billion) were the two largest issuers in the top 25. These numbers were still small in relation to what Fannie and Freddie had been buying since data became available in 1997. The total in Table 7 for Fannie and Freddie between 1997 and 2007 is approximately $1.5 trillion for subprime loans and over $4 trillion for all NTMs as a group. Because subprime PMBS were rich in NTM loans eligible for credit under HUD’s AH goals, Fannie and Freddie were also the largest individual purchasers of subprime PMBS from 2002 to 2006, acquiring 33 percent of the total issuances, or $579 billion. 32 In Table 3 above, which organizes mortgages by delinquency rate, these purchases are included in line 1, which had the highest rate of delinquency. These were self-denominated subprime—designated as subprime by the lender when originated—and thus had low FICO scores and usually a higher interest rate than prime loans; many also had low downpayments and were subject to other deficiencies. Ultimately, HUD’s policies were responsible for both the poor quality of the subprime and Alt-A mortgages that backed the PMBS and for the enormous size to which this market grew. This was true not only because Fannie and Freddie 31 2003 10-K, Table 33, p.84 http://www.sec.gov/Archives/edgar/data/310522/000095013303001151/ w84239e10vk.htm#031. 32 See Table 3 of “High LTV, Subprime and Alt-A Originations Over the Period 1992-2007 and Fannie, Freddie, FHA and VA’s Role” found at http://www.aei.org/docLib/Pinto-High-LTV-Subprime-Alt-A.pdf . stimulated the growth of that market through their purchases of PMBS, but also because the huge inflow of government or government-directed funds into the housing market turned what would have been a normal housing bubble into a bubble of unprecedented size and duration. This encouraged and enabled unprecedented growth in the PMBS market in two ways. CHRG-111hhrg55811--303 Mr. Bachus," We didn't really have any problem with commodity derivatives. What we had problems with was basically the subprime market, that it was junk, and they put junk in derivatives, and if you put junk in, then the derivative is junk. And so if you regulate, if you put rules which the Congress has on subprime loans, and you--we have regulations on underwriting, and we had unregulated subprime lenders, but if we regulate those, and we try to have some credit-rating reform, and we have had subprime lending reform, that wouldn't be repeated hopefully, would it? " CHRG-110shrg46629--100 Chairman Bernanke," Certainly Senator. Just one word on your initial comment. I agree with you that legitimate subprime lending is beneficial. It gives people access to homeownership and access to credit. So the real trick for us is to write rules, to write regulations that will screen out the abusive practices and the improper practices while preserving this market. I think that is a very challenging task. Senator Bennett. If I just might, a witness in a previous hearing said not all predatory lending is subprime. " CHRG-110hhrg34673--60 Mr. Bernanke," I think good progress has been made in trying to understand how to distinguish predatory lending from legitimate subprime lending. That is always the challenge. How do you define the rules in a way to address predatory lending without driving out legitimate subprime lending? And what we have seen lately is that a number of States, and your own State, North Carolina, has been one of the pioneers there, have introduced legislation which have moved the ball forward in terms of achieving that objective. And I was very pleased to see that because I think the States are good laboratories. They can really try out different things, and we can see what works and what doesn't work. At some point when we understand well enough how to distinguish between predatory and legitimate lending, probably a Federal standard would be a good idea because it would eliminate the many differences across States and make it more costly for lenders to lend on a national basis. I don't really have a good judgment as to whether the States have reached a point where we feel, you know, we are ready to do that, but at some point we should really consider-- " CHRG-110hhrg38392--187 Mr. Bernanke," The best guess is that food and energy prices, or at least energy prices, will stay high. The question, though, is whether they will keep rising at the pace that they have been rising. As best we can tell, as best as futures markets suggest, while they may remain high, they will not continue to rise at the same pace. Now, that is a very uncertain judgment. I discussed in my testimony that this is one of the risks that we are examining. One of the things that could happen to make inflation more of a problem would be if energy prices in fact did continue to rise at the pace they have in recent years. Mr. Miller of North Carolina. I have more questions, but I want to move on to subprime lending. Many people have asked about subprime lending. When I have asked in the past about subprime lending, it has been a pretty lonely effort. The concerns about subprime lending are not new for many of us. I introduced a predatory mortgage lending bill 4 years ago, 4\1/2\ years ago, when I first came to Congress, and I dearly wish that Congress had enacted that legislation because we would not have seen the spike, the disastrous spike in foreclosure rates and the default rates that we have. There has been more discussion in the press about the spike in foreclosures in the subprime market has affected the stability, what it has done to hedge funds that hold portfolios than there has to how it affects the families who have lost their homes. You have talked some about the importance of homeownership, equity in homes, to the wealth of no class families. The information I have: there were about 900,000 residential foreclosures in 2005; 1.2 million foreclosures last year; and there will be 1.5 million foreclosures this year. As you have said, based upon the change in underwriting last year, it is going to explode the year after that and the year after that. What is that doing to the wealth, to the life savings of families who are now facing foreclosure? " CHRG-111hhrg52406--207 Mr. Bachus," Thank you, Mr. Miller. I guess I will ask--is it Ms. Keest? Of course, Mr. Miller and others worked on the subprime bill that has now passed. Does that address most of the problems in subprime lending--that in combination with other things that have been done? Ms. Keest. No. " FinancialCrisisReport--260 Subprime lending fueled the overall growth in housing demand and housing price increases that began in the late 1990s and ran through mid-2006. 1008 “Between 2000 and 2007, backers of subprime mortgage - backed securities – primarily Wall Street and European investment banks – underwrote $2.1 trillion worth of [subprime mortgage backed securities] business, according to data from trade publication Inside Mortgage Finance .” 1009 By 2006, subprime lending made up 13.5% of mortgage lending in the United States, a fivefold increase from 2001. 1010 The graph below reflects the unprecedented growth in subprime mortgages between 2003 and 2006. 1011 1008 See 3/2009 U.S. Department of Housing and Urban Development Interim Report to Congress, “Root Causes of the Foreclosure Crisis,” at 36. See also “A Brief History of Credit Rating Agencies: How Financial Regulation Entrenched this Industry’s Role in the Subprime Mortgage Debacle of 2007 – 2008,” Mercatus on Policy (10/2009), at 2. 1009 “The Roots of the Financial Crisis: Who is to Blame?” The Center for Public Integrity (5/6/2009), http://www.publicintegrity.org/investigations/economic_meltdown/articles/entry/1286. 1010 3/2009 U.S. Department of Housing and Urban Development Interim Report to Congress, “Root Causes of the Foreclosure Crisis,” at 7. 1011 1/25/2010, “Mortgage Subprime Origination,” chart prepared by Paulson & Co. Inc., PSI-Paulson&Co-02-0001- 21, at 4. fcic_final_report_full--102 SUBPRIME LOANS:  “BUYERS WILL PAY A HIGH PREMIUM ” The subprime market roared back from its shakeout in the late s. The value of subprime loans originated almost doubled from  through , to  billion. In ,  of these were securitized; in , .  Low interest rates spurred this boom, which would have long-term repercussions, but so did increasingly wide- spread computerized credit scores, the growing statistical history on subprime bor- rowers, and the scale of the firms entering the market. Subprime was dominated by a narrowing field of ever-larger firms; the marginal players from the past decade had merged or vanished. By , the top  subprime lenders made  of all subprime loans, up from  in .  There were now three main kinds of companies in the subprime origination and securitization business: commercial banks and thrifts, Wall Street investment banks, and independent mortgage lenders. Some of the biggest banks and thrifts—Citi- group, National City Bank, HSBC, and Washington Mutual—spent billions on boost- ing subprime lending by creating new units, acquiring firms, or offering financing to other mortgage originators. Almost always, these operations were sequestered in nonbank subsidiaries, leaving them in a regulatory no-man’s-land. When it came to subprime lending, now it was Wall Street investment banks that worried about competition posed by the largest commercial banks and thrifts. For- mer Lehman president Bart McDade told the FCIC that the banks had gained their own securitization skills and didn’t need the investment banks to structure and dis- tribute.  So the investment banks moved into mortgage origination to guarantee a supply of loans they could securitize and sell to the growing legions of investors. For example, Lehman Brothers, the fourth-largest investment bank, purchased six differ- ent domestic lenders between  and , including BNC and Aurora.  Bear Stearns, the fifth-largest, ramped up its subprime lending arm and eventually ac- quired three subprime originators in the United States, including Encore. In , Merrill Lynch acquired First Franklin, and Morgan Stanley bought Saxon Capital; in , Goldman Sachs upped its stake in Senderra Funding, a small subprime lender. Meanwhile, several independent mortgage companies took steps to boost growth. fcic_final_report_full--82 SUBPRIME LENDING CONTENTS Mortgage securitization: “This stuff is so complicated how is anybody going to know?” .............................................................................  Greater access to lending: “A business where we can make some money” ............  Subprime lenders in turmoil: “Adverse market conditions” .................................  The regulators: “Oh, I see” ..................................................................................  In the early s, subprime lenders such as Household Finance Corp. and thrifts such as Long Beach Savings and Loan made home equity loans, often second mort- gages, to borrowers who had yet to establish credit histories or had troubled financial histories, sometimes reflecting setbacks such as unemployment, divorce, medical emergencies, and the like. Banks might have been unwilling to lend to these borrow- ers, but a subprime lender would if the borrower paid a higher interest rate to offset the extra risk. “No one can debate the need for legitimate non-prime (subprime) lending products,” Gail Burks, president of the Nevada Fair Housing Center, Inc., tes- tified to the FCIC.  Interest rates on subprime mortgages, with substantial collateral—the house— weren’t as high as those for car loans, and were much less than credit cards. The ad- vantages of a mortgage over other forms of debt were solidified in  with the Tax Reform Act, which barred deducting interest payments on consumer loans but kept the deduction for mortgage interest payments. In the s and into the early s, before computerized “credit scoring”—a statistical technique used to measure a borrower’s creditworthiness—automated the assessment of risk, mortgage lenders (including subprime lenders) relied on other factors when underwriting mortgages. As Tom Putnam, a Sacramento-based mort- gage banker, told the Commission, they traditionally lent based on the four C’s: credit (quantity, quality, and duration of the borrower’s credit obligations), capacity (amount and stability of income), capital (sufficient liquid funds to cover down pay- ments, closing costs, and reserves), and collateral (value and condition of the prop- erty).  Their decisions depended on judgments about how strength in one area, such as collateral, might offset weaknesses in others, such as credit. They underwrote bor- rowers one at a time, out of local offices.  FOMC20080130meeting--362 360,MR. MISHKIN., But they could come back. I think subprime lending will come back under a different business model. CHRG-111hhrg54868--40 Mr. Neugebauer," Thank you. So your response, let me be clear, is that in response to the consumer protection, you weren't doing anything, what you are saying is in that area, for example, FDIC, you do not feel like you had any jurisdictional authority to address consumer issues? Ms. Bair. We feel we did not have strong enough rules against abuses like overdraft protection and credit card and subprime lending. Our subprime lending cases were brought as safety and soundness cases because those weren't prudent loans either. But we didn't have rules in place to tackle it from a consumer protection standpoint. " CHRG-110shrg38109--72 Chairman Bernanke," I think, first of all, that this distress in the subprime area is a significant concern. I am obviously following it very carefully, both in terms of the impact it has on the borrowers and lenders as well. I do not think that it has at this point implications for the aggregate economy in terms of the ongoing expansion, but as I said, it is an important issue for those sectors. I could certainly list a wide variety of things that we do to try to address predatory lending, which I do think is an important issue, and I think the subprime market, which is distinct from predatory lending, it is a legitimate market. Senator Martinez. Right. That is a good distinction to make. " CHRG-111hhrg54872--163 The Chairman," The gentleman from North Carolina, Mr. Miller. Mr. Miller of North Carolina. Thank you, Mr. Chairman. Mr. Castle said in his opening statement that the worst subprime loans, the bulk of the bad subprime loans were not made by depository institutions that were fairly closely regulated but by nondepository institution, independent lenders. Mr. John, you testified a few months ago before the Investigations and Oversight Subcommittee, of the Science and Technology Committee, which I Chair, on the role--and one issue that came up was the role of the Community Reinvestment Act. Mr. Castle is right, a relatively small number of the bad subprime loans were made by depository institutions subsequent to the Community Reinvestment Act. And in fact a study by the Federal Reserve Board found that only 6 percent of all the subprime loans were made in assessment areas or in the neighborhoods where CRA encouraged lending--or to borrowers that CRA encouraged lending to. And you agreed then that CRA had a negligible effect in the subprime crisis and the financial crisis generally. Is that still your view? " CHRG-111shrg57319--40 Mr. Melby," That is correct, yes. Senator Levin. Now, wholesale specialty lending was its broker-initiated subprime operation, right? " CHRG-110hhrg41184--71 Mr. Bernanke," Of course it is possible. As I said in a recent speech, whenever we do regulation, we need to think about the cost and benefit of that regulation, and make sure there is an appropriate balance between them. And as we have done regulations on mortgage lending, I believe, for example, that subprime mortgage lending, if done responsibly, is a very positive thing and can allow some to get homeownership who might otherwise not be able to do so. There is plenty of evidence that people can do subprime lending in a responsible way. So in doing our regulations, we wanted to be sure that we didn't put a heavy hand on the market that would just shut it down and make it uneconomic. We want to help consumers understand the product, but we don't want to censure the market. Mr. Price of Georgia. Sure. Would you agree with the statement that excessive deregulation is the single greatest cause of the challenge that we currently find ourselves in? " CHRG-111shrg57319--101 Mr. Vanasek," I don't think CRA led or forced WaMu into doing a great deal more low-income moderate housing, moderate-income lending. It had a small influence. But the real influence was the pure profitability of subprime lending. Senator Coburn. Right, the up-front profitability. " CHRG-110hhrg38392--77 Mr. Bernanke," Well, the Federal Reserve has multiple roles, and the primary purpose of this hearing is to talk about monetary policy in the economy, and that is normally the only topic I would cover. In this case, though, the Federal Reserve also has some regulatory roles in reference to subprime mortgage markets in particular, and I thought this would be a useful opportunity to update this committee on some of the actions we are taking specifically in this particular market. The concerns are in terms of what the effects of tightened lending standards might be on the housing demand, for example, which is one of the factors affecting the growth of the overall economy. But the main concerns I was addressing in the latter part of my testimony were really the maintenance of legitimate subprime lending and the protection of consumers from abusive practices. " CHRG-111shrg51290--54 Chairman Dodd," Let me just--one point I wanted to make before the conclusion, we are allowing the words ``subprime'' and ``predatory lending'' to become interchangeable and that is dangerous, in my view. If you have good underwriting standards, subprime lending can work, provided you don't have a lot of bells and whistles on it. This has been one of the great wealth creators for people who are moving up economically to be able to acquire a home and to watch equity build up. It becomes a great stabilizer, not to mention it does a lot for families and neighborhoods. Equity interest in homes is, I think, one of the great benefits. I think we are one of the few countries in the world that ever had a 30-year fixed-rate mortgage for people. Now, that is not always the best vehicle, I understand that, as well. But I wonder if you would agree with me or disagree with me. I just worry about this idea that we are going to exclude the possibility of poorer people becoming home owners. They have to meet standards, obviously. I think you pointed out where Community Investment Act requirements are in place, I think only 6 percent of those institutions ended up in some kind of problems. There has been an assumption that the Community Reinvestment Act gave mortgages to a lot of poor people who couldn't afford them. But, in fact, the evidence I have seen is quite the contrary. Where institutions followed CRA guidelines here and insisted upon those underwriting standards, there were very few problems, in fact. I wonder if you might comment on those two points. Ms. McCoy. If I may, Senator Dodd, the performance of CRA loans has, in fact, been much better. That turned out to be a viable model for doing subprime lending, and there are two other viable models. One are FHA guaranteed loans. That works pretty well. And then the activities, the lending activities of CDFIs such as ShoreBank are an excellent model to look at, as well. Ms. Seidman. Let me just add, first of all, you are certainly right that subprime used to mean a borrower with less than stellar credit. " CHRG-110hhrg38392--153 Mr. Lynch," Thank you, Mr. Chairman. I will try to be brief. I do want to go back to an issue that Mr. Royce and others have talked about, the subprime mortgage problems that we have been having. In your own remarks, Mr. Chairman, you mentioned that the subprime mortgage sector has deteriorated significantly, the conditions there, and that reflecting mounting delinquency rates on adjustable rate loans continue to be a growing problem. You also note that one risk to the economic outcome is that the ongoing housing correction might indeed prove larger than originally anticipated with possible spillovers into the consumer spending area. And in addition, you made remarks that the recent rabid expansion of the subprime market was clearly accompanied by deterioration underwriting standards, and in some cases, by abusive lending practices and outright fraud. And while we all agree that promoting access, as you have noted, to credit and to homeownership are important objectives, we do, in my opinion, need to do something more concrete, not only going forward. And I appreciate that I know you worked with some other Federal supervisory agencies to issue a principles-based guidance and nontraditional mortgage regulation, and that in June, you issued a supervisory guidance on subprime lending going forward. But I do want to note that in Massachusetts, this is just one example that I throw out there, Governor Deval Patrick instituted a moratorium working with mortgage lenders in Massachusetts, instituted a moratorium on foreclosures and a coordinated workout process for some of those folks that were harmed because of the, as you have noted, abusive lending practices and in some cases outright fraud. And I was wondering, is there anything--it is sort of a two-part question. One, are we doing anything going forward more significantly and more specific than described in your general guidance, and are we looking at all at possibilities working--I know you are working with the States--are we looking at any ways to maybe hold those people harmless or to mitigate the damage that might have been done because of abusive lending practices or that fraud? " FinancialCrisisReport--75 Likewise, Steven Rotella, WaMu’s President and Chief Operating Officer, who began with the bank in January 2005, testified before the Subcommittee: “In particular, I want to be very clear on the topic of high-risk lending, this Subcommittee’s focus today. High-risk mortgage lending in WaMu’s case, primarily Option ARMs and subprime loans through Long Beach Mortgage, a subsidiary of WaMu, were expanded and accelerated at explosive rates starting in the early 2000s, prior to my hiring in 2005…. In 2004 alone, the year before I joined, Option ARMs were up 124 [percent], and subprime lending was up 52 percent.” 195 In his testimony, Mr. Rotella took credit for curtailing WaMu’s growth and high risk lending. 196 Mr. Rotella’s own emails, however, show that he supported the High Risk Lending Strategy. On October 15, 2005, Mr. Rotella emailed Mr. Killinger about WaMu’s 2006 strategic plan: “I think our focus needs to be on organic growth of home eq, and subprime, and greater utilization of [the Home Loans division] as we know it today to facilitate that at lower acquisition costs and greater efficiency.” 197 Mr. Killinger replied by email the next day: “Regarding Longbeach, I think there is a good opportunity to be a low cost provider and gain significant share when the industry implodes.” 198 Responding to Mr. Rotella’s ideas about the Home Loans division, Mr. Killinger wrote: “It makes sense to leverage the home loans distribution channels with home equity, sub prime, and alt. A.” 199 In this late 2005 email exchange, WaMu’s two senior-most executives contemplate reducing prime lending, not subprime. Mr. Killinger wrote: “If we can’t make a shift in our business model, we might be better off exiting the prime space.” 200 Mr. Rotella replied to Mr. Killinger’s email later on October 16, 2005. He continued to emphasize the importance of focusing on high risk lending, referring to his previous experience as a mortgage banker at JPMorgan Chase: “We did these kinds of analyses all the time at Chase which led us to run as fast as we could into home eq, alt a, subprime (our investment banking brethren stopped us from going too far here). We viewed prime as a source of scale benefits in servicing for the other areas and a conduit of higher margin product and aimed to hold our prime servicing 194 April 13, 2010 Subcommittee Hearing at 18-19. 195 Id. at 83. 196 See id., e.g., at 83-84. 197 10/15/2005-10/16/2005 email from Steve Rotella to Kerry Killinger, JPM_WM00665373-75. 198 Id. at JPM_WM00665374. 199 Id. 200 Id. flat to down. I feel strongly that where we need to land is a new home loan unit that includes prime, heq, and subprime. It is a far superior model.” 201 CHRG-111shrg56376--73 Mr. Dugan," We regulated the bank, and it did a portion of its business inside the bank. It did most of its subprime lending outside the bank, not in the bank. The affiliate was subject to California law. Senator Reed. It was subject to California law. " CHRG-110hhrg34673--125 Mr. Hensarling," No. I think I will quit while I am ahead, Mr. Chairman. I think I will quit while I am ahead. To the extent that I have any time left, subprime lending--you mentioned that there is a great challenge in figuring out the difference between predatory and subprime. I believe the world works off of incentives. Are subprime lenders incented to actually take back the collateral, to take back the house, to repossess it, particularly since, I think you testified, we are now in a softening real estate market, and if that is not the incentive structure might the competitive marketplace help ameliorate what we are seeing as far as some of the high foreclosure rates? " CHRG-111hhrg54872--39 Mr. Calhoun," Yes, if I may respond on two counts. One it seems to me if we were starting from scratch, and that might be a good place to think about here, it is hard to see that five separate consumer protection agencies are less government than one combined one. And in terms of the council, we tried a version of that over the last few years, the agencies did issue joint guidance. And it proved to not be a workable process. For example, looking at subprime loans, despite all the requests from this committee and all the reports of problems in subprime lending, it was not until July 2008 that the joint agencies finally issued guidance on subprime loans, and then it was unenforceable. They issued guidance 10 months earlier on alternative loans and overlooked subprime loans. And the problem with the council was it became the least common denominator, there were holdouts. " CHRG-110shrg46629--115 STATEMENT OF SENATOR THOMAS R. CARPER Senator Carper. Thanks, Mr. Chairman. Chairman Bernanke, welcome. It is good to see you again. Thank your coming and joining us today, and for your service. Others have asked about the subprime mortgage market. I want to just touch briefly on that as we start out here. Yesterday, we tried to have a hearing in this same room on FHA reauthorization. In my opening statement yesterday, I mentioned that if you look at the increase in the subprime mortgage market it really mirrors the decrease of FHA's market presence for subprime lending. The Administration has come to us with the recommendation, a series of recommendations, on how to change things in the FHA program. I just wanted to ask if you have any thoughts on what might be an appropriate course for us? " fcic_final_report_full--93 This guidance applied only to regulated banks and thrifts, and even for them it would not be binding but merely laid out the criteria underlying regulators’ bank examina- tions. It explained that “recent turmoil in the equity and asset-backed securities mar- ket has caused some non-bank subprime specialists to exit the market, thus creating increased opportunities for financial institutions to enter, or expand their participa- tion in, the subprime lending business.”  The agencies then identified key features of subprime lending programs and the need for increased capital, risk management, and board and senior management oversight. They further noted concerns about various accounting issues, notably the valuation of any residual tranches held by the securitizing firm. The guidance went on to warn, “Institutions that originate or purchase subprime loans must take special care to avoid violating fair lending and consumer protection laws and regulations. Higher fees and interest rates combined with compensation incentives can foster predatory pricing. . . . An adequate compliance management program must identify, monitor and control the consumer protection hazards associated with subprime lending.”  In spring , in response to growing complaints about lending practices, and at the urging of members of Congress, HUD Secretary Andrew Cuomo and Treasury Secretary Lawrence Summers convened the joint National Predatory Lending Task Force. It included members of consumer advocacy groups; industry trade associa- tions representing mortgage lenders, brokers, and appraisers; local and state officials; and academics. As the Fed had done three years earlier, this new entity took to the field, conducting hearings in Atlanta, Los Angeles, New York, Baltimore, and Chicago. The task force found “patterns” of abusive practices, reporting “substantial evidence of too-frequent abuses in the subprime lending market.” Questionable prac- tices included loan flipping (repeated refinancing of borrowers’ loans in a short time), high fees and prepayment penalties that resulted in borrowers’ losing the eq- uity in their homes, and outright fraud and abuse involving deceptive or high-pres- sure sales tactics. The report cited testimony regarding incidents of forged signatures, falsification of incomes and appraisals, illegitimate fees, and bait-and-switch tactics. The investigation confirmed that subprime lenders often preyed on the elderly, mi- norities, and borrowers with lower incomes and less education, frequently targeting individuals who had “limited access to the mainstream financial sector”—meaning the banks, thrifts, and credit unions, which it viewed as subject to more extensive government oversight.  Consumer protection groups took the same message to public officials. In inter- views with and testimony to the FCIC, representatives of the National Consumer Law Center (NCLC), Nevada Fair Housing Center, Inc., and California Reinvestment Coalition each said they had contacted Congress and the four bank regulatory agen- cies multiple times about their concerns over unfair and deceptive lending prac- tices.  “It was apparent on the ground as early as ’ or ’ . . . that the market for low-income consumers was being flooded with inappropriate products,” Diane Thompson of the NCLC told the Commission.  The HUD-Treasury task force recommended a set of reforms aimed at protecting borrowers from the most egregious practices in the mortgage market, including bet- ter disclosure, improved financial literacy, strengthened enforcement, and new leg- islative protections. However, the report also recognized the downside of restricting the lending practices that offered many borrowers with less-than-prime credit a chance at homeownership. It was a dilemma. Gary Gensler, who worked on the re- port as a senior Treasury official and is currently the chairman of the Commodity Fu- tures Trading Commission, told the FCIC that the report’s recommendations “lasted on Capitol Hill a very short time. . . . There wasn’t much appetite or mood to take these recommendations.”  CHRG-111shrg52619--151 Mr. Tarullo," This should be something which is an oversight mechanism on top of it in the general course of things. But as I think you have pointed out, you will sometimes have practices--and subprime mortgage lending that was either predatory or not well backed by good underwriting is a principal example--that became pervasive and should have been regulated earlier. " CHRG-110hhrg45625--134 Mr. Gutierrez," You lumped them together. I have heard that time and time again. You know, financial institutions, and we have had hearings here, and Chairman Bernanke has come before us to talk about subprime lending, we have had numerous hearings here about the crisis that was looming because of subprime lending. The victims are in neighborhoods across this country because people decided--I mean, we cannot put somebody who wanted to own a home and be part of the American Dream equally with investment bankers on Wall Street who were bundling these securities and selling them out on the market and making a lot of money because today they still made their profits, they still made their bonuses. But you know what that homeowner has because of his risk? Nothing. As a matter of fact, he has a home that he paid a certain amount for. So what are we going to do to kind of balance the $700 billion to kind of balance those things out? " CHRG-110hhrg38392--135 Mr. Bernanke," Earlier, we mentioned the 30th anniversary of the Humphrey-Hawkins Act. Thirty years ago was also the creation of the Community Reinvestment Act (CRA), the premise of which was to address the fact that banks were not lending in certain neighborhoods--there was red lining--and that it was important to extend credit to low- and moderate-income people. The development of the subprime lending market made that feasible to a significant extent. And I agree with you that legitimate, well-underwritten, well-managed subprime lending has been constructive. It does give people better access to credit and better access to home ownership. Moreover, regulations should take care not to destroy a legitimate part of this market, even as we do all that we can to make sure that bad actors are not taking unfair advantage or confusing or misrepresenting their product to people who are essentially being victimized by them. So it is our challenge--and we take it very, very seriously--to provide regulation and disclosures that will allow this market to continue to function, but at the same time to eliminate some of the bad aspects that we have seen in the last couple of years. " fcic_final_report_full--98 Mortgage credit became more available when subprime lending started to grow again after many of the major subprime lenders failed or were purchased in  and . Afterward, the biggest banks moved in. In , Citigroup, with  billion in assets, paid  billion for Associates First Capital, the second-biggest subprime lender. Still, subprime lending remained only a niche, just . of new mortgages in .  Subprime lending risks and questionable practices remained a concern. Yet the Federal Reserve did not aggressively employ the unique authority granted it by the Home Ownership and Equity Protection Act (HOEPA). Although in  the Fed fined Citigroup  million for lending violations, it only minimally revised the rules for a narrow set of high-cost mortgages.  Following losses by several banks in sub- prime securitization, the Fed and other regulators revised capital standards. HOUSING: “A POWERFUL STABILIZING FORCE ” By the beginning of , the economy was slowing, even though unemployment re- mained at a -year low of . To stimulate borrowing and spending, the Federal Reserve’s Federal Open Market Committee lowered short-term interest rates aggres- sively. On January , , in a rare conference call between scheduled meetings, it cut the benchmark federal funds rate—at which banks lend to each other overnight—by a half percentage point, rather than the more typical quarter point. Later that month, the committee cut the rate another half point, and it continued cut- ting throughout the year— times in all—to ., the lowest in  years. In the end, the recession of  was relatively mild, lasting only eight months, from March to November, and gross domestic product, or GDP—the most common gauge of the economy—dropped by only .. Some policy makers concluded that perhaps, with effective monetary policy, the economy had reached the so-called end of the business cycle, which some economists had been predicting since before the tech crash. “Recessions have become less frequent and less severe,” said Ben Bernanke, then a Fed governor, in a speech early in . “Whether the dominant cause of the Great Moderation is structural change, improved monetary policy, or simply good luck is an important question about which no consensus has yet formed.”  With the recession over and mortgage rates at -year lows, housing kicked into high gear—again. The nation would lose more than , nonfarm jobs in  but make small gains in construction. In states where bubbles soon appeared, con- struction picked up quickly. California ended  with a total of only , more jobs, but with , new construction jobs. In Florida,  of net job growth was in construction. In , builders started more than . million single-family dwellings, a rate unseen since the late s. From  to , residential construction con- tributed three times more to the economy than it had contributed on average since . FinancialCrisisReport--86 In June 2007, WaMu decided to discontinue Long Beach as a separate entity, and instead placed its subprime lending operations in a new WaMu division called “Wholesale Specialty Lending.” That division continued to purchase subprime loans and issue subprime securitizations. Some months later, an internal WaMu review assessed “the effectiveness of the action plans developed and implemented by Home Loans to address” the first payment default problem in the Wholesale Specialty Lending division. 255 After reviewing 187 FPD loans from November 2006 through March 2007, the review found: “The overall system of credit risk management activities and process has major weaknesses resulting in unacceptable level of credit risk. Exposure is considerable and immediate corrective action is essential in order to limit or avoid considerable losses, reputation damage, or financial statement errors.” 256 In particular, the review found: “Ineffectiveness of fraud detection tools – 132 of the 187 (71%) files were reviewed … for fraud. [The review] confirmed fraud on 115 [and 17 were] … ‘highly suspect’. ... Credit weakness and underwriting deficiencies is a repeat finding …. 80 of the 112 (71%) stated income loans were identified for lack of reasonableness of income[.] 133 (71%) had credit evaluation or loan decision errors …. 58 (31%) had appraisal discrepancies or issues that raised concerns that the value was not supported.” 257 July 2007 was a critical moment not only for WaMu, but also for the broader market for mortgage securities. In that month, Moody’s and S&P downgraded the ratings of hundreds of RMBS and CDO securities, including 40 Long Beach subprime securities. 258 The mass downgrades caused many investors to immediately stop buying subprime RMBS securities, and the securities plummeted in value. Wall Street firms were increasingly unable to find investors for new subprime RMBS securitizations. In August 2007, WaMu’s internal audit department released a lengthy audit report criticizing Long Beach’s poor loan origination and underwriting practices. 259 By that time, Long Beach had been rebranded as WaMu’s Wholesale Specialty Lending division, the subprime market had collapsed, and subprime loans were no longer marketable. The audit report nevertheless provided a detailed and negative review of its operations: 255 9/28/2007 “Wholesale Specialty Lending-FPD,” WaMu Corporate Credit Review, JPM_WM04013925, Hearing Exhibit 4/13-21. 256 Id. at 2. 257 Id. at 3. 258 7/10/2007-7/12/2007 excerpts from Standard & Poor’s and Moody’s Downgrades, Hearing Exhibit 4/23-99. 259 8/20/2007 “Long Beach Mortgage Loan Origination & Underwriting,” WaMu audit report, JPM_WM02548939, Hearing Exhibit 4/13-19. “[T]he overall system of risk management and internal controls has deficiencies related to multiple, critical origination and underwriting processes .… These deficiencies require immediate effective corrective action to limit continued exposure to losses. … Repeat Issue – Underwriting guidelines established to mitigate the risk of unsound underwriting decisions are not always followed …. Improvements in controls designed to ensure adherence to Exception Oversight Policy and Procedures is required …. [A]ccurate reporting and tracking of exceptions to policy does not exist.” 260 fcic_final_report_full--27 There were government reports, too. The Department of Housing and Urban De- velopment and the Treasury Department issued a joint report on predatory lending in June  that made a number of recommendations for reducing the risks to bor- rowers.  In December , the Federal Reserve Board used the HOEPA law to amend some regulations; among the changes were new rules aimed at limiting high- interest lending and preventing multiple refinancings over a short period of time, if they were not in the borrower’s best interest.  As it would turn out, those rules cov- ered only  of subprime loans. FDIC Chairman Sheila C. Bair, then an assistant treasury secretary in the administration of President George W. Bush, characterized the action to the FCIC as addressing only a “narrow range of predatory lending is- sues.”  In , Gramlich noted again the “increasing reports of abusive, unethical and in some cases, illegal, lending practices.”  Bair told the Commission that this was when “really poorly underwritten loans, the payment shock loans” were beginning to proliferate, placing “pressure” on tradi- tional banks to follow suit.  She said that she and Gramlich considered seeking rules to rein in the growth of these kinds of loans, but Gramlich told her that he thought the Fed, despite its broad powers in this area, would not support the effort. Instead, they sought voluntary rules for lenders, but that effort fell by the wayside as well.  In an environment of minimal government restrictions, the number of nontradi- tional loans surged and lending standards declined. The companies issuing these loans made profits that attracted envious eyes. New lenders entered the field. In- vestors clamored for mortgage-related securities and borrowers wanted mortgages. The volume of subprime and nontraditional lending rose sharply. In , the top  nonprime lenders originated  billion in loans. Their volume rose to  billion in , and then  billion in .  California, with its high housing costs, was a particular hotbed for this kind of lending. In , nearly  billion, or  of all nontraditional loans nationwide, were made in that state; California’s share rose to  by , with these kinds of loans growing to  billion or by  in California in just two years.  In those years, “subprime and option ARM loans saturated California communities,” Kevin Stein, the associate director of the California Reinvestment Coalition, testified to the Commission. “We estimated at that time that the average subprime borrower in Cali- fornia was paying over  more per month on their mortgage payment as a result of having received the subprime loan.”  Gail Burks, president and CEO of Nevada Fair Housing, Inc., a Las Vegas–based housing clinic, told the Commission she and other groups took their concerns di- rectly to Greenspan at this time, describing to him in person what she called the “metamorphosis” in the lending industry. She told him that besides predatory lend- ing practices such as flipping loans or misinforming seniors about reverse mortgages, she also witnessed examples of growing sloppiness in paperwork: not crediting pay- ments appropriately or miscalculating accounts.  Lisa Madigan, the attorney general in Illinois, also spotted the emergence of a troubling trend. She joined state attorneys general from Minnesota, California, Washington, Arizona, Florida, New York, and Massachusetts in pursuing allegations about First Alliance Mortgage Company, a California-based mortgage lender. Con- sumers complained that they had been deceived into taking out loans with hefty fees. The company was then packaging the loans and selling them as securities to Lehman Brothers, Madigan said. The case was settled in , and borrowers received  million. First Alliance went out of business. But other firms stepped into the void.  State officials from around the country joined together again in  to investi- gate another fast-growing lender, California-based Ameriquest. It became the na- tion’s largest subprime lender, originating  billion in subprime loans in —mostly refinances that let borrowers take cash out of their homes, but with hefty fees that ate away at their equity.  Madigan testified to the FCIC, “Our multi- state investigation of Ameriquest revealed that the company engaged in the kinds of fraudulent practices that other predatory lenders subsequently emulated on a wide scale: inflating home appraisals; increasing the interest rates on borrowers’ loans or switching their loans from fixed to adjustable interest rates at closing; and promising borrowers that they could refinance their costly loans into loans with better terms in just a few months or a year, even when borrowers had no equity to absorb another refinance.”  FinancialCrisisReport--171 OTS recommended, and the bank agreed, to spell out its new lending strategy in a written document that had to be approved by the WaMu Board of Directors. 610 The result was the bank’s January 2005 High Risk Lending Strategy, discussed in the prior chapter, in which WaMu management obtained the approval of its Board to shift its focus from originating lower risk fixed rate and government backed loans to higher risk subprime, home equity, and Option ARM loans. 611 The High Risk Lending Strategy also outlined WaMu’s plans to increase its issuance of higher risk loans to borrowers with a higher risk profile. The purpose of the shift was to maximize profits by originating loans with the highest profit margins, which were usually the highest risk loans. According to actual loan data analyzed by WaMu, higher risk loans, such as subprime, Option ARM, and home equity loans, produced a higher “gain on sale” or profit for the bank compared to lower risk loans. For example, a presentation supporting the High Risk Lending Strategy indicated that selling subprime loans garnered more than eight times the gain on sale as government backed loans. 612 The WaMu submission to the Board noted that, in order for the plan to be successful, WaMu would need to carefully manage its residential mortgage business as well as its credit risk, meaning the risk that borrowers would not repay the higher risk loans. 613 During the Board’s discussion of the strategy, credit officers noted that losses would likely lag by several years. 614 WaMu executives knew that even if loan losses did not immediately materialize, the strategy presented potentially significant risks down the road. OTS did not object to the High Risk Lending Strategy, even though OTS noted that the bank’s five-year plan did not articulate a robust plan for managing the increased risk. 615 610 6/30/2004 OTS Memo to Lawrence Carter from Zalka Ancely, OTSWME04-0000005357 at 61 (“Joint Memo #9 - Subprime Lending Strategy”); 3/15/2004 OTS Report of Examination, at OTSWMS04-0000001483 [Sealed Exhibit]. See also 1/2005 “Higher Risk Lending Strategy Presentation,” submitted to Washington Mutual Board of Directors, at JPM_WM00302978, Hearing Exhibit 4/13-2a (“As we implement our Strategic Plan, we need to address OTS/FDIC 2004 Safety and Soundness Exam Joint Memos 8 & 9 . . . Joint Memo 9: Develop and present a SubPrime/Higher Risk Lending Strategy to the Board.”). 611 1/2005 “Higher Risk Lending Strategy Presentation,” submitted to Washington Mutual Board of Directors, at JPM_WM00302978, Hearing Exhibit 4/13-2a; see also “WaMu Product Originations and Purchases by Percentage – 2003-2007,” chart prepared by the Subcommittee, Hearing Exhibit 4/13-1i. 612 4/18/2006 Washington Mutual Home Loans Discussion Board of Directors Meeting, at JPM_WM00690894, Hearing Exhibit 4/13-3 (see chart showing gain on sale for government loans was 13 basis points (bps); for 30-year, fixed rate loans was 19 bps; for Option ARMs was 109 bps; for home equity loans was 113 bps; and for subprime loans was 150 bps.) 613 The Home Loans presentation to the Board acknowledged that risks of the High Risk Lending Strategy included managing credit risk, implementing lending technology and enacting organizational changes. 4/18/2006 Washington Mutual Home Loans Discussion Board of Directors Meeting, at JPM_WM00690899, Hearing Exhibit 4/13-3. 614 1/18/2005 Washington Mutual Inc. Washington Mutual Bank FA Finance Committee Minutes, JPM_WM06293964-68 at 67; see also 1/2005 Washington Mutual, Higher Risk Lending Strategy Presentation, at JPM_WM00302987, Hearing Exhibit 4/13-2a (chart showing peak loss rates in 2007). 615 See 3/15/2004 OTS Report of Examination, at OTSWMS04-0000001509, Hearing Exhibit 4/16-94 [Sealed Exhibit]. fcic_final_report_full--454 Securitization and structured products . Securitization—often pejoratively described as the “originate to distribute process”—has also been blamed for the financial crisis. But securitization is only a means of financing. If securitization was a cause of the financial crisis, so was lending. Are we then to condemn lending? For decades, without serious incident, securitization has been used to finance car loans, credit card loans and jumbo mortgages that were not eligible for acquisition by Fannie Mae and Freddie Mac. The problem was not securitization itself, it was the weak and high risk loans that securitization financed. Under the category of securitization, it is necessary to mention the role of collateralized debt obligations, known as CDOs. These instruments were “toxic assets” because they were ultimately backed by the subprime mortgages that began to default in huge numbers when the bubble deflated, and it was diffi cult to determine where those losses would ultimately settle. CDOs, accordingly, for all their dramatic content, were just another example of the way in which subprime and other high risk loans were distributed throughout the world’s financial system. The question still remains why so many weak loans were created, not why a system that securitized good assets could also securitize bad ones. Credit default swaps and other derivatives . Despite a diligent search, the FCIC never uncovered evidence that unregulated derivatives, and particularly credit default swaps (CDS), was a significant contributor to the financial crisis through “interconnections”. The only company known to have failed because of its CDS obligations was AIG, and that firm appears to have been an outlier. Blaming CDS for the financial crisis because one company did not manage its risks properly is like blaming lending generally when a bank fails. Like everything else, derivatives can be misused, but there is no evidence that the “interconnections” among financial institutions alleged to have caused the crisis were significantly enhanced by CDS or derivatives generally. For example, Lehman Brothers was a major player in the derivatives market, but the Commission found no indication that Lehman’s failure to meet its CDS and other derivatives obligations caused significant losses to any other firm, including those that had written CDS on Lehman itself. Predatory lending . The Commission’s report also blames predatory lending for the large build-up of subprime and other high risk mortgages in the financial system. This might be a plausible explanation if there were evidence that predatory lending was so widespread as to have produced the volume of high risk loans that were actually originated. In predatory lending, unscrupulous lenders take advantage of unwitting borrowers. This undoubtedly occurred, but it also appears that many people who received high risk loans were predatory borrowers, or engaged in mortgage fraud, because they took advantage of low mortgage underwriting standards to benefit from mortgages they knew they could not pay unless rising housing prices enabled them to sell or refinance. The Commission was never able to shed any light on the extent to which predatory lending occurred. Substantial portions of the Commission majority’s report describe abusive activities by some lenders and mortgage brokers, but without giving any indication of how many such loans were originated. Further, the majority’s report fails to acknowledge that most of the buyers for subprime loans were government agencies or private companies complying with government affordable housing requirements. FinancialCrisisInquiry--642 CHAIRMAN ANGELIDES: OK. But we certainly would like to see that. All right. And I guess I would ask you to what extent did you see these products migrate out from, you know, a narrow band of the population to a larger band? GORDON: Well, I actually want to divide things into a couple of different categories, so we don’t conflate different things. In terms of lending to people with lower credit scores, which is sometimes what people call subprime lending, that is something that our organization does. And there are ways to do that safely and sustainably for the people involved. January 13, 2010 CHRG-111hhrg54872--234 Mr. Ellison," Ms. Bowdler? Ms. Bowdler. Yes. That kind of structure actually allowed a bifurcated outreach strategy, especially to minority and low-income communities. So we saw an example--I read about it in my testimony--where in conversations with a major lender, we found that their subprime wholesale unit, which offered exclusively subprime products, 80 percent, 90 percent of their lending was going to African Americans, while their retail unit went predominantly to their white bank consumers. It allowed them to actually split these outreach-- " FinancialCrisisInquiry--193 Today bank regulators are far more sensitive to lending risk and force banks to be much more conservative in underwriting on all types of loans. While this is to be expected after a deep recession, the regulatory pendulum has swung too far in the direction of overkill and choking off credit at the community bank level. Indeed, the mixed signals that appear to be coming out of Washington have dampened the lending environment in many communities. On one hand, the administration and lawmakers are saying lend, lend, lend, and on the other, that message seems to be lost on the examiners, particularly in the parts of the nation most severely affected by the recession. Bankers continue to comment that they are being treated like they have portfolio full of subprime mortgages and even though they had no subprime on their books. Under the climate community bankers may avoid making good loans for the fear of an examination criticism, write-down and resulting loss of income and capital. Community banks are willing to lend. That’s how banks generate a return and survive. However, quality loan demand is down. It is a fact that demand for credit overall is down as business suffered lower sales, reducing their inventory, cut capital spending, shed workers and cut debt. In a recent National Federation of Independent Business survey, respondents identified weak sales as the biggest problem they face, with only 5 percent of the respondents saying that access to credit is a hurdle. I can tell you from my own bank’s experience customers are scared about the economic climate and are not borrowing. They are basically panicked. Credit is available, but businesses are not demanding it. The good news is that my bank did make $233 million in new loans this past year. MidSouth is extremely well capitalized and would do even more if quality loans were available. fcic_final_report_full--257 COMMISSION CONCLUSIONS ON CHAPTER 12 The Commission concludes that entities such as Bear Stearns’s hedge funds and AIG Financial Products that had significant subprime exposure were affected by the collapse of the housing bubble first, creating financial pressures on their par- ent companies. The commercial paper and repo markets—two key components of the shadow banking lending markets—quickly reflected the impact of the housing bubble collapse because of the decline in collateral asset values and con- cern about financial firms’ subprime exposure. CHRG-111shrg57319--218 Mr. Schneider," Chairman Levin, Dr. Coburn, and Members of the Subcommittee, thank you for the opportunity to appear before you today. My name is David Schneider.--------------------------------------------------------------------------- \1\ The prepared statement of Mr. Schneider appears in the Appendix on page 158.--------------------------------------------------------------------------- Beginning in July 2005, I served as President of Washington Mutual's Home Loan Business, which originated prime mortgage loans. In 2006, I was given the additional responsibility for Long Beach Mortgage Company, which was WaMu's subprime lending channel. Before I arrived at WaMu, its management and Board had adopted a lending strategy for the coming years. I understood that its strategy was intended, at least in part, to reduce WaMu's exposure to market risk, that is, its exposure to interest rate changes. WaMu planned to do so by shifting the assets it held on its balance sheet away from market risk towards credit risk, for example, by holding more adjustable-rate mortgages. This strategy was called a higher-risk lending strategy and would have been implemented through the bank's Asset and Liability Committee. ALCO made decisions on which loans to hold and which to sell based on the loans' risk-return profile and other relevant issues, including the type and geographic location of the loans WaMu already had on its books. Although WaMu intended to change its business strategy, market conditions soon caused WaMu to go in another direction. As house prices peaked, the economy softened, and credit markets tightened, WaMu adopted increasingly conservative credit policies and moved away from loan products with greater credit risk. WaMu increased documentation requirements, raised minimum FICO scores, lowered LTV ratios, and curtailed underwriting exceptions. My team also enhanced WaMu's fraud detection programs. During my time at WaMu, we reduced and then entirely stopped making Alt A loans and Option ARM loans. Alt A lending ended in 2007. Option ARM loans decreased by more than a half from 2005 to 2006, and by another third from 2006 to 2007. WaMu stopped offering Option ARM loans altogether at the beginning of 2008. When the subprime lending operation at Long Beach was placed under my supervision in 2006, I was asked to address the challenges its business presented. During that year, I changed Long Beach management twice. As I became more familiar with Long Beach Mortgage, I concluded that its lending parameters should be tightened, so across various loan products we raised FICO scores, lowered LTV ratios, established maximum loan values, increased documentation requirements, improved programs to detect and prevent fraud, and in 2007 eliminated stated income lending. As a result, the percentage of approved Long Beach loans that were based on full documentation increased every year I oversaw Long Beach, and the percentage of loans with combined LTV ratios greater than 90 percent decreased every year over that same period. More broadly, WaMu eliminated many subprime products and then stopped originating subprime loans entirely. As a result, WaMu's subprime lending declined by a third from 2005 to 2006 and by 80 percent from 2006 to 2007. When I began my job at Washington Mutual, my goal was to evaluate and improve our home lending efforts in all respects. As market changes began to change, my team and I worked very hard to adapt to the new conditions and at the same time address the challenges WaMu faced. During the time I was President of Home Loans, we acted to reduce the size and associated risk of the Home Loans business. Specifically, we closed its broker and correspondent lending channels. We closed Long Beach Mortgage. We eliminated a number of higher-risk loan products and bolstered quality controls through tightening credit standards, improving the automated underwriting tools, enhancing fraud detection and prevention, and curtailing underwriting exceptions. I hope this brief summary has been helpful and I look forward to your questions. Thank you. Senator Levin. Thank you very much, Mr. Schneider. Mr. Beck. TESTIMONY OF DAVID BECK,\1\ FORMER DIVISION HEAD OF CAPITAL CHRG-111shrg57319--134 Mr. Cathcart," Five-fifty is extremely low---- Senator Kaufman. Right. Mr. Cathcart [continuing]. And the only way to--that would definitely be subprime, probably deep subprime. There are ways to lend into that market that involve such techniques as calling the borrower the day before the loan is due, keeping track of them, almost handling them by hand. Senator Kaufman. But what really was happening, what Michael Lewis says, is they were taking the 550s and throwing them in to get an average that passed the rating game, realizing that the 550s are going to fail and there wasn't going to be anybody calling them on the phone and holding their hand, right? Is that fair to say? " FinancialCrisisReport--71 In 2003, 64% of WaMu’s mortgage originations and purchases were fixed rate loans, and only 19% were subprime, Option ARM, or home equity loans. In 2004, 31% of WaMu’s mortgage originations and purchases were fixed rate loans, and 55% were subprime, Option ARM, or home equity loans. In 2005, 31% of WaMu’s mortgage originations and purchases were fixed rate loans, and 56% were subprime, Option ARM, or equity loans. By 2006, only 25% of WaMu’s mortgage originations and purchases were fixed rate loans, and 55% were subprime, Option ARM, or home equity loans. 182 Even after market forces began taking their toll in 2007, and WaMu ended all subprime lending in the fall of that year, its higher risk originations and purchases at 47% were double its fixed rate loans at 23%. 183 181 4/2010 “WaMu Product Originations and Purchases by Percentage – 2003-2007,” chart prepared by the Subcommittee, Hearing Exhibit 4/13-1i. 182 Id. 183 Id. FinancialCrisisReport--63 OTS directed the bank to spell out its new lending strategy in a written document that had to be presented to and gain approval by the WaMu Board of Directors. 154 In response, in January 2005, WaMu management developed a document entitled, “Higher Risk Lending Strategy” and presented it to its Board of Directors for approval to shift the bank’s focus from originating low risk fixed rate and government backed loans to higher risk subprime, home equity, and Option ARM loans. 155 The Strategy disclosed that WaMu planned to increase both its issuance of higher risk loans and its offering of loans to higher risk borrowers. The explicit reasoning for the shift was the increased profitability of the higher risk loans, measured by actual bank data showing that those loans produced a higher “gain on sale” or profit for the bank compared to lower risk loans. For example, one chart supporting the Strategy showed that selling subprime loans garnered more than eight times the gain on sale as government backed loans. 156 The WaMu submission to the Board noted that, in order for the plan to be successful, WaMu would need to carefully manage its residential mortgage business as well as its credit risk, meaning the risk that borrowers would not repay the higher risk loans. 157 During the Board’s discussion of the strategy, credit officers noted that losses would likely lag by several years. 158 These documents show that WaMu knew that, even if loan losses did not immediately come to pass after initiating the High Risk Lending Strategy, it did not mean the strategy was free of problems. 153 See 3/15/2004 OTS Report of Examination, at OTSWMS04-0000001509, Hearing Exhibit 4/16-94 [Sealed Exhibit]. 154 6/30/2004 OTS Memo to Lawrence Carter from Zalka Ancely, OTSWME04-0000005357 at 61 (“Joint Memo #9 - Subprime Lending Strategy”); 3/15/2004 OTS Report of Examination, at OTSWMS04-0000001483, Hearing Exhibit 4/16-94 [Sealed Exhibit]. See also 1/2005 “Higher Risk Lending Strategy Presentation,” submitted to Washington Mutual Board of Directors, at JPM_WM00302978, Hearing Exhibit 4/13-2a (“As we implement our Strategic Plan, we need to address OTS/FDIC 2004 Safety and Soundness Exam Joint Memos 8 & 9 . . . Joint Memo 9: Develop and present a SubPrime/Higher Risk Lending Strategy to the Board.”). 155 1/2005 “Higher Risk Lending Strategy Presentation,” submitted to Washington Mutual Board of Directors, at JPM_WM00302978, Hearing Exhibit 4/13-2a; see also 4/2010 “WaMu Product Originations and Purchases by Percentage – 2003-2007,” chart prepared by the Subcommittee, Hearing Exhibit 4/13-1i. 156 4/18/2006 Washington Mutual Home Loans Discussion Board of Directors Meeting, at JPM_WM00690894, Hearing Exhibit 4/13-3 (see chart showing gain on sale for government loans was 13 basis points; for 30-year, fixed rate loans was 19; for option loans was 109; for home equity loans was 113; and for subprime loans was 150.). 157 See 4/18/2006 Washington Mutual Home Loans Discussion Board of Directors Meeting, at JPM_WM00690899, Hearing Exhibit 4/13-3 (acknowledging that the risks of the High Risk Lending Strategy included managing credit risk, implementing lending technology and enacting organizational changes). 158 1/18/2005 Washington Mutual Inc. Washington Mutual Bank FA Finance Committee Minutes, JPM_WM06293964; see also 1/2005 “Higher Risk Lending Strategy Presentation,” submitted to Washington Mutual Board of Directors, at JPM_WM00302987, Hearing Exhibit 4/13-2a (“Lags in Effects of Expansion,” chart showing peak loss rates in 2007). (3) Definition of High Risk Lending fcic_final_report_full--510 The next question is whether the GSEs loosened their underwriting standards to compete with Countrywide, Ameriquest and the other subprime lenders who were the dominant players in the PMBS market between 2004 and 2007. Again, the answer seems clearly to be no. The subprime PMBS market was very small until 2002, when for the first time it exceeded $100 billion and reached $134 billion in subprime PMBS issuances. 107 Yet, Table 7 shows that in 2002 alone the GSEs bought $206 billion in subprime loans, more than the total amount securitized by all the subprime lenders and others combined in that year. The discussion of internal documents that follows will focus almost exclusively on Fannie Mae. The Commission concentrated its investigation on Fannie and it was from Fannie that the Commission received the most complete set of internal documents. By the early 2000s, Countrywide had succeeded in creating an integrated system of mortgage distribution that included originating, packaging, issuing and underwriting NTMs through PMBS. Other subprime lenders, as noted above, were also major issuers, but they sold their PMBS through Wall Street firms that were functioning as underwriters. The success of Countrywide and other subprime lenders as distributors of NTMs through PMBS was troubling to Fannie for two reasons. First, Countrywide had been Fannie’s largest supplier of subprime mortgages; the fact that it could now securitize mortgages it formerly sold to Fannie meant that Fannie would have more diffi culty finding subprime mortgages that were AH goals-eligible. In addition, the GSEs knew that their support in Congress depended heavily on meeting the AH goals and “leading the market” in lending to low income borrowers. In 2005 and 2006, the Bush administration and a growing number of Republicans in Congress were calling for tighter regulation of Fannie and Freddie, and the GSEs needed allies in Congress to hold this off. The fact that subprime lenders were taking an increasing market share in these years—suggesting that the GSEs were no longer the most important sources of low income mortgage credit—was thus a matter of great concern to Fannie’s management. Without strong support among the Democrats in Congress, there was a significant chance that the Republican Congress would enact tougher regulatory legislation. This was expressed at Fannie as concern about a loss of “relevance,” and provoked wide-ranging consideration within the firm about how they could regain their leadership role in low-income lending. Nevertheless, although Fannie had strong reasons for wanting to compete for market share with Countrywide and others, it did not have either the operational 106 107 Inside Mortgage Finance, The 2009 Mortgage Market Statistical Annual—Volume II , pp. 139 and 140. Inside Mortgage Finance, The 2009 Market Statistical Annual—Volume II , p.143. or financial capacity to do so. In the end, Fannie was unable to take any significant action during the key years 2005 and 2006 that would regain market share from the subprime lenders or anyone else. They reduced their underwriting standards to the degree necessary to keep pace with the increasing AH goals, but not to go significantly beyond those requirements. CHRG-111shrg54675--35 Mr. Templeton," We have seen some of the things more similar to what the gentleman from South Dakota was saying. We just did not see a big inflow into our marketplace of lenders who were offering loans that just didn't make good sense, and I think primarily because we didn't see extreme home value rises over the past 2 or 3 years in our marketplace. It was a more reasonable rise, which I think led to people searching for more reasonable loans. Now, that said, we have certainly had foreclosures. We have had modifications that we have done. But I am not sure that I am--I am not aware of any loan that specifically was a result of some type of egregious act, where somebody put somebody in an interest-only loan or something like that. All we have been seeing is the normal re-fis that people are going through because of the market that we are in. Like the gentleman from South Dakota, we did not originate the sales, so every loan we made through last year is currently in a portfolio. This year, we are originating some for sale, but they are what everybody would call a conforming, main-stream type of loan. I would go one step further to say one thing as concerns the rural areas. In our market, anyway, those brokers weren't interested in the rural areas because those homes were not homes that they could sell as a package to anybody. There was no appreciation in values. They were--before we invented the phrase subprime mortgage, you go back 4 or 5 years ago, if you think about what you would call a subprime home or subprime mortgage, it was an inexpensive home on a dirt street that needed painting and that is what a lot of the homes in our rural communities are and we lend to a lot of those people. So that is what we call internally our subprime, because nobody else will touch a home like that, but that is what we do and that is what we are about. And consequently, we are not suffering in our community from a serious issue with egregious lending. Maybe some are there, I am just not aware of it, but I stay pretty close with the community. Thank you very much. " fcic_final_report_full--89 In , President Bill Clinton asked regulators to improve banks’ CRA perform- ance while responding to industry complaints that the regulatory review process for compliance was too burdensome and too subjective. In , the Fed, Office of Thrift Supervision (OTS), Office of the Comptroller of the Currency (OCC), and Federal Deposit Insurance Corporation (FDIC) issued regulations that shifted the regulatory focus from the efforts that banks made to comply with the CRA to their actual re- sults. Regulators and community advocates could now point to objective, observable numbers that measured banks’ compliance with the law. Former comptroller John Dugan told FCIC staff that the impact of the CRA had been lasting, because it encouraged banks to lend to people who in the past might not have had access to credit. He said, “There is a tremendous amount of investment that goes on in inner cities and other places to build things that are quite impressive. . . . And the bankers conversely say, ‘This is proven to be a business where we can make some money; not a lot, but when you factor that in plus the good will that we get from it, it kind of works.’”  Lawrence Lindsey, a former Fed governor who was responsible for the Fed’s Divi- sion of Consumer and Community Affairs, which oversees CRA enforcement, told the FCIC that improved enforcement had given the banks an incentive to invest in technology that would make lending to lower-income borrowers profitable by such means as creating credit scoring models customized to the market. Shadow banks not covered by the CRA would use these same credit scoring models, which could draw on now more substantial historical lending data for their estimates, to under- write loans. “We basically got a cycle going which particularly the shadow banking industry could, using recent historic data, show the default rates on this type of lend- ing were very, very low,” he said.  Indeed, default rates were low during the prosper- ous s, and regulators, bankers, and lenders in the shadow banking system took note of this success. SUBPRIME LENDERS IN TURMOIL: “ADVERSE MARKET CONDITIONS ” Among nonbank mortgage originators, the late s were a turning point. During the market disruption caused by the Russian debt crisis and the Long-Term Capital Management collapse, the markets saw a “flight to quality”—that is, a steep fall in de- mand among investors for risky assets, including subprime securitizations. The rate of subprime mortgage securitization dropped from . in  to . in . Meanwhile, subprime originators saw the interest rate at which they could borrow in credit markets skyrocket. They were caught in a squeeze: borrowing costs increased at the very moment that their revenue stream dried up.  And some were caught holding tranches of subprime securities that turned out to be worth far less than the value they had been assigned. Mortgage lenders that depended on liquidity and short-term funding had imme- diate problems. For example, Southern Pacific Funding (SFC), an Oregon-based sub- prime lender that securitized its loans, reported relatively positive second-quarter results in August . Then, in September, SFC notified investors about “recent ad- verse market conditions” in the securities markets and expressed concern about “the continued viability of securitization in the foreseeable future.”  A week later, SFC filed for bankruptcy protection. Several other nonbank subprime lenders that were also dependent on short-term financing from the capital markets also filed for bank- ruptcy in  and . In the two years following the Russian default crisis,  of the top  subprime lenders declared bankruptcy, ceased operations, or sold out to stronger firms.  fcic_final_report_full--90 When these firms were sold, their buyers would frequently absorb large losses. First Union, a large regional bank headquartered in North Carolina, incurred charges of almost . billion after it bought The Money Store. First Union eventually shut down or sold off most of The Money Store’s operations. Conseco, a leading insurance company, purchased Green Tree Financial, another subprime lender. Disruptions in the securitization markets, as well as unexpected mortgage defaults, eventually drove Conseco into bankruptcy in December . At the time, this was the third-largest bankruptcy in U.S. history (after WorldCom and Enron). Accounting misrepresentations would also bring down subprime lenders. Key- stone, a small national bank in West Virginia that made and securitized subprime mortgage loans, failed in . In the securitization process—as was common prac- tice in the s—Keystone retained the riskiest “first-loss” residual tranches for its own account. These holdings far exceeded the bank’s capital. But Keystone assigned them grossly inflated values. The OCC closed the bank in September , after dis- covering “fraud committed by the bank management,” as executives had overstated the value of the residual tranches and other bank assets.  Perhaps the most signifi- cant failure occurred at Superior Bank, one of the most aggressive subprime mort- gage lenders. Like Keystone, it too failed after having kept and overvalued the first-loss tranches on its balance sheet. Many of the lenders that survived or were bought in the s reemerged in other forms. Long Beach was the ancestor of Ameriquest and Long Beach Mortgage (which was in turn purchased by Washington Mutual), two of the more aggressive lenders during the first decade of the new century. Associates First was sold to Citi- group, and Household bought Beneficial Mortgage before it was itself acquired by HSBC in . With the subprime market disrupted, subprime originations totaled  billion in , down from  billion two years earlier.  Over the next few years, however, subprime lending and securitization would more than rebound. THE REGULATORS: “OH, I SEE ” During the s, various federal agencies had taken increasing notice of abusive subprime lending practices. But the regulatory system was not well equipped to re- spond consistently—and on a national basis—to protect borrowers. State regulators, as well as either the Fed or the FDIC, supervised the mortgage practices of state banks. The OCC supervised the national banks. The OTS or state regulators were re- sponsible for the thrifts. Some state regulators also licensed mortgage brokers, a growing portion of the market, but did not supervise them.  CHRG-111shrg54789--188 RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN DODD FROM EDWARD L. YINGLINGQ.1. In assessing the need for and scope of a new Consumer Financial Protection Agency (CFPA), the Committee must conduct an objective evaluation regarding the responsibility of various types of financial services providers for the lending problems that have occurred in recent years. In your written testimony, you identify nonbank lenders as the source for the vast majority of abusive mortgage lending in recent years. Specifically you write that `` . . . the Treasury's plan noted that 94 percent of high cost mortgages were made outside the traditional banking system.'' Your testimony also says that `` . . . it is likely that an even higher percent of the most abusive loans were made outside our sector.'' On the other hand, the Committee heard testimony from Professor McCoy of the University of Connecticut on March 3, 2009, that such an assertion, ``fails to mention that national banks moved aggressively into Alt-A low-documentation and no-documentation loans during the housing boom.'' Professor McCoy cites data indicating that national banks and thrifts issued mortgage loans from 2006-2008 with higher default rates than State-chartered thrifts and banks. Moreover, Assistant Secretary Barr testified on the panel prior to you that ``about one-half of the subprime originations in 2005 and 2006--the shoddy that set off the wave of foreclosures--were by banks and thrifts and their affiliates.'' Is it your view that national banks and thrifts did not play a significant role, either directly or through their subsidiaries, in offering abusive or unsustainable mortgage loans?A.1. Thank you for your question, Mr. Chairman. Certainly, some banks--both national and State chartered--were involved in subprime lending, but the fundamental fact remains that the vast majority of banks in the country never made a toxic subprime loan. These regulated banks did not cause the problem; rather, they are the solution to the economic problem we face. The comment by Professor McCoy you cite in your question is not directed at the Treasury's statistic we referenced, i.e., that a very high percentage of high cost loans were made outside the banking industry. In fact, Professor McCoy refers to a study by the OCC which finds that national banks only accounted for 10 percent of subprime lending in 2006--thus confirming the evidence that the heart of the problem is with nonbanks. Even though attempts have been made to increase Federal regulation of the nonbank sector, the fact remains that in the key areas of examination and enforcement, nonbanks still are not regulated as strictly or robustly as banks. In fact, the GAO recently released a study on Fair Lending (July 2009) which found that the independent mortgage lenders represented ``higher fair lending risks than depository institutions'' yet ``Federal reviews of their activities are limited.'' Furthermore, GAO found that ``[d]epository institution regulators also have established varying policies to help ensure that many lenders not identified through HMDA screening routinely undergo compliance examinations, which may include fair lending components.'' This increased focus on insured depository institutions occurs because the banking agencies ``have large examination staffs and other personnel to carry out fair lending oversight.'' Traditional banks are the survivors of this financial crisis, not the cause. The fly-by-night nonbank mortgage lenders have disappeared as fast as they appeared. As I mentioned in detail in my written statement, the focus of policymaking should be on the core cause of the problem--the unregulated nonbank financial sector--and not end up punishing the very institutions that are most likely to restart our economy. ------ CHRG-111hhrg55814--27 The Chairman," I want to begin and use my 5 minutes essentially to make some points. I know there will be no dearth of questions, Mr. Secretary. So while I will not be asking you any questions, I do not think you will feel ignored by the end of this morning. First, let me address the timing issue. The ideas that we are talking about here really were first formulated for major public debate by former Treasury Secretary Paulson in April of 2008, and they have been under serious discussion since then. Various versions have gone forward. This particular draft, reflecting a lot of conversations a lot of people have had was recently released. We won't get to mark it up until next week, and probably not until Wednesday now, because we have a couple of things to finish up from Tuesday. The argument that we should wait, we are more open to the criticism that we haven't moved quickly enough rather than we are moving too quickly in this. There was a paralysis in the financial system, but that is happily ending. And we don't want to get behind that curve. Second, I want to address the question of Fannie Mae and Freddie Mac. I am astounded by the notion that we have to regulate them. We did. In 2007, as chairman of this committee, I made as our first major order of business adopting the regulation of Fannie Mae and Freddie Mac that the Bush Administration wanted. We did that in the House. We did not get prompt action in the Senate, surprisingly, and when the first stimulus bill came up in January of 2008, I urged that they take our Fannie/Freddie reform, which was approved by the Bush Administration, and make it part of the bill. They weren't able to get agreement with themselves to do it. The Senate did act on our reform in 2008--too late to stall off the crisis--but the fact is that the Fannie and Freddie that exist today are already the ones that were strictly regulated. Now, they have collapsed. They are not acting as they did before. It is important for us going forward to totally revise the functions of the secondary market and whether or not the subsidy should be a part of that. That certainly will be on our agenda next year. But, Fannie and Freddie are not out there doing what they did before: (A) they are subject to regulation; and (B) there is a collapse. It is not a case that they are two unregulated entities working out. I think part of this debate suffers from serious cultural lag with a little partisan motivation. Next, I want to talk about the comparison between this year and last year. In the events leading up to the collapse of last year, there was no regulation of subprime lending, a major contributing factor. We adopted legislation to control subprime lending in the House. It didn't get enacted in the Senate. The Fed is still active. We have that as part of this bill. We will not have the unrestricted, unregulated, irresponsible subprime lending that led in part to the collapse because so many of the securities that fell apart were of that sort. We had no regulation of derivatives. AIG was engaged in wild speculation and these things all interact. You had bad subprime mortgages that shouldn't have been issued. Then you had AIG without any restriction ensuring against the default of these bad subprime mortgages. That again will be corrected by the time we go forward. We will have hedge fund registration, private equity registration, much more data collection than we had before. We, as I said, have Fannie and Freddie playing a very different role. You had an unregulated Fannie and Freddie before this House began the process of regulating for 2007. You had unregulated subprime mortgages. You had unregulated derivatives. All those things are now incorporated, so yes, we want to avoid the ``too-big-to-fail.'' Part of it is that we have restrictions here that will keep these institutions: (A) from getting too big; (B) from being likely to fail; and (C) having fewer consequences when they do. So the comparison of today to before, as I said, is serious cultural lag. We will have severely restricted the kind of irresponsible activity in derivatives in subprime lending; and another piece that I mentioned, in securitization. I myself think one of the biggest causes that happened here was that 30 years ago people who lent money to other people were the people who were expected to be paid back. Once they were able to get rid of all of those loans, the discipline of the lender-borrower relationship diminished, so we are severely--we are going to reform securitization with some risk retention. We are restricting irresponsible subprime loans. We are regulating derivatives. There will be no unregistered, large financial enterprises going forward. We will have the ability to significantly increase capital requirements, more than proportionally, so all of those things are there. Yes, in the absence of all of those, we had greater problems. We are talking about a regime that puts all those in a place and then in the end says, for all of that, somebody fails. We step in and we hammer them pretty hard and we protect the taxpayers. The gentleman from Alabama. " CHRG-110hhrg38392--50 Mr. Bernanke," Well, I think there is a balance. I have discussed this in a number of speeches. I do believe the legitimate subprime lending in particular helps expand homeownership. It helps expand access to credit. At the same time, it is very important that we protect those who are possibly subject to abusive or to fraudulent lending, so we have to draw a fine line. We have to make sure we find ways to prevent the bad actors, the abusive lending, while preserving this market, which is an important market, both for the sake of those people who would like to borrow and to become homeowners, and also for the broad sake of our economy in maintaining the demand for housing. So it is really a case-by-case issue, but it is very important to try to walk that fine line between protecting consumers adequately by making sure that we do not shut down what is, I think, essentially, a valuable market. " fcic_final_report_full--551 Session : Firm Structure and Risk Management Anil Kashyap, Edward Eagle Brown Professor of Economics and Finance and Richard N. Rosett Faculty Fellow, University of Chicago Session : Shadow Banking Gary Gorton, Professor of Finance, School of Management, Yale University Public Hearing on Subprime Lending and Securitization and Government-Spon- sored Enterprises (GSEs), Rayburn House Office Building, Room , Washington, DC, Day , April ,  Session : The Federal Reserve Alan Greenspan, Former Chairman, Board of Governors of the Federal Reserve System Session : Subprime Origination and Securitization Richard Bitner, Managing Director of Housingwire.com; Author, Confessions of a Subprime Lender: An Insider’s Tale of Greed, Fraud, and Ignorance Richard Bowen, Former Senior Vice President and Business Chief Underwriter, CitiMortgage, Inc. Patricia Lindsay, Former Vice President, Corporate Risk, New Century Financial Corporation Susan Mills, Managing Director of Mortgage Finance, Citi Markets & Banking, Global Securi- tized Markets Session : Citigroup Subprime-Related Structured Products and Risk Management Murray C. Barnes, Former Managing Director, Independent Risk, Citigroup, Inc. David C. Bushnell, Former Chief Risk Officer, Citigroup, Inc. Nestor Dominguez, Former Co-head, Global Collateralized Debt Obligations, Citi Markets & Banking, Global Structured Credit Products Thomas G. Maheras, Former Co-chief Executive Officer, Citi Markets & Banking Public Hearing on Subprime Lending and Securitization and Government-Spon- sored Enterprises (GSEs), Rayburn House Office Building, Room , Washington, DC, Day , April ,  Session : Citigroup Senior Management Charles O. Prince, Former Chairman of the Board and Chief Executive Officer, Citigroup, Inc. Robert Rubin, Former Chairman of the Executive Committee of the Board of Directors, Citi- group, Inc. Session : Office of the Comptroller of the Currency John C. Dugan, Comptroller, Office of the Comptroller of the Currency John D. Hawke Jr., Former Comptroller, Office of the Comptroller of the Currency Public Hearing on Subprime Lending and Securitization and Government-Spon- sored Enterprises (GSEs), Rayburn House Office building, Room , Washington, DC, Day , April ,  Session : Fannie Mae Robert J. Levin, Former Executive Vice President and Chief Business Officer, Fannie Mae Daniel H. Mudd, Former President and Chief Executive Officer, Fannie Mae Session : Office of Federal Housing Enterprise Oversight Armando Falcon Jr., Former Director, Office of Federal Housing Enterprise Oversight James Lockhart, Former Director, Office of Federal Housing Enterprise Oversight CHRG-110hhrg44901--42 Mr. Bernanke," Well, at the current moment, as we all know, the subprime market is pretty moribund, and so these rules are important but they are not having much impact on the market. What we hope to do is have rules in place so that when the market comes back, as it some day will, that the lending will be done in a way that is prudent and also supportive of homeownership among people with a more modest means. That is our intention, and we have followed the regulatory principles in order to do that. " FinancialCrisisReport--77 Effective implementation of the High Risk Lending Strategy also required robust risk management. But while WaMu was incurring significantly more credit risk than it had in the past, risk managers were marginalized, undermined, and subordinated to WaMu’s business units. As a result, when credit risk management was most needed, WaMu found itself lacking in effective risk management and oversight. D. Shoddy Lending Practices At the same time they increased their higher risk lending, WaMu and Long Beach engaged in a host of poor lending practices that produced billions of dollars in poor quality loans. Those practices included offering high risk borrowers large loans; steering borrowers to higher risk loans; accepting loan applications without verifying the borrower’s income; using loans with low teaser rates to entice borrowers to take out larger loans; promoting negative amortization loans which led to many borrowers increasing rather than paying down their debt over time; and authorizing loans with multiple layers of risk. WaMu and Long Beach also exercised weak oversight over their loan personnel and third party mortgage brokers, and tolerated the issuance of loans with fraudulent or erroneous borrower information. (1) Long Beach Throughout the period reviewed by the Subcommittee, from 2004 until its demise in September 2007, Long Beach was plagued with problems. Long Beach was one of the largest subprime lenders in the United States, 206 but it did not have any of its own loan officers. Long Beach operated exclusively as a “wholesale lender,” meaning all of the loans it issued were obtained from third party mortgage brokers who had brought loans to the company to be financed. Long Beach “account executives” solicited and originated the mortgages that were initiated by mortgage brokers working directly with borrowers. Long Beach account executives were paid according to the volume of loans they originated, with little heed paid to loan quality. Throughout the period reviewed by the Subcommittee, Long Beach’s subprime home loans and mortgage backed securities were among the worst performing in the subprime industry. Its loans repeatedly experienced early payment defaults, its securities had among the highest delinquencies in the market, and its unexpected losses and repurchase demands damaged its parent corporation’s financial results. Internal documentation from WaMu shows that senior management at the bank was fully aware of Long Beach’s shoddy lending practices, but failed to correct them. 2003 Halt in Securitizations. For a brief period in 2003, Long Beach was required by WaMu lawyers to stop all securitizations until significant performance problems were remedied. While the problems were addressed and securitizations later resumed, many of the issues returned and lingered for several years. 206 See 1/2007 Washington Mutual Presentation, “Subprime Mortgage Program,” Hearing Exhibit 4/13-5 (slide showing Long Beach Annual Origination Volume). CHRG-111shrg57319--292 Mr. Schneider," Senator, I think we were all very concerned about it. We tightened credit standards in our subprime space significantly in 2006 when we started to see the challenges, and then we tightened credit standards in our prime space, in our Option ARM book, and on, frankly, all lending types throughout 2007 as we experienced challenges with the performance. Senator Kaufman. Did you have any reason to believe that WaMu's internal controls were insufficient to deter fraud in these products? " CHRG-111shrg49488--105 Mr. Clark," Yes. Although when I started my first house, I bought the insurance and put down less than 20 percent. But you can do it. But, again, we would not lend to that person unless we were sure they were going to pay us back because we are responsible for the collections, we are responsible for managing that, and it is really our customer relationship, which is how we regard it. Senator Collins. I think it is fascinating that homeownership levels are actually higher in Canada than in the United States, because the justification for all these policies that encouraged the subprime mortgage market was to increase homeownership. And, in fact, it has caused a lot of people to lose homes that they could not afford in the first place, and the Canadian experience is very instructive. Mr. Green, last question to you. In the United Kingdom, what are the lending policies? Are they more similar to the Canadian practices or to the American practices? " CHRG-110shrg50415--2 Chairman Dodd," The Committee will come to order. Let me welcome everyone to the hearing this morning. I want to welcome my colleagues who are here. Senator Crapo, I welcome you and thank you very much for being here this morning. Senator Akaka, Senator, how are you this morning? Good to see you as well. And, Sherrod, thanks for being here this morning. Let me thank our witnesses as well. What I am going to do, if we can here this morning, is to make an opening statement, turn to my colleagues for any opening comments they would like to have this morning, and then we will get to our witnesses. Any and all statements or supporting documents that you would like to have included in the record, we will certainly make it a part of the record. Just so people can be aware, my intention over the coming weeks is to have a series of hearings and meetings--some of them more informal, some of them more formal--to do what we are doing today, obviously, to go back and examine how we arrived at the situation we are in today; but just as importantly--in fact, I would argue even more importantly--what do we need to do from here forward so as to minimize these problems from ever occurring again. Second, we want to watch and we are going to monitor very carefully, of course, the rescue plan that was adopted several weeks ago. As I think all of you are aware, there are provisions in that bill that literally require almost hourly reporting, every 48 hours or so on various transactions that occur, and we want to watch very carefully following the auditing process that we wrote into the legislation with the GAO and the Inspector General as well. And so the Committee will be working at that almost on a daily basis. Then, third, the issue of financial regulatory reform. Secretary Paulson a number of weeks ago now, months ago, submitted a proposal on regulatory financial reform, and we never got to having the hearings we wanted to have on that, frankly, over the summer because of events with the foreclosure crisis and more recently with the broader economic crisis. But I would like over these coming weeks between now and the first of the year to have this Committee, both formally and informally, meet with knowledgeable people--and there are some at this very panel who could be of help in this regard--as to what the architecture and structures of our financial services system ought to look like in light of the changes that have obviously occurred, updating a system that in many instances actually dates back more than 80 years. The world has obviously changed dramatically, as we are all painfully aware, and having an architecture and a structure that reflects the world we're in today is going to be a critical challenge. This is not an easy task. It will require a lot of thought, and careful thought, about how you do this. But I thought it would be worthwhile to begin that process, and then with a new administration arriving on January 20th, to already have sort of an up-and-running effort that we could then work with the new administration, be it a McCain administration or an Obama administration, to move that process along rather than just wait until after January 20th to begin a process that I think will take some time, quite candidly, given the complexity involved, going back to the 1933 act and other provisions. And as I said, several of you on this panel here have a wealth of knowledge about those laws and how they work or do not work. So I may very well be calling on some of you to participate, either informally or more formally, in that conversation and discussion. Today's hearing is entitled ``Turmoil in the U.S. Credit Markets: The Genesis of the Current Economic Crisis,'' and I want to share some opening comments if I can on this and, again, turn to Senator Crapo and then to others to share some thoughts as well, if they care to, before we turn to our witnesses. This morning the Committee examines the genesis, as I said a moment ago, of the crisis in our credit markets. Such an examination is in keeping with this Committee's extensive work over the past 21 months to understand the implosion of the mortgage markets and how that implosion has infected the wider economy. All told, this Committee has held 73 hearings and meetings since January of 2007 when I first became the Chairman of this Committee. No less than 31 of those hearings have addressed in one form or another the origins and nature of the current market turmoil. Today's meeting is essential to understand not only how we got here, but just as importantly--and I would argue even more importantly--where we as a nation need to go. Only if we undertake a thorough and complete postmortem examination of the corpus of this damaged economy will we have any chance to create a world where the mistakes of the past are less likely to be repeated and where all Americans will have a fair chance at achieving security and prosperity. It is by now beyond dispute that the current conflagration threatening our economy started several years ago in what was then a relatively discreet corner of the credit markets known as subprime mortgage lending. The Chairman of the Federal Reserve, Ben Bernanke, and Treasury Secretary Hank Paulson and many other respected individuals have all agreed on that fact. Mortgage market participants, from brokers to lenders to investment banks to credit rating agencies formed an unholy alliance conceived in greed and dedicated to exploiting millions of unsuspecting, hard-working American families seeking to own or refinance their homes. Relying on two faulty assumptions that housing prices would continue to rise maybe forever and that new financial instruments would allow them to shift the risk to others, these market participants flouted the fundamentals of prudent lending. Certainly some borrowers themselves sought unjust enrichment in the process. They deserve neither our sympathy nor our assistance. But the millions of American homebuyers who today face foreclosure and financial ruination, the vast majority were victims, not perpetrators, of what will be remembered as the financial crime of the century. Indeed, the misdeeds of a few have robbed nearly every American. Whether they suffer from the loss of a home, retirement security, a job, or access to credit, Americans are reeling from the credit crisis. Sadly, in my view, this crisis was entirely preventable. It is clear to me that greed and avarice overcame sound judgment in the marketplace, causing some very smart people to act in very stupid ways. But what makes this scandal different from others is the abject failure of regulators to adequately police the markets. Regulators exist to check the tendency to excess of the regulated. They are supposed to step in to maintain transparency, competition, and fairness in our economy. In this case, though, our Nation's financial regulators willfully ignored abuses taking place on their beat, choosing to embrace the same faulty assumptions that fueled the excessive risk taking in the marketplace. Instead of checking the tendency to excess, they permitted and in some ways even encouraged it. They abandoned sensible and appropriate regulation and supervision. No one can say that the Nation's financial regulators were not aware of the threats posed by reckless subprime lending to homeowners, communities, and, indeed, the entire country. That threat had already been recognized by Congress. In fact, the Congress had already taken strong steps to neutralize it. In 1994, 14 years ago, then President Clinton signed into law the Home Owners and Equity Protection Act. This law required--let me repeat, required, mandated--the Federal Reserve Board as the Nation's chief financial regulator, and I quote, ``to prohibit unfair, deceptive, and excessive acts and practices in the mortgage lending market.'' Despite this direct requirement and mandate, the Federal Reserve Board under its previous leadership decided to simply ignore the law--not for days, not for weeks, not for months, but for years. Indeed, instead of enforcing the law by simply imposing the common-sense requirements that a mortgage loan be based on a borrower's ability to repay it, the Fed leadership actually encouraged riskier mortgage products to be introduced into the marketplace. And the public information on this point is massive. The Fed's defiance of the law and encouragement of risky lending occurred even as the Fed's own officials warned that poor underwriting in the subprime mortgage market threatened homeownership and wealth accumulation. And it was incompatible with safe and sound lending practices. The Fed's defiance of the law and encouragement of risky lending occurred despite warnings issued by Members of Congress, I would add, including some of us who served on this Committee, that occurred despite warnings from respected economists and others that the Fed and its sister agencies were playing with fire. It was only this year, 14 years after the enactment of the 1994 law, that the Fed finally published regulations to enforce the bill's provisions, the needed protections. By that time, of course, the proverbial horse was out of the barn. Trillions of dollars in subprime mortgages had already been brokered, lent, securitized, and blessed with unrealistic credit ratings. Millions of American homeowners faced foreclosure, nearly 10,000 a day in our country. I spoke to a housing group from my State yesterday. There are 1,000 legal foreclosure proceedings every week in the State of Connecticut, and we have a foreclosure rate that is lower than the national average. A thousand cases a week in the courts in Connecticut in foreclosures. Tens of millions more are watching as their most valuable asset--their homes--decline in value. And the entire global financial marketplace has been polluted by toxic financial instruments backed by these subprime mortgages, which has caused a financial meltdown of unprecedented proportions and laid low our economy. The evidence is overwhelming. This crisis is a direct consequence of years of regulatory failures by government officials. They ignored the law. They ignored the risks to homeowners. And they ignored the harm done to our economy. Despite this clear and unimpeachable evidence, there are still some who point fingers of blame to the discretion of Fannie Mae, Freddie Mac, and the Community Reinvestment Act. These critics are loud and they are shrill. They are also very wrong. It is no coincidence that they are some of the very same sources who were the greatest cheerleaders for the very deregulatory policies that created the financial crisis. Let's look at the facts, or as Pat Moynihan used to say, ``Everyone's entitled to their own opinions, but not their own facts.'' On Fannie Mae and Freddie Mac, the wrong-headed critics say Fannie and Freddie lit the match of the subprime crisis. In fact, Fannie and Freddie lagged in the subprime market. They did not lead it. Between 2004 and 2006, the height of the subprime lending boom, Fannie and Freddie's share of subprime securitizations plummeted from 48 percent to 24 percent. The dominant players were not Fannie and Freddie, but the Wall Street firms and their other private sector partners: the mortgage brokers and the unregulated lenders. In fact, in 2006, the height of the subprime boom, more than 84 percent of subprime mortgages were issued by private lenders. Private lenders. One of the reasons Fannie and Freddie lagged is because they were subject to tougher underwriting standards than those rogue private unregulated lenders. So it was the private sector not the Government or Government-sponsored enterprises that was behind the soaring subprime lending at the core of this crisis. At the risk of stating the obvious, it is worth noting that at the height of the housing boom, the President and his supporters in and out of Government did nothing to criticize or stop predatory lending. They did nothing to support, much less advance, the legislation that some of us were working on to move in the Congress that would have cracked down on predatory lending. Regarding the Community Reinvestment Act, the critics are also speaking in ignorance of the facts. The overwhelming majority of predatory subprime loans were made by lenders and brokers who were not, I repeat were not, subject to CRA. In 2006, for example, 24 of the top 25 subprime lenders were exempt--exempt--from the CRA. In fact, CRA lending is in no way responsible for the subprime crisis. CRA has been the law of the land for three decades. If it were responsible for creating a crisis, this crisis would have occurred decades ago. The late Ned Gramlich, the former Fed Governor, put it well when he said that two-thirds of CRA loans did not have interest rates high enough to be considered subprime. Rather than being risky, lenders have found CRA loans to have low default rates. According to former Governor Gramlich, ``Banks that have participated in CRA lending have found that this new lending is good business.'' So people are entitled to their own opinions, as Pat Moynihan would say, but they are not entitled to their own facts. And Ronald Reagan once said, ``Facts are stubborn things.'' Indeed, they are, as they should be in this regard. Let me also say that I have learned over the years from this debacle that the American consumers, when all is said and done, remain the backbone of the American economy and deserve far better than they have been getting from too many people. The lessons, obviously, of this crisis are already becoming clear to us. One of the central lessons is that never again should we permit the kind of systematic regulatory failures that allowed reckless lending practices to mushroom in the global credit crisis. Anther is that never again should we allow Federal financial regulators to treat consumer protection as a nuisance or of secondary importance to safety and soundness regulation. If we have learned one thing from all of this, it is, as I said a moment ago, the American consumer, when all is said and done, remains the backbone of the American economy, that consumer protection and safe and sound operation of financial institutions are inextricably linked. I look forward to hearing from our distinguished panel of witnesses and from my colleagues this morning as we go back and look at what occurred here and the ideas that can be put forward as to how do we minimize these problems from ever occurring again. Again, I thank the witnesses very much and my colleagues for interrupting their time back in their respective States and districts to be here this morning to participate in the hearing. With that, Senator Crapo. CHRG-111shrg57319--99 Mr. Vanasek," Yes. I used to use a phrase. It was a bit of humor or attempted humor. I used to say the world was a very dark and ugly place in reference to subprime loans. I cautioned about subprime loans consistently. The problem we had at Washington Mutual was the line managers and people like myself, members of the Executive Committee, if we were in conflict--let us suppose I was in conflict with the head of mortgage lending. We had no way to resolve that because the chairman would not engage in conflict resolution. He was very conflict-averse. So it was left to the two of us to work it out ourselves. Sometimes that implied a bit of compromise on my part to allow, for example, a small amount of some particular underwriting to be done, even though I didn't particularly favor it. In the context of a $300 million institution, I tried to limit it to a point where it wouldn't be terribly effective, but still allowed the line unit to compete. But the absence of pure conflict resolution, where I might say, I don't want to do any more subprime mortgages versus what the chairman wanted to do or the head of mortgage wanted to do, there was no way to resolve it. Senator Coburn. At any time in your thinking prior to your retirement, did you see some of the handwriting on the wall for the direction WaMu was going? " FinancialCrisisReport--57 From 1999 to 2006, Long Beach operated as a subsidiary of Washington Mutual Inc., the parent of Washington Mutual Bank. Long Beach’s loans repeatedly experienced early payment defaults, high delinquency rates, and losses, and its securitizations were among the worst performing in the market. 119 In 2006, in a bid to strengthen Long Beach’s performance, WaMu received permission from its regulator, OTS, to purchase the company from its parent and make it a wholly owned subsidiary of the bank. WaMu installed new management, required the head of Long Beach to report to its Home Loans Division President, and promised OTS that it would improve Long Beach. When Long Beach’s loans continued to perform poorly, in June 2007, WaMu shut down Long Beach as a separate entity, and took over its subprime lending operations, rebranding Long Beach as its “Wholesale Specialty Lending” channel. WaMu continued to issue and securitize subprime loans. After the subprime market essentially shut down a few months later in September 2007, WaMu ended all of its subprime lending. From 2000 to 2007, Long Beach and WaMu together securitized tens of billions of dollars in subprime loans, creating mortgage backed securities that frequently received AAA or other investment grade credit ratings. 120 Although AAA securities are supposed to be very safe investments with low default rates of one to two percent, of the 75 Long Beach mortgage backed security tranches rated AAA by Standard and Poor’s in 2006, all 75 have been downgraded to junk status, defaulted, or been withdrawn. 121 In most of the 2006 Long Beach securitizations, the underlying loans have delinquency rates of 50% or more. 122 (4) Securitization Washington Mutual depended on the securitization process to generate profit, manage risk, and obtain capital to originate new loans. Washington Mutual and Long Beach sold or securitized most of the subprime home loans they acquired. Initially, Washington Mutual kept most of its Option ARMs in its proprietary investment portfolio, but eventually began selling or securitizing those loans as well. From 2000 to 2007, Washington Mutual and Long Beach 118 See April 13, 2010 Subcommittee Hearing at 50. 119 See 4/14/2005 email exchange between OTS examiners, “Fitch – LBMC Review,” Hearing Exhibit 4/13-8a (discussing findings by Fitch, a credit rating agency, highlighting poor performance of Long Beach securities). 120 “Securitizations of Washington Mutual Subprime Home Loans,” chart prepared by the Subcommittee, Hearing Exhibit 4/13-1c. 121 See Standard and Poor’s data at www.globalcreditportal.com. 122 See, e.g., wamusecurities.com (subscription website maintained by JPMorgan Chase with data on Long Beach and WaMu mortgage backed securities showing, as of March 2011, delinquency rates for particular mortgage backed securities, including LBMLT 2006-1 – 58.44%; LBMLT 2006-6 – 60.06%; and LBMLT 2005-11 – 54.32%). securitized at least $77 billion in subprime home loans. Washington Mutual sold or securitized at least $115 billion of Option ARM loans, as well as billions more of other types of high risk loans, including hybrid adjustable rate mortgages, Alt A, and home equity loans. CHRG-109shrg30354--46 Chairman Bernanke," Senator, so far the credit quality looks to be good. We see that mortgages are, for the most part, fixed-rate despite the fact that we have seen more nontraditional mortgages and ARM's issued recently. We only see about 10 percent of all mortgages being repriced during 2006. Because of these rapid increases in house prices, a lot of homeowners do have a lot of equity. And, therefore, they are able to make the payments on their homes. So we do not see any near-term significant increase in mortgage delinquencies or credit risk. The one area that we are watching very carefully is low and moderate-income subprime mortgage lending. That area, more than the broader market, has seen adjustable-rate mortgage lending. And therefore, there is more susceptibility, I think, there to increases in interest rates affecting the monthly cost of mortgages. " CHRG-110hhrg44901--33 Mr. Manzullo," Thank you, Mr. Chairman. Chairman Bernanke, earlier this week you took an action to crack down on a range of shady lending practices that have hurt the Nation's riskiest subprime borrowers and also have caused a tremendous amount of economic distress in this country. Among other things, the Fed issued regulations that would prohibit lenders from lending without considering the borrower's ability to repay and also would require creditors to verify their income and assets at the time of the borrowing. These are pretty basic. Although hindsight is a 20/20 issue, and it is easy to sit here and say the Fed should have done this a long time ago, the evidence of this housing bubble has been going on for some time. And my question is, what took the Fed so long to act? And then the regulation you are coming out with is not going to be effective until October 1st of next year. Those are the issues just involving in the subprime borrowers. As to the regular borrowers, you came up with another landmark regulation that says, whenever a borrower gives a check to the bank that the bank has to credit it that day to the borrower's account. I mean, this shows knowledge of some very basic problems that have been wrong in the housing industry. But what took the Fed so long to act? And why wait 15 months before the regulations go into effect? " CHRG-111shrg57319--466 Mr. Rotella," Senator, this report labeled ``Wholesale Specialty Lending'' is about the subprime business. By August 2007, we had shut that business down. This audit report is reflective of the actions that I took, which were to relieve management of their duties, take the volume down, and ultimately shut this business down by the time this was issued. Senator Levin. But you said you first became aware of fraud in 2008 and this shows significant fraud in 2007. " fcic_final_report_full--508 Freddie were major buyers of NTMs well before Wall Street firms and the subprime lenders who came to dominate the business entered the subprime PMBS market in any significant way. Moreover, the GSEs did not (indeed, could not) appreciably increase their purchases of NTMs during the years 2005 and 2006, when they had lost market share to the real PMBS issuers, Countrywide and other subprime lenders. The following discussion addresses each of the claims about the GSEs’ motives in turn, and in the end will show that the only plausible motive for their actions was their effort to comply with HUD’s AH goals. Did the GSEs acquire NTMs to “compete for market share” with Wall Street or others? The idea that Fannie and Freddie were newcomers to the purchase of NTMs between 2004 and 2007, and reduced their underwriting standards so they could compete for market share with Wall Street or others, is wrong. As shown in Table 7, the GSEs’ acquisition of subprime loans and other NTMs began in the 1990s, when they first became subject to the AH goals. Research shows that, in contravention of their earlier standards, the GSEs began to acquire high loan-to-value (LTV) mortgages in 1994, shortly after the enactment of the GSE Act and the imposition of the AH goals, and by 2001—before the PMBS market reached $100 billion in annual issuances—the GSEs had already acquired at least $700 billion in NTMs, including over $400 billion in subprime loans. 104 Far from following Wall Street or anyone else into subprime loans between 2004 and 2007, the GSEs had become the largest buyers of subprime and other NTMs many years before the PMBS market began to develop. Given these facts, it would be more accurate to say that Wall Street and the subprime lenders who later came to dominate the PMBS market followed the GSEs into subprime lending. Table 7 does not show any significant increase in the GSEs’ acquisition of NTMs from 2004 to 2007, and the amount of subprime PMBS they acquired during this period actually decreased. This is consistent with the fact—outlined below—that the GSEs did not make any special effort to compete for market share during these years. 104 Pinto, “Government Housing Policies in the Lead-up to the Financial Crisis: A Forensic Study,” Chart 52, p.148, http://www.aei.org/docLib/Government-Housing-Policies-Financial-Crisis-Pinto-102110.pdf. CHRG-110shrg50415--24 Mr. Morial," Thank you very much. It is almost afternoon, but good morning. Let me, first of all, say that I am proud to be here on behalf of the National Urban League, its 100 affiliates who exist in all of the States and cities represented by Members of the Committee. I am also here representing the Black Leadership Forum, an umbrella organization of some 30-plus African American-focused organizations from coast to coast. I serve this year as its Chair. I come today to set the record straight about what I call the ``financial weapon of mass deception,'' the ugly, insidious, and concerted effort to blame minority borrowers for the Nation's current economic straits. This financial weapon of mass deception, as false and outrageous as it is, has taken hold, thanks to constant and organized repetition and dissemination through the media, political circles, newspapers, and the Internet. It is not a harmless lie. It is a stretching of the truth for fleeting political advantage. It is an enormously damaging and far-reaching smear designed to shift the blame for this crisis from Wall Street and Washington, where it belongs, onto middle-class families on Main Streets throughout this Nation. For years, the National Urban League and others have raised the flag and urged Congress and the administration to address the predatory lending practices that were plaguing our communities. For example, in March of 2007, I issued the Homebuyers Bill of Rights in which I called upon the Government to clamp down on predatory lending and other practices that were undermining the minority homebuyer and homebuyers of all races. Unfortunately, not only did our call go unheeded, but also we spent time right here in this Congress fighting back efforts to preempt the ability of States to regulate predatory practices. Now disaster has struck. Many of those who caused it are trying now to blame communities of color and urban communities and those measures that helped clear the way for qualified people to purchase homes--most notably the Community Reinvestment Act. In fact, it was the failure of regulatory policy and oversight that led to this debacle that has been completely expressed by every one of the three witnesses that have gone before me. But I want for the record to share with you some plain and simple facts, stubborn facts, Senator Dodd. It was Wall Street investors--not Fannie Mae and Freddie Mac--who were the major purchasers/investors of subprime loans between 2004 and 2007, and we have a chart that demonstrates this very clearly that we will make a part of the record. No. 2, while minorities and low-income borrowers received a disproportionate share of subprime loans, the vast majority of subprime loans--the vast majority--went to white middle- and upper-income borrowers. The true racial dimensions of the housing crisis have been reported in places like the New York Times, and that is expressed by another chart. Third, African Americans and Latinos were given subprime loans disproportionately compared to whites, according to ComplianceTech, a leading expert in lending to financial services companies, researcher to financial services companies. Also, African American borrowers were more than twice as likely to be scared into a subprime loan as white borrowers. In each year from 2004 to 2007, non-Hispanic whites had more subprime rate loans than all minorities combined. In 2007, 37 percent of African American borrowers were given subprime loans, versus 14.21 percent of whites, according to ComplianceTech. More than 53 percent of African American borrowers were given subprime loans compared versus 14 percent of whites, according to ComplianceTech. The vast majority of subprime rate loans were originated in largely white census tracts. The volume of subprime rate loans made to non-Hispanic whites dwarfs the volume of subprime rate loans made to minorities. In each year, the white proportion of subprime rate loans was lower than all minorities, except Asians. I want to point out that while the majority of subprime loans did go to white Americans, African Americans and Hispanics were disproportionately steered into subprime loans. At the end of the day, this is a problem that affects Americans of all races, and I urge this Committee to strongly and publicly not only affirm that but to challenge the false assumptions being peddled by the agents of mass deception. Upper-income borrowers--upper-income borrowers--had the highest share of subprime rate loans during each year except 2004, where middle-income borrowers had the highest share. The misconception is that lending to low- and moderate-income Latinos and African Americans caused this problem. The stubborn facts, not hidden but in the Mortgage Disclosure Act, clearly affirm this point. It is clear that a large number of people who ended up with subprime loans could have qualified for a prime loan, and the incentive system set up for brokers and originators which incentivized steering people into higher-rate loans was one of the causes of this. Non-CRA, as the Treasurer mentioned, financial services companies--non-CRA financial services companies were the major originators of subprime loans between 2004 and 2007. These facts are unequivocal. They are clear. And they are indisputable. There have been commentators, some who hold a great deal of respect, who write and broadcast, some members of the other side of this Congress, who for some reason have peddled this story of mass deception as though they were reading off a set of political talking points. As we have seen in numerous Internet blogs, highly trafficked sites, this baseless blame game has turned into vicious attacks on the Internet directed at African Americans, Latinos, Jews, gays, and lesbians. In the last few weeks, I have undertaken an aggressive campaign directed at the Nation's financial leaders to dispel this myth. I have written to Treasury Secretary Paulson and Federal Reserve Chairman Bernanke and asked that they publicly refute claims by these pundits and politicians that most of the defaulted subprime loans at the root cause of the crisis were made to African Americans, Hispanics, and other so-called ``unproductive borrowers.'' On the basis of hearsay, on the basis of rumors, on the basis of statements made by respected commentators, the seeds of division around this financial crisis are being sown in this Nation. History tells us too many times that the consequences of singling out only certain segments of the population as culprits for the Nation's woes for us not to do all within our power to stop these attacks, to end this smear campaign in its tracks, requires--and I would ask and urge that this Committee join us in the strongest possible terms available to stand up to this lie, to stand up to these agents of mass deception, to stop the waste of discussion and time being spent on blaming victims and force, as this Committee seeks to do, a healthy debate on what must be done to curb too much Wall Street greed and too little Washington oversight. This hearing is an important start toward that. So I urge you to stay focused and take strong and positive steps to strengthen our communities and this Nation's financial foundation through regulatory reform. Finally, with respect to regulation, I want to encourage the Congress not to leave it to the rulemaking authority of the Federal Reserve to regulate anti-predatory lending. I urge this Congress, I urge this Committee to take the lead, as you suggested, Senator Dodd, to codify the boundaries going forward for the type of loan products that financial services companies are going to be able to offer to the American people. No. 2, an area of failed oversight and regulation not mentioned thus far has been the failure to enforce fair lending laws. Both the Department of Justice and the Department of Housing and Urban Development ought to be called to account, ought to be called to be transparent, on where they were as this crisis has fomented, because they, too, have a very important responsibility in enforcing laws on the books. No. 3, the Community Reinvestment Act is a very important vehicle that has yielded great benefits for this Nation. The idea that it has been assigned responsibility and blame for this crisis is so far-fetched, so imaginary as to almost not merit a response. But we know that there are those who for years have held it close on their legislative agenda to try to water down, to try to eliminate, to try to undercut the Community Reinvestment Act. I would suggest that at a time when the taxpayers of this Nation have been asked to take an unprecedented move--that is, to authorize the Treasury to invest taxpayer dollars in the preferred stock of financial services corporations--then the direction that the Congress should take in exchange and in return is not a weakening of the Community Reinvestment Act, but a strengthening of the Community Reinvestment Act and its enforcement mechanisms. So, Senator Dodd, I thank you for your leadership. I urge the Committee to take a very strong stand, and I thank you for your time today. " fcic_final_report_full--473 Subprime mortgage loans, whether held in our portfolio or backing Fannie Mae MBS, represented less than 1% of our single-family business volume in each of 2007, 2006 and 2005. 41 [emphasis supplied] We estimate that subprime mortgage loans held in our portfolio or subprime mortgage loans backing Fannie Mae MBS, excluding re-securitized private label mortgage related securities backed by subprime mortgage loans, represented approximately 0.3% of our single-family mortgage credit book of business as of December 31, 2007, compared with 0.2% and 0.1% as of December 31, 2006 and 2005, respectively. 42 [emphasis supplied] These statements could have lulled market participants and others—including 37 Offi ce of Comptroller of the Currency, Federal Reserve, Federal Deposit Insurance Corporation, and Offi ce of Thrift Supervision advised in its “Expanded Guidance for Subprime Lending Programs”, published in 2001, http://www.federalreserve.gov/Boarddocs/SRletters/2001/sr0104a1.pdf that “the term ‘subprime’ refers to the credit characteristics of individual borrowers. Subprime borrowers typically have weakened credit histories that include payment delinquencies and possibly more severe problems such as charge-offs, judgments, and bankruptcies.” A FICO score of 660 or below was evidence of “relatively high default probability.” 38 39 40 41 42 Derived from Table 12. Fannie Mae, 2005 10-K report, filed May 2, 2007. Fannie Mae, 2007 Form 10K, pp. 129 and 155. Fannie Mae, 2007 Form 10K, p.129. Fannie Mae, 2007 Form 10K, p.130. the Lehman analysts—into believing that Fannie and Freddie did not hold or had not guaranteed substantial numbers of high risk loans, and thus that there were many fewer such loans in the financial system than in fact existed. fcic_final_report_full--528 As the first member of the MBA to sign, Countrywide probably realized that there were political advantages in being seen as assisting low-income mortgage lending, and it became one of a relatively small group of subprime lenders who were to prosper enormously as Fannie and Freddie began to look for sources of the subprime loans that would enable them to meet the AH goals. By 1998, there were 117 MBA signatories to HUD’s Best Practices Initiative, which was described as follows: The companies and associations that sign “Best Practices” Agreements not only commit to meeting the responsibilities under the Fair Housing Act, but also make a concerted effort to exceed those requirements. In general, the signatories agree to administer a review process for loan applications to ensure that all applicants have every opportunity to qualify for a mortgage. They also assent to making loans of any size so that all borrowers may be served and to provide information on all loan programs for which an applicant qualifies…. The results of the initiative are promising. As lenders discover new, untapped markets, their minority and low-income loans applications and originations have risen. Consequently, the homeownership rate for low-income and minority groups has increased throughout the nation. 146 Countrywide was by far the most important participant in the HUD program. Under that program, it made a series of multi-billion dollar commitments, culminating in a “trillion dollar commitment” to lend to minority and low income 144 HUD’s Best Practices Initiative was described this way by HUD: “Since 1994, HUD has signed Fair Lending Best Practices (FLBP) Agreements with lenders across the nation that are individually tailored to public-private partnerships that are considered on the leading edge. The Agreements not only offer an opportunity to increase low-income and minority lending but they incorporate fair housing and equal opportunity principles into mortgage lending standards. These banks and mortgage lenders, as represented by Countrywide Home Loans, Inc., serve as industry leaders in their communities by demonstrating a commitment to affi rmatively further fair lending.” Available at: http://www.hud.gov/ local/hi/working/nlwfal2001.cfm. 145 Steve Cocheo, “Fair-Lending Pressure Builds”, ABA Banking Journal , vol. 86, 1994, http://www. questia.com/googleScholar.qst?docId=5001707340. 146 HUD, “Building Communities and New Markets for the 21st Century,” FY 1998 Report , p.75, http:// www.huduser.org/publications/polleg/98con/NewMarkets.pdf. families, which in part it fulfilled by selling subprime and other NTMs to Fannie and Freddie. In a 2000 report, the Fannie Mae Foundation noted: “FHA loans constituted the largest share of Countrywide’s activity, until Fannie Mae and Freddie Mac began accepting loans with higher LTVs and greater underwriting flexibilities.” 147 In late 2007, a few months before its rescue by Bank of America, Countrywide reported that it had made $789 billion in mortgage loans toward its trillion dollar commitment. 148 6. The Community Reinvestment Act FinancialCrisisInquiry--201 GORDON: Correct. CHAIRMAN ANGELIDES: OK. And you have data for that? GORDON: Yes. CHAIRMAN ANGELIDES: Anecdotal or—or based on... GORDON: No, real data. CHAIRMAN ANGELIDES: And have you provided the underlying data to us? GORDON: I—I can only say I assume I dropped A footnote but if I didn’t, I will get it to you. CHAIRMAN ANGELIDES: OK. But we certainly would like to see that. All right. And I guess I would ask you to what extent did you see these products migrate out from, you know, a narrow band of the population to a larger band? GORDON: Well, I actually want to divide things into a couple of different categories, so we don’t conflate different things. In terms of lending to people with lower credit scores, which is sometimes what people call subprime lending, that is something that our organization does. And there are ways to do that safely and sustainably for the people involved. fcic_final_report_full--92 In June , two years after HOEPA took effect, the Fed held the first set of pub- lic hearings required under the act. The venues were Los Angeles, Atlanta, and Wash- ington, D.C. Consumer advocates reported abuses by home equity lenders. A report summarizing the hearings, jointly issued with the Department of Housing and Urban Development and released in July , said that mortgage lenders acknowledged that some abuses existed, blamed some of these on mortgage brokers, and suggested that the increasing securitization of subprime mortgages was likely to limit the op- portunity for widespread abuses. The report stated, “Creditors that package and se- curitize their home equity loans must comply with a series of representations and warranties. These include creditors’ representations that they have complied with strict underwriting guidelines concerning the borrower’s ability to repay the loan.”  But in the years to come, these representations and warranties would prove to be inaccurate. Still, the Fed continued not to press its prerogatives. In January , it formalized its long-standing policy of “not routinely conducting consumer compliance examina- tions of nonbank subsidiaries of bank holding companies,”  a decision that would be criticized by a November  General Accounting Office report for creating a “lack of regulatory oversight.”  The July  report also made recommendations on mortgage reform.  While preparing draft recommendations for the report, Fed staff wrote to the Fed’s Committee on Consumer and Community Affairs that “given the Board’s traditional reluctance to support substantive limitations on market behavior, the draft report discusses various options but does not advocate any particular ap- proach to addressing these problems.”  In the end, although the two agencies did not agree on the full set of recommen- dations addressing predatory lending, both the Fed and HUD supported legislative bans on balloon payments and advance collection of lump-sum insurance premiums, stronger enforcement of current laws, and nonregulatory strategies such as commu- nity outreach efforts and consumer education and counseling. But Congress did not act on these recommendations. The Fed-Lite provisions under the Gramm-Leach-Bliley Act affirmed the Fed’s hands-off approach to the regulation of mortgage lending. Even so, the shakeup in the subprime industry in the late s had drawn regulators’ attention to at least some of the risks associated with this lending. For that reason, the Federal Reserve, FDIC, OCC, and OTS jointly issued subprime lending guidance on March , . CHRG-111shrg54789--14 Mr. Barr," Thank you, Mr. Chairman. Let me first say I agree with you that the Consumer Financial Protection Agency is good for banks as well as for consumers. If banks are competing on the basis of price and quality, that is good for them. If banks and credit unions and their communities can compete on a level playing field so we do not have a situation where a community bank wants to do the right thing but an independent mortgage company is stealing all market share with a policy that consumers cannot understand, we don't want that in the future. We want a level playing field based on fair competition, based on transparency to consumers. With respect to the Community Reinvestment Act, I think the empirical evidence here, Mr. Chairman, is quite strong. I looked at this when I was researching at the University of Michigan. The Federal Reserve economists have looked at this question. The Federal Reserve found that about 6 percent of subprime mortgage loans were made by CRA-regulated institutions with respect to low-income communities or low-income borrowers. Six percent is unlikely to have driven, highly unlikely to have driven the subprime mortgage crisis. If you look at the timing of our subprime mortgage crisis in the mid-2000's, it is hard to imagine that that was caused by changes in CRA regulations a decade earlier in 1995. If you look at the performance of CRA lending with respect to equivalent subprime loans, comparable performance levels. So I think the empirical evidence just does not support that claim. " CHRG-111hhrg53240--76 Mr. Bachus," You know, there was no going into the banks and examining anything. But I know the State charter banks were examined for underwriting standards. One thing I ran into when I was advocating for subprime lending legislation in 2005, I would talk to some of the banks, the big banks, bank holding companies, and they would say, we don't do these subprime loans. And I found out later that was somewhat half true in that they all had nonbank affiliates who were making those loans hand over fist. But I don't think that the Fed did any audits or supervision of those nonbank affiliates, did they? Ms. Duke. I think the authority to do that kind of examination was a little unclear under Gramm-Leach-Bliley. However, we did conduct a pilot program within the last year where we went into nonbank subsidiaries jointly with the FTC, with the OTS, with State regulators, and did full compliance exams on those. And as a result of what we learned there, we are going to continue those examinations. " CHRG-110hhrg41184--35 Mr. Bernanke," Well, Congressman, as I mentioned in my testimony, the subprime problem was a trigger for all this, but there were other things that then began to kick in, including a pull-back from risk taking, concerns about valuation of these complex products, issues about liquidity and so on which, as you say, caused the problem to spread throughout the system. Right now, we are looking at solutions. The Federal Reserve, for example, is engaging in this lending process trying to reduce the pressure in the short-term money markets. I think, very importantly, the private sector has a role to play. I would encourage, for example, banks to continue to raise capital so they would be well able to continue to lend. They also need to increase transparency, to provide more information to the markets so the market could begin to understand what these assets are and what the balance sheets look like. " CHRG-111shrg57319--453 Mr. Killinger," First, we had an adjustment in our strategy that started in about 2004 to gradually increase the amount of home equity, subprime, commercial real estate, and multi-family loans that we would hold on the balance sheet. We had that long-term strategy, but as I mentioned in my opening comments, we quickly determined that the housing market was increasing in its risk, and we put most of those strategies for expansion on hold. In fact, our subprime portfolio that we held in our portfolio actually declined from the time that we had that strategy versus the strategy which had that increasing in size. Senator Levin. In 2003, your subprime amount, according to your filings with the SEC, was $20 billion. It went up in 2004 to $31 billion. It went up in 2005 to $34 billion, leveled back to $30 billion in 2006. That is your subprime, so it went actually up through 2005 and stayed high through 2006. Your fixed mortgage loans in 2003 were $263 billion. It drastically dropped in 2004 and 2005, to $77 and $78 billion, respectively. Your Option ARMs jumped from 2003 when they were $30 billion up to more than double in 2004, and in 2005 they also doubled what they were in 2003. So in terms of the direction you have dramatically increased your Option ARMs from 2003 to 2005. Even in 2006, they were more than they were in 2003. You dramatically dropped your fixed amount, and your subprime again almost doubled, not quite, from 2003 to 2005. Now, those are your SEC filings, and we will let them speak for themselves. Mr. Rotella, in your testimony you said that you did not design the strategy that was designed by the board, which was a higher-risk strategy. On page 4 and 5 of your testimony for the record, you said that prior to the time you joined WaMu in 2005, the board of directors had established a 5-year strategic plan. This plan called for additional growth in the mortgage lending business with a particular emphasis on higher-margin and higher-risk products. That is your statement. Is that correct? That is what you found when you got there? " CHRG-111shrg51290--67 The combination of easing credit standards and a growing economy resulted in a sharp increase in homeownership rates through 2004. As the credit quality of loans steadily grew worse over 2005 through 2007,\13\ however, the volume of unsustainable loans grew and homeownership rates dropped.\14\ (See Table 1).--------------------------------------------------------------------------- \13\ Subprime mortgage originated in 2005, 2006 and 2007 had successively worse default experiences than vintages in prior years. See Freddie Mac, Freddie Mac Update 19 (December 2008), available at www.freddiemac.com/investors/pdffiles/investor-presentation.pdf. \14\ See Jesse M. Abraham, Andrey Pavlov & Susan Wachter, Explaining the United States' Uniquely Bad Housing Market, XII Wharton Real Estate Rev. 24 (2008).--------------------------------------------------------------------------- Table 1. U.S. Homeownership Rates, by Year (U.S. Census Bureau) The explosion of nontraditional mortgage lending was timed to maintain securitization deal flows after traditional refinancings weakened in 2003. The major take-off in these products occurred in 2002, which coincided with the winding down of the huge increase in demand for mortgage securities through the refinance process. Coming out of the recession of 2001, interest rates fell and there was a massive securitization boom through refinancing that was fueled by low interest rates. The private-label securitization industry had grown in capacity and profits. But in 2003, rising interest rates ended the potential for refinancing at ever lower interest rates, leading to an increased need for another source of mortgages to maintain and grow the rate of securitization and the fees it generated. The ``solution'' was the expansion of the market through nontraditional mortgages, especially interest-only loans and option payment ARMs offering negative amortization. (See Figure 1 supra). This expansion of credit swept a larger portion of the population into the potential homeowner pool, driving up housing demand and prices, and consumer indebtedness. Indeed, consumer indebtedness grew so rapidly that between 1975 and 2007, total household debt soared from around 43 percent to nearly 100 percent of gross domestic product.\15\--------------------------------------------------------------------------- \15\ U.S. Federal Reserve Board, Bureau of Economic Analysis.--------------------------------------------------------------------------- The growth in nonprime mortgages was accomplished through market expansion of nontraditional mortgages and by qualifying more borrowing through easing of traditional lending terms. For example, while subprime mortgages were initially made as ``hard money'' loans with low loan-to-value ratios, by the height of their growth, combined loan-to-value ratios exceeded that of the far less risky prime market. (See Figure 3 supra). While the demand for riskier mortgages grew fueled by the need for product to securitize, the potential risk due to deteriorating lending standards also grew.B. Consumer Confusion If borrowers had been able to distinguish safe loans from highly risky loans, risky loans would not have crowded out the market. But numerous borrowers were not able to do so, for three distinct reasons. First, hybrid subprime ARMs, interest-only mortgages, and option payment ARMs were baffling in their complexity. Second, it was impossible to obtain binding price quotes early enough to permit meaningful comparison shopping in the nonprime market. Finally, borrowers usually did not know that mortgage brokers got higher compensation for steering them into risky loans. Hidden Risks--The arcane nature of hybrid ARMs, interest-only loans, and option payment ARMs often made informed consumer choice impossible. These products were highly complex instruments that presented an assortment of hidden risks to borrowers. Chief among those risks was payment shock--in other words, the risk that monthly payments would rise dramatically upon rate reset. These products presented greater potential payment shock than conventional ARMs, which had lower reset rates and manageable lifetime caps. Indeed, with these exotic ARMs, the only way interest rates could go was up. Many late vintage subprime hybrid ARMs had initial rate resets of 3 percentage points, resulting in increased monthly payments of 50 percent to 100 percent or more.\16\--------------------------------------------------------------------------- \16\ Statement of Sheila C. Bair, Chairman, Federal Deposit Insurance Corporation, on Strengthening the Economy: Foreclosure Prevention and Neighborhood Preservation, before the Committee on Banking, Housing and Urban Affairs, U.S. Senate, 538 Dirksen Senate Office Building, January 31, 2008, www.fdic.gov/news/news/speeches/chairman/spjan3108.html. --------------------------------------------------------------------------- For a borrower to grasp the potential payment shock on a hybrid, interest-only, or option payment ARM, he or she would need to understand all the moving parts of the mortgage, including the index, rate spread, initial rate cap, and lifetime rate cap. On top of that, the borrower would need to predict future interest rate movements and translate expected rate changes into changes in monthly payments. Interest-only ARMs and option payment ARMs had the added complication of potential deferred or negative amortization, which could cause the principal payments to grow. Finally, these loans were more likely to carry large prepayment penalties. To understand the effect of such a prepayment penalty, the borrower would have to use a formula to compute the penalty's size and then assess the likelihood of moving or refinancing during the penalty period.\17\ Truth-in-Lending Act disclosures did not require easy-to-understand disclosures about any of these risks.\18\--------------------------------------------------------------------------- \17\ Federal Reserve System, Truth in Lending, Part III: Final rule, official staff commentary, 73 Fed. Reg. 44522, 44524-25 (July 30, 2008); Federal Reserve System, Truth in Lending, Part II: Proposed rule; request for public comment, 73 Fed. Reg. 1672, 1674 (January 9, 2008). \18\ Patricia A. McCoy, Rethinking Disclosure in a World of Risk-Based Pricing, 44 Harv. J. Legis. 123 (2007), available at http://www.law.harvard.edu/students/orgs/jol/vol44_1/mccoy.pdf. --------------------------------------------------------------------------- Inability to Do Meaningful Comparison Shopping--The lack of binding rate quotes also hindered informed comparison-shopping in the nonprime market. Nonprime loans had many rates, not one, which varied according to the borrower's risk, the originator's compensation, the documentation level of the loan, and the naivety of the borrower. Between their complicated price structure and the wide variety of products, subprime loans were not standardized. Furthermore, it was impossible to obtain a binding price quote in the subprime market before submitting a loan application and paying a non-refundable fee. Rate locks were also a rarity in the subprime market. In too many cases, subprime lenders waited until the closing to unveil the true product and price for the loan, a practice that the Truth in Lending Act rules countenanced. These rules, promulgated by the Federal Reserve Board, helped foster rampant ``bait-and-switch'' schemes in the subprime market.\19\--------------------------------------------------------------------------- \19\ Id.; Federal Reserve System, Truth in Lending--Proposed rule; request for public comment, 73 Fed. Reg. 1672, 1675 (Jan. 9, 2008).--------------------------------------------------------------------------- As a result, deceptive advertising became a stock-in-trade of the nonprime market. Nonprime lenders and brokers did not advertise their prices to permit meaningful comparison-shopping. To the contrary, lenders treated their rate sheets--which listed their price points and pricing criteria--as proprietary secrets that were not to be disclosed to the mass consumer market. Subprime advertisements generally focused on fast approval and low initial monthly payments or interest rates, not on accurate prices. While the Federal Reserve exhorted people to comparison-shop for nonprime loans,\20\ in reality, comparison-shopping was futile. Nonprime lenders did not post prices, did not provide consumers with firm price quotes, and did not offer lock-in commitments as a general rule. Anyone who attempted to comparison-shop had to pay multiple application fees for the privilege and, even then, might not learn the actual price until the closing if the lender engaged in a bait-and-switch.--------------------------------------------------------------------------- \20\ See, e.g., Federal Reserve Board, Looking for the Best Mortgage, www.federalreserve.gov/pubs/mortgage/mortb_11.htm.--------------------------------------------------------------------------- As early as 1998, the Federal Reserve Board and the Department of Housing and Urban Development were aware that Truth in Lending Act disclosures did not come early enough in the nonprime market to allow meaningful comparison shopping. That year, the two agencies issued a report diagnosing the problem. In the report, HUD recommended changes to the Truth in Lending Act to require mortgage originators to provide binding price quotes before taking loan applications. The Federal Reserve Board dissented from the proposal, however, and it was never adopted.\21\ To this day, the Board has still not revamped Truth in Lending disclosures for closed-end mortgages.--------------------------------------------------------------------------- \21\ See Bd. of Governors of the Fed. Reserve Sys. & Dep't of Hous. & Urban Dev., Joint Report to the Congress, Concerning Reform to the Truth in Lending Act and the Real Estate Settlement Procedures Act, at 28-29, 39-42 (1998), available at www.federalreserve.gov/boarddocs/rptcongress/tila.pdf.--------------------------------------------------------------------------- Perverse Fee Incentives--Finally, many consumers were not aware that the compensation structure rewarded mortgage brokers for riskier loan products and higher interest rates. Mortgage brokers only got paid if they closed a loan. Furthermore, they were paid solely through upfront fees at closing, meaning that if a loan went bad, the losses would fall on the lender or investors, not the broker. In the most pernicious practice, lenders paid brokers thousands of dollars per loan in fees known as yield spread premiums (or YSPs) in exchange for loans saddling borrowers with steep prepayment penalties and higher interest rates than the borrowers qualified for, based on their incomes and credit scores. In sum, these three features--the ability to hide risk, thwart meaningful comparison-shopping, and reward steering--allowed lenders to entice unsuspecting borrowers into needlessly hazardous loans.C. The Crowd-Out Effect The ability to bury risky product features in fine print allowed irresponsible lenders to out-compete safe lenders. Low initial monthly payments were the most visible feature of hybrid ARMs, interest-only loans, and option payment ARMs. During the housing boom, lenders commonly touted these products based on low initial monthly payments while obscuring the back-end risks of those loans.\22\--------------------------------------------------------------------------- \22\ See, e.g., Julie Haviv & Emily Kaiser, Web lenders woo subprime borrowers despite crisis, Reuters (Apr. 22, 2007); E. Scott Reckard, Refinance pitches in sub-prime tone, Los Angeles Times, October 29, 2007.--------------------------------------------------------------------------- The ability to hide risks made it easy to out-compete lenders offered fixed-rate, fully amortizing loans. Other things being equal, the initial monthly payments on exotic ARMs were lower than on fixed-rate, amortizing loans. Furthermore, some nonprime lenders qualified borrowers solely at the low initial rate alone until the Federal Reserve Board finally banned that practice in July 2008.\23\--------------------------------------------------------------------------- \23\ In fall 2006, Federal regulators issued an interagency guidance advising option ARM lenders to qualify borrowers solely at the fully indexed rate. Nevertheless, Washington Mutual (WaMu) apparently continued to qualify applicants for option ARMs at the low, introductory rate alone until mid-2007. It was not until July 30, 2007 that WaMu finally updated its ``Bulk Seller Guide'' to require its correspondents to underwrite option ARMs and other ARMs at the fully indexed rate.--------------------------------------------------------------------------- Of course, many sophisticated customers recognized the dangers of these loans. That did not deter lenders from offering hazardous nontraditional ARMs, however. Instead, the ``one-sizefits-one'' nature of nonprime loans permitted lenders to discriminate by selling safer products to discerning customers and more lucrative, dangerous products to naive customers. Sadly, the consumers who were least well equipped in terms of experience and education to grasp arcane loan terms \24\ ended up with the most dangerous loans.--------------------------------------------------------------------------- \24\ Howard Lax, Michael Manti, Paul Raca & Peter Zorn, Subprime Lending: An Investigation of Economic Efficiency, 15 Housing Pol'y Debate 533, 552-554 (2004), http://www.fanniemaefoundation.org/programs/hpd/pdf/hpd_1503_Lax.pdf. --------------------------------------------------------------------------- In the meantime, lenders who offered safe products--such as fixed-rate prime loans--lost market share to lenders who peddled exotic ARMs with low starting payments. As conventional lenders came to realize that it didn't pay to compete on good products, those lenders expanded into the nonprime market as well.II. The Regulatory Story: Race to the Bottom Federal banking regulators added fuel to the crisis by allowing reckless loans to flourish. It is a basic tenet of banking law that banks should not extend credit without proof of ability to repay. Federal banking regulators \25\ had ample authority to enforce this tenet through safety and soundness supervision and through Federal consumer protection laws. Nevertheless, they refused to exercise their substantial powers of rulemaking, formal enforcement, and sanctions to crack down on the proliferation of poorly underwritten loans until it was too late. Their abdication allowed irresponsible loans to multiply. Furthermore, their green light to banks to invest in investment-grade subprime mortgage-backed securities and CDOs left the nation's largest banks struggling with toxic assets. These problems were a direct result of the country's fragmented system of financial regulation, which caused regulators to compete for turf.--------------------------------------------------------------------------- \25\ The four Federal banking regulators include the Federal Reserve System, which serves as the central bank and supervises State member banks; the Office of the Comptroller of the Currency, which oversees national banks; the Federal Deposit Insurance Corporation, which operates the Deposit Insurance Fund and regulates State nonmember banks; and the Office of Thrift Supervision, which supervises savings associations.---------------------------------------------------------------------------A. The Fragmented U.S. System of Mortgage Regulation In the United States, the home mortgage lending industry operates under a fragmented regulatory structure which varies according to entity.\26\ Banks and thrift institutions are regulated under Federal banking laws and a subset of those institutions--namely, national banks, Federal savings associations, and their subsidiaries--are exempt from State anti-predatory lending and credit laws by virtue of Federal preemption. In contrast, mortgage brokers and independent non-depository mortgage lenders escape Federal banking regulation but have to comply with all State laws in effect. Only State-chartered banks and thrifts in some states (a dwindling group) are subject to both sets of laws.--------------------------------------------------------------------------- \26\ This discussion is drawn from Patricia A. McCoy & Elizabeth Renuart, The Legal Infrastructure of Subprime and Nontraditional Mortgage Lending, in Borrowing to Live: Consumer and Mortgage Credit Revisited 110 (Nicolas P. Retsinas & Eric S. Belsky eds., Joint Center for Housing Studies of Harvard University & Brookings Institution Press, 2008).--------------------------------------------------------------------------- Under this dual system of regulation, depository institutions are subject to a variety of Federal examinations, including fair lending, Community Reinvestment Act, and safety and soundness examinations, but independent nondepository lenders are not. Similarly, banks and thrifts must comply with other provisions of the Community Reinvestment Act, including reporting requirements and merger review. Federally insured depository institutions must also meet minimum risk-based capital requirements and reserve requirements, unlike their independent non-depository counterparts. Some Federal laws applied to all mortgage originators. Otherwise, lenders could change their charter and form to shop for the friendliest regulatory scheme.B. Applicable Law Despite these differences in regulatory regimes, the Federal Reserve Board did have the power to prohibit reckless mortgages across the entire mortgage industry. The Board had this power by virtue of its authority to administer a Federal anti-predatory lending law known as ``HOEPA.''1. Federal Law Following deregulation of home mortgages in the early 1980's, disclosure became the most important type of Federal mortgage regulation. The Federal Truth in Lending Act (TILA),\27\ passed in 1968, mandates uniform disclosures regarding cost for home loans. Its companion law, the Federal Real Estate Settlement Procedures Act of 1974 (RESPA),\28\ requires similar standardized disclosures for settlement costs. Congress charged the Federal Reserve with administering TILA and the Department of Housing and Urban Development with administering RESPA.--------------------------------------------------------------------------- \27\ 15 U.S.C. 1601-1693r (2000). \28\ 12 U.S.C. 2601-2617 (2000).--------------------------------------------------------------------------- In 1994, Congress augmented TILA and RESPA by enacting the Home Ownership and Equity Protection Act (HOEPA).\29\ HOEPA was an early Federal anti-predatory lending law and prohibits specific abuses in the subprime mortgage market. HOEPA applies to all residential mortgage lenders and mortgage brokers, regardless of the type of entity.--------------------------------------------------------------------------- \29\ 15 U.S.C. 1601, 1602(aa), 1639(a)-(b).--------------------------------------------------------------------------- HOEPA has two important provisions. The first consists of HOEPA's high-cost loan provision,\30\ which regulates the high-cost refinance market. This provision seeks to eliminate abuses consisting of ``equity stripping.'' It is hobbled, however, by its extremely limited reach--covering only the most exorbitant subprime mortgages--and its inapplicability to home purchase loans, reverse mortgages, and open-end home equity lines of credit.\31\ Lenders learned to evade the high-cost loan provisions rather easily by slightly lowering the interest rates and fees on subprime loans below HOEPA's thresholds and by expanding into subprime purchase loans.--------------------------------------------------------------------------- \30\ 15 U.S.C. Sec. 1602(aa)(1)-(4); 12 C.F.R. 226.32(a)(1), (b)(1). \31\ 15 U.S.C. Sec. 1602(i), (w), (bb); 12 C.F.R. 226.32(a)(2) (1997); Edward M. Gramlich, Subprime Mortgages: America's Latest Boom and Bust 28 (Urban Institute Press, 2007).--------------------------------------------------------------------------- HOEPA also has a second major provision, which gives the Federal Reserve Board the authority to prohibit unfair or deceptive lending practices and refinance loans involving practices that are abusive or against the interest of the borrower.\32\ This provision is potentially broader than the high-cost loan provision, because it allows regulation of both the purchase and refinance markets, without regard to interest rates or fees. However, it was not self-activating. Instead, it depended on action by the Federal Reserve Board to implement the provision, which the Board did not take until July 2008.--------------------------------------------------------------------------- \32\ 15 U.S.C. 1639(l)(2).---------------------------------------------------------------------------2. State Law Before 2008, only the high-cost loan provision of HOEPA was in effect as a practical matter. This provision had a serious Achilles heel, consisting of its narrow coverage. Even though the Federal Reserve Board lowered the high-cost triggers of HOEPA effective in 2002, that provision still only applied to 1 percent of all subprime home loans.\33\--------------------------------------------------------------------------- \33\ Gramlich, supra note 31 (2007, p. 28).--------------------------------------------------------------------------- After 1994, it increasingly became evident that HOEPA was incapable of halting equity stripping and other sorts of subprime abuses. By the late 1990s, some cities and states were contending with rising foreclosures and some jurisdictions were contemplating regulating subprime loans on their own. Many states already had older statutes on the books regulating prepayment penalties and occasionally balloon clauses. These laws were relatively narrow, however, and did not address other types of new abuses that were surfacing in subprime loans. Consequently, in 1999, North Carolina became the first State to enact a comprehensive anti-predatory lending law.\34\ Soon, other states followed suit and passed anti-predatory lending laws of their own. These newer State laws implemented HOEPA's design but frequently expanded coverage or imposed stricter regulation on subprime loans. By year-end 2005, 29 States and the District of Columbia had enacted one of these ``mini-HOEPA'' laws. Some States also passed stricter disclosure laws or laws regulating mortgage brokers. By the end of 2005, only six States--Arizona, Delaware, Montana, North Dakota, Oregon, and South Dakota--lacked laws regulating prepayment penalties, balloon clauses, or mandatory arbitration clauses, all of which were associated with exploitative subprime loans.\35\--------------------------------------------------------------------------- \34\ N.C. Gen Stat. 24-1.1E (2000). \35\ See Raphael Bostic, Kathleen C. Engel, Patricia A. McCoy, Anthony Pennington-Cross & Susan Wachter, State and Local Anti-Predatory Lending Laws: The Effect of Legal Enforcement Mechanisms, 60 J. Econ. & Bus. 47-66 (2008), full working paper version available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1005423. --------------------------------------------------------------------------- Critics, including some Federal banking regulators, have blamed the states for igniting the credit crisis through lax regulation. Certainly, there were states that were largely unregulated and there were states where mortgage regulation was weak. Mortgage brokers were loosely regulated in too many states. Similarly, the states never agreed on an effective, uniform system of mortgage regulation. Nevertheless, this criticism of the states disregards the hard-fought efforts by a growing number of states--which eventually grew to include the majority of states--to regulate abusive subprime loans within their borders. State attorneys general and State banking commissioners spearheaded some of the most important enforcement actions against deceptive mortgage lenders.\36\--------------------------------------------------------------------------- \36\ For instance, in 2002, State authorities in 44 states struck a settlement with Household Finance Corp. for $484 million in consumer restitution and changes in its lending practices following enforcement actions to redress alleged abusive subprime loans. Iowa Attorney General, States Settle With Household Finance: Up to $484 Million for Consumers (Oct. 11, 2002), available at www.iowa.gov/government/ag/latest_news/releases/oct_2002/Household_Chicago.html. In 2006, forty-nine states and the District of Columbia reached a $325 million settlement with Ameriquest Mortgage Company over alleged predatory lending practices. See, e.g., Press Release, Iowa Dep't of Justice, Miller: Ameriquest Will Pay $325 Million and Reform its Lending Practices (Jan. 23, 2006), available at http://www.state.ia.us/government/ag/latest_news/releases/jan_2006/Ameriquest_Iowa.html. ---------------------------------------------------------------------------C. The Ability to Shop For Hospitable Laws and Regulators State-chartered banks and thrifts and their subsidiaries had to comply with the State anti-predatory lending laws. So did independent nonbank lenders and mortgage brokers. For the better part of the housing boom, however, national banks, Federal savings associations, and their mortgage lending subsidiaries did not have to comply with the State anti-predatory lending laws due to Federal preemption rulings by their Federal regulators. This became a problem because Federal regulators did not replace the preempted State laws with strong Federal underwriting rules.1. Federal Preemption The states that enacted anti-predatory lending laws did not legislate in a vacuum. In 1996, the Federal regulator for thrift institutions--the Office of Thrift Supervision or OTS--promulgated a sweeping preemption rule declaring that henceforth Federal savings associations did not have to observe State lending laws.\37\ Initially, this rule had little practical effect because any State anti-predatory lending provisions on the books then were fairly narrow.\38\--------------------------------------------------------------------------- \37\ 12 C.F.R. 559.3(h), 560.2. \38\ Bostic et al., supra note 35; Office of Thrift Supervision, Responsible Alternative Mortgage Lending: Advance notice of proposed rulemaking, 65 Fed. Reg. 17811, 17814-16 (2000).--------------------------------------------------------------------------- Following adoption of the OTS preemption rule, Federal thrift institutions and their subsidiaries were relieved from having to comply with State consumer protection laws. That was not true, however, for national banks, State banks, State thrifts, and independent nonbank mortgage lenders and brokers. The stakes rose considerably starting in 1999, when North Carolina passed the first comprehensive State anti-predatory lending law. As State mini-HOEPA laws proliferated, national banks lobbied their regulator--a Federal agency known as the Office of the Comptroller of the Currency or OCC--to clothe them with the same Federal preemption as Federal savings associations. They succeeded and, in 2004, the OCC issued its own preemption rule banning the states from enforcing their laws impinging on real estate lending by national banks and their subsidiaries.\39\ In a companion rule, the OCC denied permission to the states to enforce their own laws that were not federally preempted--state lending discrimination laws are one example--against national banks and their subsidiaries. After a protracted court battle, the controversy ended up in the U.S. Supreme Court, which upheld the OCC preemption rule.\40\--------------------------------------------------------------------------- \39\ Office of the Comptroller of the Currency, Bank Activities and Operations; Final rule, 69 Fed. Reg. 1895 (2004) (codified at 12 C.F.R. 7.4000); Office of the Comptroller of the Currency, Bank Activities and Operations; Real Estate Lending and Appraisals; Final rule, 69 Fed. Reg. 1904 (2004) (codified at 12 C.F.R. 7.4007-7.4009, 34.4). National City Corporation, the parent of National City Bank, N.A., and a major subprime lender, spearheaded the campaign for OCC preemption. Predatory lending laws neutered, Atlanta Journal Constitution, Aug. 6, 2003. \40\ Watters v. Wachovia Bank, N.A., 550 U.S. 1 (2007); Arthur E. Wilmarth, Jr., The OCC's Preemption Rules Exceed the Agency's Authority and Present a Serious Threat to the Dual Banking System, 23 Ann. Rev. Banking & Finance Law 225 (2004). The Supreme Court recently granted certiorari to review the legality of the OCC visitorial powers rule. Cuomo v. Clearing House Ass'n, L.L.C.,__U.S.__, 129 S. Ct. 987 (2009). The OCC and the OTS left some areas of State law untouched, namely, State criminal law and State law regulating contracts, torts, homestead rights, debt collection, property, taxation, and zoning. Both agencies, though, reserved the right to declare that any State laws in those areas are preempted in the future. For fuller discussion, see. McCoy & Renuart, supra note 26.--------------------------------------------------------------------------- OTS and the OCC had institutional motives to grant Federal preemption to the institutions that they regulated. Both agencies depend almost exclusively on fees from their regulated entities for their operating budgets. Both were also eager to persuade State-chartered depository institutions to convert to a Federal charter. In addition, the OCC was aware that if national banks wanted Federal preemption badly enough, they might defect to the thrift charter to get it. Thus, the OCC had reason to placate national banks to keep them in its fold. Similarly, the OTS was concerned about the steady decline in thrift institutions. Federal preemption provided an inducement to thrift institutions to retain the Federal savings association charter.2. The Ability to Shop for the Most Permissive Laws As a result of Federal preemption, State anti-predatory lending laws applied to State-chartered depository institutions and independent nonbank lenders, but not to national banks, Federal savings associations, or their mortgage lending subsidiaries. The only anti-predatory lending provisions that national banks and federally chartered thrifts had to obey were HOEPA and agency pronouncements on subprime and nontraditional mortgage loans.\41\ Of these, HOEPA had extremely narrow scope. Meanwhile, agency guidances lacked the binding effect of rules and their content was not as strict as the stronger State laws.--------------------------------------------------------------------------- \41\ Board of Governors of the Federal Reserve System et al., Interagency Guidance on Subprime Lending (March 1, 1999); OCC, Abusive Lending Practices, Advisory Letter 2000-7 (July 25, 2000); OCC et al., Expanded Guidance for Subprime Lending Programs (Jan. 31, 2001); OCC, Avoiding Predatory and Abusive Lending Practices in Brokered and Purchased Loans, Advisory Letter 2003-3 (Feb. 21, 2003); OCC, Guidelines for National Banks to Guard Against Predatory and Abusive Lending Practices, Advisory Letter 2003-2 (Feb. 21, 2003); OCC, OCC Guidelines Establishing Standards for Residential Mortgage Lending Practices, 70 Fed. Reg. 6329 (2005); Department of the Treasury et al., Interagency Guidance on Nontraditional Mortgage Product Risks; Final guidance, 71 Fed. Reg. 58609 (2006); Department of the Treasury et al., Statement on Subprime Mortgage Lending; Final guidance, 72 Fed. Reg. 37569 (2007). Of course, these lenders, like all lenders, are subject to prosecution in cases of fraud. Lenders are also subject to the Federal Trade Commission Act, which prohibits unfair and deceptive acts and practices (UDAPs). However, Federal banking regulators were slow to propose rules to define and punish UDAP violations by banking companies in the mortgage lending area.--------------------------------------------------------------------------- This dual regulatory system allowed mortgage lender to play regulators off one another by threatening to change charters. Mortgage lenders are free to operate with or without depository institution charters. Similarly, depository institutions can choose between a State and Federal charter and between a thrift charter and a commercial bank charter. Each of these choices allows a lender to change regulators. A lender could escape a strict State law by switching to a Federal bank or thrift charter or by shifting its operations to a less regulated State. Similarly, a lender could escape a strict regulator by converting its charter to one with a more accommodating regulator. Countrywide, the nation's largest mortgage lender and a major subprime presence, took advantage of this system to change its regulator. One of its subsidiaries, Countrywide Home Loans, was supervised by the Federal Reserve. This subsidiary switched and became an OTS-regulated entity as of March 2007. That same month, Countrywide Bank, N.A., converted its charter from a national bank charter under OCC supervision to a Federal thrift charter under OTS supervision. Reportedly, OTS promised Countrywide's executives to be a ``less antagonistic'' regulator if Countrywide switched charters to OTS. Six months later, the regional deputy director of the OTS West Region, where Countrywide was headquartered, was promoted to division director. Some observers considered it a reward.\42\--------------------------------------------------------------------------- \42\ Richard B. Schmitt, Regulator takes heat over IndyMac, Los Angeles Times, Oct. 6, 2008; see also Binyamin Appelbaum & Ellen Nakashima, Regulator Played Advocate Over Enforcer, Washington Post, November 23, 2008.--------------------------------------------------------------------------- The result was a system in which lenders could shop for the loosest laws and enforcement. This shopping process, in turn, put pressure on regulators at all levels--state and local--to lower their standards or relax enforcement. What ensued was a regulatory race to the bottom.III. Regulatory Failure Federal preemption would not have been such a problem if Federal banking regulators had replaced State laws with tough rules and enforcement of their own. Those regulators had ample power to stop the deterioration in mortgage underwriting standards that mushroomed into a full-blown crisis. However, they refused to intervene in disastrous lending practices until it was too late. As a result, federally regulated lenders--as well as all lenders operating in states with weak regulation--were given carte blanche to loosen their lending standards free from meaningful regulatory intervention.A. The Federal Reserve Board The Federal Reserve Board had the statutory power, starting in 1994, to curb lax lending not only for depository institutions, but for all lenders across-the-board. It declined to exercise that power in any meaningful respect, however, until after the nonprime mortgage market collapsed. In the mortgage lending area, the Fed's supervisory process has three major parts and breakdowns were apparent in two out of the three. The only part that appeared to work well was the Fed's role as the primary Federal regulator for State-chartered banks that are members of the Federal Reserve System.\43\--------------------------------------------------------------------------- \43\ In general, these are community banks on the small side. In 2007 and 2008, only one failed bank--the tiny First Georgia Community Bank in Jackson, Georgia, with only $237.5 million in assets--was regulated by the Federal Reserve System. It is not clear whether the Fed's performance is explained by the strength of its examination process, the limited role of member banks in risky lending, the fact that State banks had to comply with State anti-predatory lending laws, or all three. In the following discussion on regulatory failure by the Federal Reserve Board, the OTS, and the OCC, the data regarding failed and near-failed banks and thrifts come from Federal bank regulatory and S.E.C. statistics, disclosures, press releases, and orders; rating agency reports; press releases and other web materials by the companies mentioned; statistics compiled by the American Banker; and financial press reports.--------------------------------------------------------------------------- As the second part of its supervisory duties, the Fed regulates nonbank mortgage lenders owned by bank holding companies but not owned directly or indirectly by banks or thrifts. During the housing boom, some of the largest subprime and Alt-A lenders were regulated by the Fed, including the top- and third-ranked subprime lenders in 2006, HSBC Finance and Countrywide Financial Corporation, and Wells Fargo Financial, Inc.\44\ The Fed's supervisory record with regard to these lenders was mixed. On one notable occasion, in 2004, the Fed levied a $70 million civil money penalty against CitiFinancial Credit Company and its parent holding company, Citigroup Inc., for subprime lending abuses.\45\ Apart from that, the Fed did not take public enforcement action against the nonbank lenders that it regulated. That may be because the Federal Reserve did not routinely examine the nonbank mortgage lending subsidiaries under its supervision, which the late Federal Reserve Board Governor Edward Gramlich revealed in 2007. Only then did the Fed kick off a ``pilot project'' to examine the nonbank lenders under its jurisdiction on a routine basis for loose underwriting and compliance with Federal consumer protection laws.\46\--------------------------------------------------------------------------- \44\ Data provided by American Banker, available at www.americanbanker.com. \45\ Federal Reserve, Citigroup Inc. New York, New York and Citifinancial Credit Company Baltimore, Maryland: Order to Cease and Desist and Order of Assessment of a Civil Money Penalty Issued Upon Consent, May 27, 2004. \46\ Edward M. Gramlich, Boom and Busts, The Case of Subprime Mortgages, Speech given August 31, 2007, Jackson Hole, Wyo., at symposium titled ``Housing, Housing Finance & Monetary Policy,'' sponsored by the Federal Reserve Bank of Kansas City, pp. 8-9, available at www.kansascityfed.org/publicat/sympos/2007/pdf/2007.09.04.gramlich.pdf; Speech by Governor Randall S. Kroszner At the National Bankers Association 80th Annual convention, Durham, North Carolina, October 11, 2007.--------------------------------------------------------------------------- Finally, the Board is responsible for administering most Federal consumer credit protection laws, including HOEPA. When former Governor Edward Gramlich served on the Fed, he urged then-Chairman Alan Greenspan to exercise the Fed's power to address unfair and deceptive loans under HOEPA. Greenspan refused, preferring instead to rely on non-binding statements and guidances.\47\ This reliance on statements and guidances had two disadvantages: one, major lenders routinely dismissed the guidances as mere ``suggestions'' and, two, guidances did not apply to independent nonbank mortgage lenders.--------------------------------------------------------------------------- \47\ House of Representatives, Committee on Oversight and Government Reform, ``The Financial Crisis and the Role of Federal Regulators, Preliminary Transcript'' 35, 37-38 (Oct. 23, 2008), available at http://oversight.house.gov/documents/20081024163819.pdf. Greenspan told the House Oversight Committee in 2008: Well, let's take the issue of unfair and deceptive practices, which is a fundamental concept to the whole predatory lending issue. The staff of the Federal Reserve . . . say[ ] how do they determine as a regulatory group what is unfair and deceptive? And the problem that they were concluding . . . was the issue of maybe 10 percent or so are self-evidently unfair and deceptive, but the vast majority would require a jury trial or other means to deal with it . . . Id. at 89.--------------------------------------------------------------------------- The Federal Reserve did not relent until July 2008, when under Chairman Ben Bernanke's leadership, it finally promulgated binding HOEPA regulations banning specific types of lax and abusive loans. Even then, the regulations were mostly limited to higher-priced mortgages, which the Board confined to first-lien loans of 1.5 percentage points or more above the average prime offer rate for a comparable transaction, and 3.5 percentage points for second-lien loans. Although shoddy nontraditional mortgages below those triggers had also contributed to the credit crisis, the rule left those loans--plus prime loans--mostly untouched.\48\--------------------------------------------------------------------------- \48\ Federal Reserve System, Truth in Lending: Final rule; official staff commentary, 73 Fed. Reg. 44522, 44536 (July 30, 2008). The Board set those triggers with the intention of covering the subprime market, but not the prime market. See id. at 44536-37.--------------------------------------------------------------------------- The rules, while badly needed, were too little and too late. On October 23, 2008, in testimony before the U.S. House of Representatives Oversight Committee, Greenspan admitted that ``those of us who have looked to the self-interest of lending institutions to protect shareholder's equity (myself especially) are in a state of shocked disbelief.'' House Oversight Committee Chairman Henry Waxman asked Greenspan whether ``your ideology pushed you to make decisions that you wish you had not made?'' Greenspan replied:\49\--------------------------------------------------------------------------- \49\ House of Representatives, Committee on Oversight and Government Reform, ``The Financial Crisis and the Role of Federal Regulators, Preliminary Transcript'' 36-37 (Oct. 23, 2008), available at http://oversight.house.gov/documents/20081024163819.pdf. Mr. GREENSPAN. . . . [Y]es, I found a flaw, I don't know how significant or permanent it is, but I have been very distressed by that fact . . . Chairman WAXMAN. You found a flaw? Mr. GREENSPAN. I found a flaw in the model that defines how the world works, so to speak. Chairman WAXMAN. In other words, you found that your view of the world, your ideology, was not right, it was not working. Mr. GREENSPAN. Precisely. That's precisely the reason I was shocked, because I had been going for 40 years or more with very considerable evidence that it was working exceptionally well.\50\ \50\ Testimony of Dr. Alan Greenspan before the House of Representatives Committee of Government Oversight and Reform, October 23, 2008, available at http://oversight.house.gov/documents/20081023100438.pdf.---------------------------------------------------------------------------B. Regulatory Lapses by the OCC and OTS Federal preemption might not have devolved into a banking crisis of systemic proportions had OTS and the OCC replaced State regulation for their regulated entities with a comprehensive set of binding rules prohibiting lax underwriting of home mortgages. Generally, in lieu of binding rules, Federal banking regulators, including the OCC and OTS, issued a series of ``soft law'' advisory letters and guidelines against predatory or unfair mortgage lending practices by insured depository institutions.\51\ Federal regulators disavowed binding rules during the run-up to the subprime crisis on grounds that the guidelines were more flexible and that the agencies enforced those guidelines through bank examinations and informal enforcement actions.\52\ Informal enforcement actions were usually limited to negotiated, voluntary agreements between regulators and the entities that they supervised, which made it easy for management to drag out negotiations to soften any restrictions and to bid for more time. Furthermore, examinations and informal enforcement are highly confidential, making it easy for a lax regulator to hide its tracks.--------------------------------------------------------------------------- \51\ See note 41 supra. \52\ Office of the Comptroller of the Currency, Bank Activities and Operations; Real Estate Lending and Appraisals; Final rule, 69 Fed. Reg. 1904 (2004).---------------------------------------------------------------------------1. The Office of Thrift Supervision Although OTS was the first agency to adopt Federal preemption, it managed to fly under the radar during the subprime boom, overshadowed by its larger sister agency, the OCC. After 2003, while commentators were busy berating the OCC preemption rule, OTS allowed the largest Federal savings associations to embark on an aggressive campaign of expansion through option payment ARMs, subprime loans, and low-documentation and no-documentation loans. Autopsies of failed depository institutions in 2007 and 2008 show that five of the seven biggest failures were OTS-regulated thrifts. Two other enormous thrifts during that period--Wachovia Mortgage, FSB and Countrywide Bank, FSB--were forced to arrange hasty takeovers by large bank holding companies to avoid failing. By December 31, 2008, thrifts totaling $355 billion in assets had failed in the previous sixteen months on OTS' watch. The reasons for the collapse of these thrifts evidence fundamental regulatory lapses by OTS. Almost all of the thrifts that failed in 2007 and 2008--and all of the larger ones--succumbed to massive levels of imprudent home loans. IndyMac Bank, FSB, which became the first major thrift institution to fail during the current crisis in July 2008, manufactured its demise by becoming the nation's top originator of low-documentation and no-documentation loans. These loans, which became known as ``liar's loans,'' infected both the subprime market and credit to borrowers with higher credit scores. By 2006 and 2007, over half of IndyMac's home purchase loans were subprime loans and IndyMac Bank approved up to half of those loans based on low or no documentation. Washington Mutual Bank, popularly known as ``WaMu,'' was the nation's largest thrift institution in 2008, with over $300 billion in assets. WaMu became the biggest U.S. depository institution in history to fail on September 25, 2008, in the wake of the Lehman Brothers bankruptcy. WaMu was so large that OTS examiners were stationed there permanently onsite. Nevertheless, from 2004 through 2006, despite the daily presence of the resident OTS inspectors, risky option ARMs, second mortgages, and subprime loans constituted over half of WaMu's real estate loans each year. By June 30, 2008, over one fourth of the subprime loans that WaMu originated in 2006 and 2007 were at least thirty days past due. Eventually, it came to light that WaMu's management had pressured its loan underwriters relentlessly to approve more and more exceptions to WaMu's underwriting standards in order to increase its fee revenue from loans.\53\--------------------------------------------------------------------------- \53\ Peter S. Goodman & Gretchen Morgenson, Saying Yes, WaMu Built Empire on Shaky Loans, N.Y. Times, Dec. 28, 2008.--------------------------------------------------------------------------- Downey Savings & Loan became the third largest depository institution to fail in 2008. Like WaMu, Downey had loaded up on option ARMs and subprime loans. When OTS finally had to put it into receivership, over half of Downey's total assets consisted of option ARMs and nonperforming loans accounted for over 15 percent of the thrift's total assets. In short, the three largest depository institution failures in 2007 and 2008 resulted from high concentrations of poorly underwritten loans, including low- and no-documentation ARMs (in the case of IndyMac) and option ARMs (in the case of WaMu and Downey) that were often only underwritten to the introductory rate instead of the fully indexed rate. During the housing bubble, OTS issued no binding rules to halt the proliferation by its largest regulated thrifts of option ARMs, subprime loans, and low- and no-documentation mortgages. Instead, OTS relied on oversight through guidances. IndyMac, WaMu, and Downey apparently treated the guidances as solely advisory, however, as evidenced by the fact that all three made substantial numbers of hazardous loans in late 2006 and in 2007 in direct disregard of an interagency guidance on nontraditional mortgages issued in the fall of 2006 and subscribed to by OTS that prescribed underwriting ARMs to the fully indexed rate.\54\--------------------------------------------------------------------------- \54\ Department of the Treasury et al., Interagency Guidance on Nontraditional Mortgage Product Risks; Final guidance, 71 Fed. Reg. 58609 (2006).--------------------------------------------------------------------------- The fact that all three institutions continued to make loans in violation of the guidance suggests that OTS examinations failed to result in enforcement of the guidance. Similarly, OTS fact sheets on the failures of all three institutions show that the agency consistently declined to institute timely formal enforcement proceedings against those thrifts prohibiting the lending practices that resulted in their demise. In sum, OTS supervision of residential mortgage risks was confined to ``light touch'' regulation in the form of examinations, nonbinding guidances, and occasional informal agreements that ultimately did not work.2. The Office of the Comptroller of the Currency The OCC has asserted that national banks made only 10 percent of subprime loans in 2006. But this assertion fails to mention that national banks moved aggressively into Alt-A low-documentation and no-documentation loans during the housing boom.\55\ This mattered a lot, because the biggest national banks are considered ``too big to fail'' and pose systemic risk on a scale unmatched by independent nonbank lenders. We might not be debating the nationalization of Citibank and Bank of America today had the OCC stopped them from expanding into toxic mortgages, bonds, and SIVs.--------------------------------------------------------------------------- \55\ Testimony by John C. Dugan, Comptroller, before the Senate Committee on Banking, Housing, and Urban Affairs, March 4, 2008.--------------------------------------------------------------------------- Like OTS, ``light touch'' regulation was apparent at the OCC. Unlike OTS, the OCC did promulgate one rule, in 2004, prohibiting mortgages to borrower who could not afford to repay. However, the rule was vague in design and execution, allowing lax lending to proliferate at national banks and their mortgage lending subsidiaries through 2007. Despite the 2004 rule, through 2007, large national banks continued to make large quantities of poorly underwritten subprime loans and low- and no-documentation loans. In 2006, for example, fully 62.6 percent of the first-lien home purchase mortgages made by National City Bank, N.A., and its subsidiary, First Franklin Mortgage, were higher-priced subprime loans. Starting in the third quarter of 2007, National City Corporation reported five straight quarters of net losses, largely due to those subprime loans. Just as with WaMu, the Lehman Brothers bankruptcy ignited a silent run by depositors and pushed National City Bank to the brink of collapse. Only a shotgun marriage with PNC Financial Services Group in October 2008 saved the bank from FDIC receivership. The five largest U.S. banks in 2005 were all national banks and too big to fail. They too made heavy inroads into low- and no-documentation loans. The top-ranked Bank of America, N.A., had a thriving stated-income and no-documentation loan program which it only halted in August 2007, when the market for private-label mortgage-backed securities dried up. Bank of America securitized most of those loans, which may be why the OCC tolerated such lax underwriting practices. Similarly, in 2006, the OCC overrode public protests about a ``substantial volume'' of no-documentation loans by JPMorgan Chase Bank, N.A., the second largest bank in 2005, on grounds that the bank had adequate ``checks and balances'' in place to manage those loans. Citibank, N.A., was the third largest U.S. bank in 2005. In September 2007, the OCC approved Citibank's purchase of the disreputable subprime lender Argent Mortgage, even though subprime securitizations had slowed to a trickle. Citibank thereupon announced to the press that its new subsidiary--christened ``Citi Residential Lending''--would specialize in nonprime loans, including reduced documentation loans. But not long after, by early May 2008 after Bear Stearns narrowly escaped failure, Citibank was forced to admit defeat and dismantle Citi Residential's lending operations. The fourth largest U.S. bank in 2005, Wachovia Bank, N.A., originated low- and no-documentation loans through its two mortgage subsidiaries. Wachovia Bank originated such large quantities of these loans--termed Alt-A loans--that by the first half of 2007, Wachovia Bank was the twelfth largest Alt-A lender in the country. These loans performed so poorly that between December 31, 2006 and September 30, 2008, the bank's ratio of net write-offs on its closed-end home loans to its total outstanding loans jumped 2400 percent. Concomitantly, the bank's parent company, Wachovia Corporation, was reported its first quarterly loss in years due to rising defaults on option ARMs made by Wachovia Mortgage, FSB, and its Golden West predecessor. Public concern over Wachovia's loan losses triggered a silent run on Wachovia Bank in late September 2008, following Lehman Brothers' failure. To avoid receivership, the FDIC brokered a hasty sale of Wachovia to Wells Fargo after Wells Fargo outbid Citigroup for the privilege. Wells Fargo Bank, N.A., was in better financial shape than Wachovia, but it too made large quantities of subprime and reduced documentation loans. In 2006, over 23 percent of the bank's first-lien refinance mortgages were high-cost subprime loans. Wells Fargo Bank also securitized substantial numbers of low- and no-documentation mortgages in its Alt-A pools. In 2007, a Wells Fargo prospectus for one of those pools stated that Wells Fargo had relaxed its underwriting standards in mid-2005 and did not verify whether the mortgage brokers who had originated the weakest loans in that loan pool complied with its underwriting standards before closing. Not long after, as of July 25, 2008, 22.77 percent of the loans in that loan pool were past due or in default. As the Wells Fargo story suggests, the OCC depended on voluntary risk management by national banks, not regulation of loan terms and practices, to contain the risk of improvident loans. A speech by the then-Acting Comptroller, Julie Williams, confirmed as much. In 2005, Comptroller Williams, in a speech to risk managers at banks, coached them on how to ``manage'' the risks of no-doc loans through debt collection, higher reserves, and prompt loss recognition. Securitization was another risk management device favored by the OCC. Three years later, in 2008, the Treasury Department's Inspector General issued a report that was critical of the OCC's supervision of risky loans.\56\ Among other things, the Inspector General criticized the OCC for not instituting formal enforcement actions while lending problems were still manageable in size. In his written response to the Inspector General, the Comptroller, John Dugan, conceded that ``there were shortcomings in our execution of our supervisory process'' and ordered OCC examiners to start initiating formal enforcement actions on a timely basis.\57\--------------------------------------------------------------------------- \56\ Office of Inspector General, Department of the Treasury, ``Safety and Soundness: Material Loss Review of ANB Financial, National Association'' (OIG-09-013, Nov. 25, 2008). \57\ Id.--------------------------------------------------------------------------- The OCC's record of supervision and enforcement during the subprime boom reveals many of the same problems that culminated in regulatory failure by OTS. Like OTS, the OCC usually shunned formal enforcement actions in favor of examinations and informal enforcement. Neither of these supervisory tools obtained compliance with the OCC's 2004 rule prohibiting loans to borrowers who could not repay. Although the OCC supplemented that rule later on with more detailed guidances, some of the largest national banks and their subsidiaries apparently decided that they could ignore the guidances, judging from their lax lending in late 2006 and in 2007. The OCC's emphasis on managing credit risk through securitization, reserves, and loss recognition, instead of through product regulation, likely encouraged that laissez faire attitude by national banks.C. Judging by the Results: Loan Performance By Charter OCC and OTS regulators have argued that their agencies offer ``comprehensive'' supervision resulting in lower default rates on residential mortgages. The evidence shows otherwise. Data from the Federal Deposit Insurance Corporation show that among depository institutions, Federal thrift institutions had the worst default rate for one-to-four family residential mortgages from 2006 through 2008. (See Figure 5). Figure 5. Total Performance of Residential Mortgages by Depository Institution Lenders FinancialCrisisReport--21 Subprime loans provided new fuel for the securitization engines on Wall Street. 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. 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) at 4. 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 markets. 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. FinancialCrisisInquiry--203 Yes. You know, what we’ve observed over time with traditionally underserved borrowers or people with lower or nontraditional credit histories is that we always had higher delinquency rates than was typical in the prime markets but our actual loss rates always ran under 1 percent. And part of that was because—part of how to run a successful operation, lending to these communities, includes understanding that there can be different kinds of income interruptions and vicissitudes of life and working with borrowers through those periods to keep the loan performing. And so, really, we—you know, now, of course, we’ve been impacted by the larger crisis. But just—then what’s become what we now talk about as subprime lending is loan products that had risky features and, as Professor Rosen’s discussed, lots of layers of risk. And these were not products, for the most part, except in the narrowest, narrowest sense—for the most part, these were never products that provided particular benefits to the consumers. They were products that were push-marketed to, you know, more vulnerable populations and then spread out as the bubble grew and housing became more unaffordable for most families. CHAIRMAN ANGELIDES: All right. Thank you very much. And, last question here, before we move on, which is that—do you have data on—and maybe, again, it’s contained. I’ve read a lot, but at 56, I don’t retain all. And that is, do you have data on the extent to which community banks engaged in subprime origination? CLOUTIER: Yes, we—we—I’m sure we have data on that, but it was very, very little. Let me—can I just add on to both of these comments... CHAIRMAN ANGELIDES: Can you—well, let me just say, can you get us some data on... CLOUTIER: fcic_final_report_full--606 Regulatory Authority (FINRA), March 24, 2009. 30. Susan Mills, testimony before the FCIC, hearing on Subprime Lending and Securitization and Government-Sponsored Enterprises (GSEs), day 1, session 2: Subprime Origination and Securitization, April 7, 2010, transcript, pp. 186–87. 31. Mills, interview. 32. Murray Barnes, former managing director of Independent Risk, interview by FCIC, March 2, 2010. 33. Notes on Senior Supervisors’ Meeting with Firms, meeting between Citigroup and Federal Re- serve Bank of New York, Federal Reserve Board, Office of the Comptroller of the Currency, Securities and Exchange Commission, U.K. Financial Services Authority, and Japan FSA, November 19, 2007, p. 17. 34. Janice Warne, interview by FCIC, February 2, 2010; Nestor Dominguez, interview by FCIC, March 2, 2010. 35. Dominguez, interview. 36. Nestor Dominguez, testimony before the FCIC, Hearing on Subprime Lending and Securitization and Government-Sponsored Enterprises (GSEs), day 1, session 3: Citigroup Subprime-Related Struc- tured Products and Risk Management, April 7, 2010, transcript, pp. 282–83. 37. Barnes, interview. 38. Ibid. 39. Notes on Senior Supervisors’ Meeting with Firms, meeting with Citigroup, November 19, 2007, p. 6. 40. FCIC staff calculations. 41. Prince, testimony before the FCIC, April 8, 2010, transcript, p. 118; David Bushnell, interview by FCIC, April 1, 2010. 42. Bushnell, interview. 43. Ellen “Bebe” Duke, Citigroup Independent Risk, interview by FCIC, March 18, 2010. 44. Barnes, interview. 45. James Xanthos, interview by Financial Industry Regulatory Authority (FINRA), March 24, 2009. 46. Barnes, interview. 47. Prince, interview. 48. Robert Rubin, former chairman of the Executive Committee and adviser, interview by FCIC, March 11, 2010. 49. Thomas Maheras, former co-CEO of Citi Markets & Banking, interview by FCIC, March 10, 2010. 50. Prince, interview. 51. Citigroup, Presentation to the Securities and Exchange Commission Regarding Overall CDO Business and Subprime Exposure, June 2007, p. 11. 52. Paul, Weiss, Citigroup’s counsel, response to FCIC Interrogatory #18, March 1, 2010. 53. Citigroup, 2Q 2007 Earnings Call Q&A transcript, July 20, 2007. 54. Complaint, Securities and Exchange Commission v. Citigroup Inc., 1:10-cv-01277 (D.D.C), July 29, 2010. 55. Federal Reserve Board of New York, letter to Vikram Pandit and the Board of the Directors of Citigroup, April 15, 2008, p. 11. 56. Dominguez, testimony before the FCIC, April 7, 2010, transcript, p. 281. 57. Maheras, interview, and testimony before the FCIC, Hearing on Subprime Lending and Securiti- zation and Government-Sponsored Enterprises (GSEs), day 1, session 3: Citigroup Subprime-Related Structured Products and Risk Management, April 7, 2010, transcript, p. 269. 58. Bushnell, interview. 59. Prince, interview. 60. Complaint, Securities and Exchange Commission v. Citigroup Inc., p. 13. 61. Maheras, interview. 603 62. Prince, interview; Charles Prince, email to Robert Rubin, re, September 9, 2007, 9:43 A . M . (on fcic_final_report_full--264 Disruptions quickly spread to other parts of the money market. In a flight to qual- ity, investors dumped their repo and commercial paper holdings and increased their holdings in seemingly safer money market funds and Treasury bonds. Market partici- pants, unsure of each other’s potential subprime exposures, scrambled to amass funds for their own liquidity. Banks became less willing to lend to each other. A closely watched indicator of interbank lending rates, called the one-month LIBOR-OIS spread, increased, signifying that banks were concerned about the credit risk involved in lending to each other. On August , it rose sharply, increasing three-to fourfold over historical values, and by September , it climbed by another . In , it would peak much higher. The panic in the repo, commercial paper, and interbank markets was met by imme- diate government action. On August , the day after BNP Paribas suspended redemp- tions, the Fed announced that it would “provid[e] liquidity as necessary to facilitate the orderly functioning of financial markets,”  and the European Central Bank infused billions of Euros into overnight lending markets. On August , the Fed cut the dis- count rate by  basis points—from . to .. This would be the first of many such cuts aimed at increasing liquidity. The Fed also extended the term of discount- window lending to  days (from the usual overnight or very short-term period) to of- fer banks a more stable source of funds. On the same day, the Fed’s FOMC released a statement acknowledging the continued market deterioration and promising that it was “prepared to act as needed to mitigate the adverse effects on the economy.”  SIV S : “AN OASIS OF CALM ” In August, the turmoil in asset-backed commercial paper markets hit the market for structured investment vehicles, or SIVs, even though most of these programs had lit- tle subprime mortgage exposure. SIVs had a stable history since their introduction in . These investments had weathered a number of credit crises—even through early summer of , as noted in a Moody’s report issued on July , , titled “SIVs: An Oasis of Calm in the Sub-prime Maelstrom.”  Unlike typical asset-backed commercial paper programs, SIVs were funded pri- marily through medium-term notes—bonds maturing in one to five years. SIVs held significant amounts of highly liquid assets and marked those assets to market prices daily or weekly, which allowed them to operate without explicit liquidity support from their sponsors. The SIV sector tripled in assets between  and . On the eve of the crisis, there were  SIVs with almost  billion in assets.  About one-quarter of that money was invested in mortgage-backed securities or in CDOs, but only  was in- vested in subprime mortgage–backed securities and CDOs holding mortgage-backed securities. Not surprisingly, the first SIVs to fail were concentrated in subprime mortgage– backed securities, mortgage-related CDOs, or both. These included Cheyne Finance (managed by London-based Cheyne Capital Management), Rhinebridge (another IKB program), Golden Key, and Mainsail II (both structured by Barclays Capital). Be- tween August and October, each of these four was forced to restructure or liquidate. Investors soon ran from even the safer SIVs. “The media was quite happy to sen- sationalize the collapse of the next ‘leaking SIV’ or the next ‘SIV-positive’ institution,” then-Moody’s managing director Henry Tabe told the FCIC.  The situation was complicated by the SIVs’ lack of transparency. “In a context of opacity about where risk resides, . . . a general distrust has contaminated many asset classes. What had once been liquid is now illiquid. Good collateral cannot be sold or financed at any- thing approaching its true value,” Moody’s wrote on September .  FinancialCrisisReport--74 Home Equity originations were projected to grow from $4 billion in 2005 to $30 billion in 2008. On the other hand, WaMu’s low risk originations were expected to be curtailed dramatically. Government backed loan originations, which totaled $8 billion in 2005, were projected to be eliminated by 2008. Fixed rate loan originations were projected to decline from $69 billion in 2005 to $4 billion in 2008. The 2007 “Strategic Direction” memorandum to the Board is dated June 18, 2007, well after U.S. housing prices had begun to decline, as Mr. Killinger acknowledged: “For the past two years, we have been predicting the bursting of the housing bubble and the likelihood of a slowing housing market. This scenario has now turned into a reality. Housing prices are declining in many areas of the country and sales are rapidly slowing. This is leading to an increase in delinquencies and loan losses. The sub-prime market was especially rocked as many sub-prime borrowers bought houses at the peak of the cycle and now find their houses are worth less and they are having difficulties refinancing their initial low-rate loans.” 192 While the memorandum’s section on home loan strategy no longer focused on overall growth, it continued to push the shift to high risk lending, despite problems in the subprime market: “Home Loans is a large and important business, but at this point in the cycle, it is unprofitable. The key strategy for 2008 is to execute on the revised strategy adopted in 2006. … We need to optimize the sub-prime and prime distribution channels with particular emphasis on growing the retail banking, home loan center and consumer direct channels. We also expect to portfolio more of Home Loans’ originations in 2008, including the new Mortgage Plus product. We will continue to emphasize higher-risk adjusted return products such as home equity, sub-prime first mortgages, Alt A mortgages and proprietary products such as Mortgage Plus.” 193 The testimony of other WaMu executives further confirms the bank’s implementation of its High Risk Lending Strategy. Ronald Cathcart, who joined WaMu in 2006, to become the company’s Chief Risk Officer, testified: “The company’s strategic plan to shift its portfolios towards higher margin products was already underway when I arrived at WaMu. Basically, this strategy involved moving away from traditional mortgage lending into alternative lending programs involving adjustable-rate mortgages as well as into subprime products. The strategic shift to 192 6/18/2007 Washington Mutual memorandum from Kerry Killinger to the Board of Directors, “Strategic Direction,” JPM_WM03227058-67 at 60, Hearing Exhibit 4/13-6a. 193 Id. at 66 [emphasis in original removed]. See also 1/2007 Washington Mutual presentation, “Subprime Mortgage Program,” JPM_WM02551400, Hearing Exhibit 4/13-5 (informing potential investors in its subprime RMBS securities that: “WaMu is focusing on higher margin products”). higher-margin products resulted in the bank taking on a higher degree of credit risk because there was a greater chance that borrowers would default.” 194 CHRG-111shrg54675--29 Mr. Hopkins," I would say that we do not have the issues with the subprime mortgages in South Dakota and, in general, most of the rural areas of the Midwest. I think it was more of a conservative lending philosophy, and we did not have a lot of the mortgage brokers in our areas. Those that we have had have come in to us, and we did not have the rapid increases in the home valuations as seen in some of the more urban areas of California, Nevada, Florida, Michigan, and some of those areas--Michigan, I take that back, has not had the rapid rise. But some of these other areas that have had the rapid rise, therefore, they have been easier to refinance into conventional mortgages when they have come in. And we have used the loan modification program for those that have come in and have found it to be successful to this point. " FinancialCrisisReport--181 The ROE also reported on an unsatisfactory review of loans that had been originated by Long Beach and warned that, if the problems were not promptly corrected, “heightened supervisory action would be taken”: “Based on our review of 75 subprime loans originated by [Long Beach], we concluded that subprime underwriting practices remain less than satisfactory …. Given that this is a repeat concern and MRBA [Matter Requiring Board Attention], we informed management that underwriting must be promptly corrected, or heightened supervisory action would be taken, including limiting the Bank’s ability to continue SFR subprime underwriting.” 664 In the fourth quarter of 2007, WaMu’s loan portfolio lost $1 billion in value. Despite that loss, and the strong language in the 2007 examinations, OTS took no enforcement action against the bank that would result in WaMu’s tightening its lending standards or strengthening compliance with the standards it had. 2008 Lending Deficiencies. In the first six months of 2008, WaMu continued to incur billions of dollars in losses, as its high risk loan portfolio lost value and its share price fell. In July 2008, about two months before the bank failed, OTS met with the WaMu Board of Directors to discuss, among other matters, the bank’s deficient lending standards. While the presentation to the Board reiterated the concerns from past years, it failed to convey a sense of urgency to a bank on the verge of collapse. Instead, the presentation focused on long term corrective action that WaMu should take. The OTS written presentation to the Board included the following: “High SFR [Single Family Residential] losses due in part to downturn in real estate market but exacerbated by: geographic concentrations[,] risk layering[,] liberal underwriting policy[,] poor underwriting. … Discontinuing higher risk lending and tightened underwriting policy should improve asset quality; however, actions should have been taken sooner. … Significant underwriting and process weaknesses noted again in the Home Loans Group[.] ... Reducing higher risk lending products and practices should have been done sooner.” 665 Failure to Correct Deficient Lending Practices. In various reports for nearly five consecutive years, OTS criticized WaMu’s lending standards, error and exception rates, and loan documentation, and directed the bank to improve its performance. When WaMu failed to improve during that span, OTS failed to take action, such as requiring a board resolution, 663 9/18/2007 OTS Report of Examination, at OTSWMEF-0000046679, Hearing Exhibit 4/16-94 [Sealed Exhibit]. 664 9/18/2007 OTS Report of Examination, at OTSWMEF-0000047146, Hearing Exhibit 4/16-94 [Sealed Exhibit]. 665 7/15/2008 OTS Presentation to WaMu Board of Directors based on Comprehensive Examinations, Polakoff_Scott-00061303_007, 012, 027, Hearing Exhibit 4/16-12b. memorandum of understanding, or cease and desist order compelling WaMu to tighten its lending standards and increase oversight of its loan officers to reduce underwriting error and exception rates and improve loan documentation. The result was that WaMu originated or purchased hundreds of billions of dollars of high risk loans, including stated income loans without verification of the borrower’s assets or ability to repay the loan; loans with low FICO scores and high loan-to-value ratios; loans that required interest-only payments; and loan payments that did not cover even the interest owed, much less the principal. (b) Deficiencies in Risk Management fcic_final_report_full--451 What Caused the Financial Crisis? George Santayana is often quoted for the aphorism that “Those who cannot remember the past are condemned to repeat it.” Looking back on the financial crisis, we can see why the study of history is often so contentious and why revisionist histories are so easy to construct. There are always many factors that could have caused an historical event; the diffi cult task is to discern which, among a welter of possible causes, were the significant ones—the ones without which history would have been different. Using this standard, I believe that the sine qua non of the financial crisis was U.S. government housing policy, which led to the creation of 27 million subprime and other risky loans—half of all mortgages in the United States— which were ready to default as soon as the massive 1997-2007 housing bubble began to deflate. If the U.S. government had not chosen this policy path—fostering the growth of a bubble of unprecedented size and an equally unprecedented number of weak and high risk residential mortgages—the great financial crisis of 2008 would never have occurred. Initiated by Congress in 1992 and pressed by HUD in both the Clinton and George W. Bush Administrations, the U.S. government’s housing policy sought to increase home ownership in the United States through an intensive effort to reduce mortgage underwriting standards. In pursuit of this policy, HUD used (i) the affordable housing requirements imposed by Congress in 1992 on the government- sponsored enterprises (GSEs) Fannie Mae and Freddie Mac, (ii) its control over the policies of the Federal Housing Administration (FHA), and (iii) a “Best Practices Initiative” for subprime lenders and mortgage banks, to encourage greater subprime and other high risk lending. HUD’s key role in the growth of subprime and other high risk mortgage lending is covered in detail in Part III. Ultimately, all these entities, as well as insured banks covered by the CRA, were compelled to compete for mortgage borrowers who were at or below the median income in the areas in which they lived. This competition caused underwriting standards to decline, increased the numbers of weak and high risk loans far beyond what the market would produce without government influence, and contributed importantly to the growth of the 1997-2007 housing bubble. When the bubble began to deflate in mid-2007, the low quality and high risk loans engendered by government policies failed in unprecedented numbers. The effect of these defaults was exacerbated by the fact that few if any investors— including housing market analysts—understood at the time that Fannie Mae and Freddie Mac had been acquiring large numbers of subprime and other high risk loans in order to meet HUD’s affordable housing goals. Alarmed by the unexpected delinquencies and defaults that began to appear in mid-2007, investors fled the multi-trillion dollar market for mortgage-backed 445 securities (MBS), dropping MBS values—and especially those MBS backed by subprime and other risky loans—to fractions of their former prices. Mark-to- market accounting then required financial institutions to write down the value of their assets—reducing their capital positions and causing great investor and creditor unease. The mechanism by which the defaults and delinquencies on subprime and other high risk mortgages were transmitted to the financial system as a whole is covered in detail in Part II. CHRG-111shrg52619--106 Chairman Dodd," I am sorry, Senator. Senator Menendez. No. Thank you, Senator Dodd. I appreciate it. Just one more line of questioning. You know, we had a witness before the Committee, Professor McCoy of the University of Connecticut School of Law, and she made some statements that were, you know, pretty alarming to me. She said, ``The OCC has asserted that national banks made only 10 percent of subprime loans in 2006. But this assertion fails to mention that national banks moved aggressively into Alternate-A low-documentation and no-documentation loans during the housing boom.'' ``Unlike OTS, the OCC did promulgate one rule in 2004 prohibiting mortgages to borrowers who could not afford to pay. However, the rule was vague in design and execution, allowing lax lending to proliferate at national banks and their mortgage lending subsidiaries through 2007.'' ``Despite the 2004 rules, through 2007, large national banks continued to make large quantities of poorly underwritten subprime loans and low- and no-documentation loans.'' ``The five largest U.S. banks in 2005 were all national banks and too big to fail. They too made heavy inroads into low- and no-documentation loans.'' And so it just seems to me that some of the biggest bank failures have been under your agency's watch, and they, too, involved thrifts heavily into nil documents, low documents, Alternate A, and nontraditionals, and it is hard to make the case that we had an adequate job of oversight given those results. We have heard a lot here about one of our problems is regulatory arbitrage. Don't you think that they chose your agency because they thought they would get a better break? " FinancialCrisisInquiry--187 Good afternoon Chairman Angelides, Vice Chairman Thomas, and members of the commission. Thank you so much for the invitation to participate in this hearing. I’m Julia Gordon, Senior Policy Counsel at the Center for Responsible Lending, a non-profit, non- partisan research and policy organization. We’re an affiliate of the Community—of the Center for Community Self Help—a community development financial institution that makes mortgage loans in lower income communities. At the end of 2006 our organization published a study projecting that one out of five subprime mortgages would fail. At the time we were called “wildly pessimistic.” Given the resulting devastation, we sincerely wish our projections had been wrong. Instead, we were far too optimistic. In this morning’s panel, several of the CEOs talked about some sleepless nights last September right before the government came in to bail out the banks. Right now there’s 6.5 million people having a sleepless night, night after night, because they fear that their family won’t have a roof over their head tomorrow. These families are either late with their payments, or many are already in the foreclosure process. More than two million foreclosures have occurred in the past two years alone, and the problem has spread far beyond the subprime market. By 2014 we expect that up to 13 million foreclosures may have taken place. Beyond the losses to the foreclosed owners themselves, the spill over cost of this crisis are massive. Millions of families who pay their mortgage very month are suffering hundreds of billions of dollars in lost wealth, just because they live close to homes in foreclosure. Those who don’t own homes suffer too. One study found that 40 percent of those who have lost their home due to this crisis are renters who’s landlords were foreclosed on. And of course foreclosures hurt all of us through lost tax revenue, and increased costs for fire, police, and other municipal services. I can summarize my testimony this way. Today’s foreclosure crisis was foreseeable and avoidable. And the loan products offered absolutely no benefit whatsoever to America’s consumers over standard loan products. Subprime lending didn’t even increase home ownership. Through 2006 first time home buyers accounted for only 10 percent of all subprime loans. And now in the aftermath of the melt down, there’s been a net loss of home ownership that set us back a decade. fcic_final_report_full--245 EARLY 2007: SPREADING SUBPRIME WORRIES CONTENTS Goldman: “Let’s be aggressive distributing things” .............................................  Bear Stearns’s hedge funds: “Looks pretty damn ugly” .......................................  Rating agencies: “It can’t be . . . all of a sudden” .................................................  AIG: “Well bigger than we ever planned for” ....................................................  Over the course of , the collapse of the housing bubble and the abrupt shutdown of subprime lending led to losses for many financial institutions, runs on money mar- ket funds, tighter credit, and higher interest rates. Unemployment remained rela- tively steady, hovering just below . until the end of the year, and oil prices rose dramatically. By the middle of , home prices had declined almost  from their peak in . Early evidence of the coming storm was the . drop in November  of the ABX Index—a Dow Jones–like index for credit default swaps on BBB- tranches of mortgage-backed securities issued in the first half of .  That drop came after Moody’s and S&P put on negative watch selected tranches in one deal backed by mortgages from one originator: Fremont Investment & Loan.  In December, the same index fell another  after the mortgage companies Ownit Mortgage Solutions and Sebring Capital ceased operations. Senior risk officers of the five largest investment banks told the Securities and Exchange Commission that they expected to see further subprime lender failures in . “There is a broad recogni- tion that, with the refinancing and real estate booms over, the business model of many of the smaller subprime originators is no longer viable,” SEC analysts told Di- rector Erik Sirri in a January , , memorandum.  That became more and more evident. In January, Mortgage Lenders Network an- nounced it had stopped funding mortgages and accepting applications. In February, New Century reported bigger-than-expected mortgage credit losses and HSBC, the largest subprime lender in the United States, announced a . billion increase in its quarterly provision for losses. In March, Fremont stopped originating subprime loans after receiving a cease and desist order from the Federal Deposit Insurance Corporation. In April, New Century filed for bankruptcy.  CHRG-111hhrg52406--218 Mr. Manzullo," Thank you. I do not believe we should start a whole new consumer agency to protect the consumer on financial products. However, the analysis done by Mr. Plunkett and Ed, I would commend that everybody on the panel read the reasons why they want to set up a new organization because of the complete failure of the existing organizations to stop the subprime massacre that took place in the country. So I can understand where they are coming from, but it is irrelevant to you guys on the insurance side. I would like to ask this question of Mr. Plunkett. On page 3, the last paragraph, you state that the failure of Federal banking agencies to stem subprime mortgage lending abuses is fairly well-known. They did not use a regulatory authority granted to them to stop unfair and deceptive lending practices until it was too late. You are advocating the setting up of another agency. I can understand the reason for that because what is there did not step into the breach. I mean the Fed had the authority, and Mr. Greenspan could have stopped it. Most of this occurred before Mr. Bernanke came on board, because there were no rules that said that you had to have proof of payment or proof of your income before you could buy a house or could do away with these predatory practices of 3/27 and 2/28 mortgages. My concern is, even though the appointees to this new body would be ``consumer-oriented,'' I would think that, ultimately, the bottom line is everything should be consumer-oriented because it is the consumer who has the greatest stake in the banks and in the other financial institutions being sound and safe. It protects them. So there is actually an identity of interest that is involved. Mr. Plunkett, what would make this new agency political proof or able to do the job or to recognize what the other agencies did not? " fcic_final_report_full--493 Lower-income and minority families have made major gains in access to the mortgage market in the 1990s. A variety of reasons have accounted for these gains, including improved housing affordability, enhanced enforcement of the Community Reinvestment Act, more flexible mortgage underwriting , and stepped-up enforcement of the Fair Housing Act. But most industry observers believe that one factor behind these gains has been the improved performance of Fannie Mae and Freddie Mac under HUD’s affordable lending goals. HUD’s recent increases in the goals for 2001-03 will encourage the GSEs to further step up their support for affordable lending . 62 [emphasis supplied] Or this statement in 2004, when HUD was again increasing the affordable housing goals for Fannie and Freddie: Millions of Americans with less than perfect credit or who cannot meet some of the tougher underwriting requirements of the prime market for reasons such as inadequate income documentation, limited downpayment or cash reserves, or the desire to take more cash out in a refinancing than conventional loans allow, rely on subprime lenders for access to mortgage financing. If the GSEs reach deeper into the subprime market, more borrowers will benefit from the advantages that greater stability and standardization create . 63 [emphasis supplied] Or, finally, this statement in a 2005 report commissioned by HUD: More liberal mortgage financing has contributed to the increase in demand for housing. During the 1990s, lenders have been encouraged by HUD and banking regulators to increase lending to low-income and minority households. The Community Reinvestment Act (CRA), Home Mortgage Disclosure Act (HMDA), government-sponsored enterprises (GSE) housing goals and fair lending laws have strongly encouraged mortgage brokers and lenders to market to low-income and minority borrowers. Sometimes these borrowers are higher risk, with blemished credit histories and high debt or simply little savings for a down payment. Lenders have responded with low down payment loan products and automated underwriting, which has allowed them to more carefully determine the risk of the loan. 64 [emphasis supplied] Despite the recent effort by HUD to deny its own role in fostering the growth of subprime and other high risk mortgage lending, there is strong—indeed irrefutable—evidence that, beginning in the early 1990s, HUD led an ultimately successful effort to lower underwriting standards in every area of the mortgage market where HUD had or could obtain influence. With support in congressional legislation, the policy was launched in the Clinton administration and extended almost to the end of the Bush administration. It involved FHA, which was under the direct control of HUD; Fannie Mae and Freddie Mac, which were subject to HUD’s affordable housing regulations; and the mortgage banking industry, which— while not subject to HUD’s legal jurisdiction—apparently agreed to pursue HUD’s 62 63 64 Issue Brief: HUD’s Affordable Housing Goals for Fannie Mae and Freddie Mac, p.5. Final Rule, http://fdsys.gpo.gov/fdsys/pkg/FR-2004-11-02/pdf/04-24101.pdf. HUD PDR, May 2005, HUD Contract C-OPC-21895, Task Order CHI-T0007, “Recent House Price Trends and Homeownership Affordability”, p.85. 489 policies out of fear that they would be brought under the Community Reinvestment Act through legislation. 65 In addition, although not subject to HUD’s jurisdiction, the new tighter CRA regulations that became effective in 1995 led to a process in which community groups could obtain commitments for substantial amounts of CRA-qualifying mortgages and other loans to subprime borrowers when banks were applying for merger approvals. 66 FinancialCrisisReport--112 The robust risk management system contemplated by in the January 2005 memorandum, which was critical to the success of the High Risk Lending Strategy, was never meaningfully implemented. To the contrary, risk managers were marginalized, undermined, and often ignored. As former Chief Risk Manager Jim Vanasek testified at the April 13 Subcommittee hearing: “I made repeated efforts to cap the percentage of high-risk and subprime loans in the portfolio. Similarly, I put a moratorium on non-owner-occupied loans when the percentage of these assets grew excessively due to speculation in the housing market. I attempted to limit the number of stated income loans, loans made without verification of income. But without solid executive management support, it was questionable how effective any of these efforts proved to be.” 391 Later in the hearing, Mr. Vanasek had the following exchange with Senator Coburn: Senator Coburn: Did you ever step in and try to get people to take a more conservative approach at WaMu? Mr. Vanasek: Constantly. Senator Coburn: Were you listened to? Mr. Vanasek: Very seldom. Senator Coburn: [Had] you ever felt that your opinions were unwelcomed, and could you be specific? Mr. Vanasek: Yes. I used to use a phrase. It was a bit of humor or attempted humor. I used to say the world was a very dark and ugly place in reference to subprime loans. I cautioned about subprime loans consistently. 392 Mr. Vanasek’s description of his efforts is supported by contemporaneous internal documents. In a February 24, 2005 memorandum to the Executive Committee with the subject heading, “Critical Pending Decisions,” for example, Mr. Vanasek cautioned against expanding WaMu’s “risk appetite”: 390 1/2005 “Higher Risk Lending Strategy ‘Asset Allocation Initiative,’” Washington Mutual Board of Directors Finance Committee Discussion, JPM_WM00302975, Hearing Exhibit 4/13-2a [emphasis in original]. 391 April 13, 2010 Subcommittee Hearing at 17. 392 Id. at 32. “My credit team and I fear that we are considering expanding our risk appetite at exactly the wrong point and potentially walking straight into a regulatory challenge and criticism from both the Street and the Board. Said another way I fear that the timing of further expansion into higher risk lending beyond what was contemplated in the ’05 Plan and most especially certain new products being considered is ill-timed given the overheated market and the risk [of] higher interest rates …. CHRG-111hhrg54872--72 The Chairman," And I think that helps make the case as well. In the pre-2004 period, it seems to me people who tell us we have to maintain the field preemption exclusion of regulators from the States being involved that came in 2004 have some burden to show us that there was serious problems before that. And frankly, I think the absence of any evidence is a pretty good sign that was not the case. The standard before 2004 was that if there were conflicting things that the national regulators thought were a problem, they could preempt them case-by-case and we could still have other forms of preemption. Second, I did want to talk about Mr. Castle's point that we were not dealing with the causes. This committee passed and this House passed, in a more partisan voice than I wish, very severe restrictions on subprime mortgages. So we have already done that. And as I have previously mentioned to him, we plan to incorporate them. I know he likes to forget that. But the fact is, over the objection of most people on the Republican side who said we were restricting credit unduly to low-income people, we passed very specific legislation which would restrict subprime mortgages and administering that would be part of the charter of this organization. It would also deal with other nonbank entities. Look, I think we should be very clear. If only banks had been involved in the financial lending business, we would not be in the situation we are in. We would not have had the subprime mortgage problem. There are abuses with check cashing, there are some abuses in payday lending, so this is not an anti-bank entity at all. Indeed, I think much of what this entity will do will be to enforce on nonbanks the rules that have guided banks, particularly the community banks. That doesn't mean there have been no bank problems. There have been some, but I don't know why the gentleman from Delaware keeps arguing that we are leaving these other things out. They will be very explicitly covering nonbank competitors of the banks, and I think that will be enhanced. On another point, though, I do agree with him--the gentleman from Texas, Mr. Hinojosa, the gentlewoman from New York, Mrs. McCarthy, and the gentlewoman from Illinois, Ms. Biggert, have been working together on financial literacy. We have had trouble figuring how to deal with this institutionally. One of the things that we expect to be a major part of this new agency is a significant emphasis on financial literacy, I think there is broad agreement. As I said, I think the gentlewoman from Illinois has been a part of that. I now recognize Mrs. Capito. " CHRG-110hhrg34673--208 Mr. Bernanke," Well, I indicated that it is very difficult. And I am not just trying to hedge here, because we want to eliminate predatory and abusive lending, but we don't want to shut down the legitimate subprime market. And that is sometimes a difficult task, and that is why I was praising some of the State efforts that represent good experiments along those lines. So approaching that I think involves disclosure, it may involve barring certain practices as well. The Federal Reserve, I should say, is very much involved in trying to control predatory lending. We are responsible for the Home Mortgage Disclosure Act. We recently added information requirements there on pricing so we can find out whether pricing is varying across, for example, minorities and nonminorities. We are responsible for the Home Ownership Equity Protection Act and other things, Regulation Z. So we are very much involved in that from the Federal level. But again, I think there is still a lot of creativity we can see at the State level to try to understand better how to address this problem. " FinancialCrisisReport--70 Mr. Vanasek agreed: “I could not agree more. All the classic signs are there and the likely outcome is probably not great. We would all like to think the air can come out of the balloon slowly but history would not lean you in that direction. Over the next month or so I am going to work hard on what I hope can be a lasting mechanism (legacy) for determining how much risk we can afford to take ….” Despite Mr. Killinger’s awareness that housing prices were unsustainable, could drop suddenly, and could make it difficult for borrowers to refinance or sell their homes, Mr. Killinger continued to push forward with WaMu’s High Risk Lending Strategy. (6) Execution of the High Risk Lending Strategy WaMu formally adopted the High Risk Lending Strategy in January 2005. 179 Over the following two years, management significantly shifted the bank’s loan originations towards riskier loans as called for in the plan, but had to slow down the pace of implementation in the face of worsening market conditions. In retrospect, WaMu executives tried to portray their inability to fully execute the plan as a strategic choice rather than the result of a failed strategy. For example, Mr. Killinger testified at the Subcommittee hearing that the bank’s High Risk Lending Strategy was only contemplated, but not really executed: “First, we had an adjustment in our strategy that started in about 2004 to gradually increase the amount of home equity, subprime, commercial real estate, and multi-family loans that we could hold on the balance sheet. We had that long-term strategy, but … we quickly determined that the housing market was increasing in its risk, and we put most of those strategies for expansion on hold.” 180 Mr. Killinger’s claim that the High Risk Lending Strategy was put “on hold” is contradicted, however, by WaMu’s SEC filings, its internal documents, and the testimony of other WaMu executives. Washington Mutual’s SEC filings contain loan origination and acquisition data showing that the bank did implement its High Risk Lending Strategy. Although rising defaults and the 2007 collapse of the subprime secondary market prevented WaMu from fully executing its plans, WaMu dramatically shifted the composition of the loans it originated and purchased, nearly 179 See 3/13/2006 OTS Report of Examination, at OTSWMS06-008 0001677, Hearing Exhibit 4/16-94 [Sealed Exhibit]. 180 April 13, 2010 Subcommittee Hearing at 88. doubling the percentage of higher risk home loans from 36% to 67%. The following chart, prepared by the Subcommittee using data from WaMu’s SEC filings, demonstrates the shift. 181 FinancialCrisisInquiry--652 GORDON: January 13, 2010 Yes. You know, what we’ve observed over time with traditionally underserved borrowers or people with lower or nontraditional credit histories is that we always had higher delinquency rates than was typical in the prime markets but our actual loss rates always ran under 1 percent. And part of that was because—part of how to run a successful operation, lending to these communities, includes understanding that there can be different kinds of income interruptions and vicissitudes of life and working with borrowers through those periods to keep the loan performing. And so, really, we—you know, now, of course, we’ve been impacted by the larger crisis. But just—then what’s become what we now talk about as subprime lending is loan products that had risky features and, as Professor Rosen’s discussed, lots of layers of risk. And these were not products, for the most part, except in the narrowest, narrowest sense—for the most part, these were never products that provided particular benefits to the consumers. They were products that were push-marketed to, you know, more vulnerable populations and then spread out as the bubble grew and housing became more unaffordable for most families. CHRG-110hhrg44900--156 Mr. Miller," Thank you. I have served on this committee for almost 6 years, and I remember the testimony pretty well on mortgage lending, but I have recently gone back and reviewed some of it to see what the lending industry was saying at the time about the kind of mortgage practices that have led to the problem. And what they have always said was that the provisions of the mortgages that may seem to be a problem, they seem unfavorable to consumers, actually were risk based, they were responding to a greater risk by certain borrowers, and that without those provisions they would not be able to lend to those borrowers, and those borrowers would be denied credit, would be unable to buy a home, and be unable to borrow against their homes to provide for life's rainy days. Looking back on the practices that actually led to the problem, the subprime mortgages made in 2005 and 2006, it is pretty clear that those provisions had nothing to do with risk and nothing to do with benefiting consumers or making credit available to them that would otherwise not have been available. It was a fundamental change in consumer lending from making an honest living off the spread to trying to trap consumers, homeowners into a cycle of having to borrow repeatedly and paying penalties and fees when they did, and that the loans were intended to become unpayable for the borrowers, so the borrower would have to borrow again. Insurance regulation at the State level generally requires that policy forms provisions and policies and premiums be approved in advance by the State regulator, and that the insurer has to justify those provisions. So the kinds of arguments that we heard in this committee that we were not really in a position to judge on a provision by provision basis, a reasonably competent regulator could judge and determine whether that really was related to the risk, whether it really was to the advantage of the consumer, and whether it also presented a solvency issue for an insurer. Secretary Paulson, the proposed regulator to protect consumers, will that regulator have the authority, should it have the authority, to review consumer lending products in advance to see if the practices can be justified both for what it might do to the solvency of the institution and also what it does to the consumer? " fcic_final_report_full--233 Contrary to this view, two Fed economists determined that lenders actually made few subprime loans to meet their CRA requirements. Analyzing a database of nearly  million loans originated in , they found that only a small percentage of all higher-cost loans as defined by the Home Mortgage Disclosure Act had any connec- tion to the CRA. These higher-cost loans serve as a rough proxy for subprime mort- gages. Specifically, the study found that only  of such higher-cost loans were made to low- or moderate-income borrowers or in low- or moderate-income neighbor- hoods by banks and thrifts (and their subsidiaries and affiliates) covered by the CRA. The other  of higher-cost loans either were made by CRA-covered institutions that did not receive CRA credit for these loans or were made by lenders not covered by the CRA. Using other data sources, these economists also found that CRA-related subprime loans appeared to perform better than other subprime loans. “Taken to- gether, the available evidence seems to run counter to the contention that the CRA contributed in any substantive way to the current crisis,” they wrote.  Subsequent research has come to similar conclusions. For example, two econo- mists at the San Francisco Fed, using a different methodology and analyzing data on the California mortgage market, found that only  of loans made by CRA-covered lenders were located in low- and moderate-income census tracts versus over  for independent mortgage companies not covered by the CRA. Further, fewer than  of the loans made by CRA lenders in low-income communities were higher priced, even at the peak of the market. In contrast, about one-half of the loans originated by independent mortgage companies in these communities were higher priced. And af- ter accounting for characteristics of the loans and the borrowers, such as income and credit score, the authors found that loans made by CRA-covered lenders in the low- and moderate-income areas they serve were half as likely to default as similar loans made by independent mortgage companies, which are not subject to CRA and are subject to less regulatory oversight in general. “While certainly not conclusive, this suggests that the CRA, and particularly its emphasis on loans made within a lender’s assessment area, helped to ensure responsible lending, even during a period of over- all declines in underwriting standards,” they concluded.  Overall, in , , and , CRA-covered banks and thrifts accounted for at least  of all mortgage lending but only between  and  of higher-priced mortgages. Independent mortgage companies originated less than one-third of all mortgages but about one-half of all higher-priced mortgages.  Finally, lending by nonbank affiliates of CRA-covered depository institutions is counted toward CRA performance at the discretion of the bank or thrift. These affiliates accounted for an- other roughly  of mortgage lending but about  of high-price lending. Bank of America provided the FCIC with performance data on its CRA-qualify- ing portfolio, which represented only  of the bank’s mortgage portfolio.  In the end of the first quarter of ,  of the bank’s  billion portfolio of residential mortgages was nonperforming:  of the  billion CRA-qualifying portfolio was nonperforming at that date. John Reed, a former CEO of Citigroup, when asked whether he thought govern- ment policies such as the CRA played a role in the crisis, said that he didn’t believe banks would originate “a bad mortgage because they thought the government policy allowed it” unless the bank could sell off the mortgage to Fannie or Freddie, which had their own obligations in this arena. He said, “It’s hard for me to answer. If the rea- son the regulators didn’t jump up and down and yell at the low-doc, no-doc sub- prime mortgage was because they felt that they, Congress had sort of pushed in that direction, then I would say yes.”  “You know, CRA could be a pain in the neck,” the banker Lewis Ranieri told the FCIC. “But you know what? It always, in my view, it always did much more good than it did anything. You know, we did a lot. CRA made a big difference in communi- ties. . . . You were really putting money in the communities in ways that really stabi- lized the communities and made a difference.” But lenders including Countrywide used pro-homeownership policies as a “smokescreen” to do away with underwriting standards such as requiring down payments, he said. “The danger is that it gives air cover to all of this kind of madness that had nothing to do with the housing goal.”  fcic_final_report_full--16 Finally, as to the matter of whether government housing policies were a primary cause of the crisis: for decades, government policy has encouraged homeownership through a set of incentives, assistance programs, and mandates. These policies were put in place and promoted by several administrations and Congresses—indeed, both Presidents Bill Clinton and George W. Bush set aggressive goals to increase home- ownership. In conducting our inquiry, we took a careful look at HUD’s affordable housing goals, as noted above, and the Community Reinvestment Act (CRA). The CRA was enacted in  to combat “redlining” by banks—the practice of denying credit to in- dividuals and businesses in certain neighborhoods without regard to their creditwor- thiness. The CRA requires banks and savings and loans to lend, invest, and provide services to the communities from which they take deposits, consistent with bank safety and soundness. The Commission concludes the CRA was not a significant factor in subprime lend- ing or the crisis. Many subprime lenders were not subject to the CRA. Research indi- cates only  of high-cost loans—a proxy for subprime loans—had any connection to the law. Loans made by CRA-regulated lenders in the neighborhoods in which they were required to lend were half as likely to default as similar loans made in the same neighborhoods by independent mortgage originators not subject to the law. Nonetheless, we make the following observation about government housing poli- cies—they failed in this respect: As a nation, we set aggressive homeownership goals with the desire to extend credit to families previously denied access to the financial markets. Yet the government failed to ensure that the philosophy of opportunity was being matched by the practical realities on the ground. Witness again the failure of the Federal Reserve and other regulators to rein in irresponsible lending. Homeown- ership peaked in the spring of  and then began to decline. From that point on, the talk of opportunity was tragically at odds with the reality of a financial disaster in the making. * * * W HEN THIS C OMMISSION began its work  months ago, some imagined that the events of  and their consequences would be well behind us by the time we issued this report. Yet more than two years after the federal government intervened in an unprecedented manner in our financial markets, our country finds itself still grap- pling with the aftereffects of the calamity. Our financial system is, in many respects, still unchanged from what existed on the eve of the crisis. Indeed, in the wake of the crisis, the U.S. financial sector is now more concentrated than ever in the hands of a few large, systemically significant institutions. While we have not been charged with making policy recommendations, the very purpose of our report has been to take stock of what happened so we can plot a new course. In our inquiry, we found dramatic breakdowns of corporate governance, profound lapses in regulatory oversight, and near fatal flaws in our financial system. We also found that a series of choices and actions led us toward a catastrophe for which we were ill prepared. These are serious matters that must be addressed and resolved to restore faith in our financial markets, to avoid the next crisis, and to re- build a system of capital that provides the foundation for a new era of broadly shared prosperity. fcic_final_report_full--126 Back in  the OTS had issued rules saying federal law preempted state preda- tory lending laws for federally regulated thrifts.  In , the OTS referred to these rules in issuing four opinion letters declaring that laws in Georgia, New York, New Jersey, and New Mexico did not apply to national thrifts. In the New Mexico opinion, the regulator pronounced invalid New Mexico’s bans on balloon payments, negative amortization, prepayment penalties, loan flipping, and lending without regard to the borrower’s ability to repay. The Comptroller of the Currency took the same line on the national banks that it regulated, offering preemption as an inducement to use a national bank charter. In a  speech, before the final OCC rules were passed, Comptroller John D. Hawke Jr. pointed to “national banks’ immunity from many state laws” as “a significant benefit of the national charter—a benefit that the OCC has fought hard over the years to pre- serve.”  In an interview that year, Hawke explained that the potential loss of regula- tory market share for the OCC “was a matter of concern.”  In August  the OCC issued its first preemptive order, aimed at Georgia’s mini-HOEPA statute, and in January  the OCC adopted a sweeping preemption rule applying to all state laws that interfered with or placed conditions on national banks’ ability to lend. Shortly afterward, three large banks with combined assets of more than  trillion said they would convert from state charters to national charters, which increased OCC’s annual budget .  State-chartered operating subsidiaries were another point of contention in the preemption battle. In  the OCC had adopted a regulation preempting state law regarding state-chartered operating subsidiaries of national banks. In response, sev- eral large national banks moved their mortgage-lending operations into subsidiaries and asserted that the subsidiaries were exempt from state mortgage lending laws. Four states challenged the regulation, but the Supreme Court ruled against them in .  Once OCC and OTS preemption was in place, the two federal agencies were the only regulators with the power to prohibit abusive lending practices by national banks and thrifts and their direct subsidiaries. Comptroller John Dugan, who suc- ceeded Hawke, defended preemption, noting that “ of all nonprime mortgages were made by lenders that were subject to state law. Well over half were made by mortgage lenders that were exclusively subject to state law.”  Lisa Madigan, the attor- ney general of Illinois, flipped the argument around, noting that national banks and thrifts, and their subsidiaries, were heavily involved in subprime lending. Using dif- ferent data, she contended: “National banks and federal thrifts and . . . their sub- sidiaries . . . were responsible for almost  percent of subprime mortgage loans, . percent of the Alt-A loans, and  percent of the pay-option and interest-only ARMs that were sold.” Madigan told the FCIC: fcic_final_report_full--572 Economics 64 (2008): 223. 31. Michael Calhoun and Julia Gordon, interview by FCIC, September 16, 2010. 32. Annamaria Lusardi, “Americans’ Financial Capability,” report prepared for the FCIC, February 26, 2010, p. 3. 33. FCIC staff estimates based on analysis of Blackbox, S&P, and IP Recovery, provided by Antje Berndt, Burton Hollifield, and Patrik Sandas, in their paper, “The Role of Mortgage Brokers in the Sub- prime Crisis,” April 2010. 34. William C. Apgar and Allen J. Fishbein, “The Changing Industrial Organization of Housing Fi- nance and the Changing Role of Community-Based Organizations,” working paper (Joint Center for Housing Studies, Harvard University, May 2004), p. 9. 35. Herb Sandler, interview by FCIC, September 22, 2010. 36. Wholesale Access, “Mortgage Brokers 2006” (August 2007), pp. 35, 37. 37. Jamie Dimon, testimony before the FCIC, First Public Hearing of the FCIC, panel 1: Financial In- stitution Representatives, January 13, 2010, transcript, p. 13. 38. October Research Corporation, executive summary of the 2007 National Appraisal Survey, p. 4. 39. Dennis J. Black, written testimony for the FCIC, Hearing on the Impact of the Financial Crisis— Miami, session 2: Uncovering Mortgage Fraud in Miami, September 21, 2010, p. 8. 40. Karen J. Mann, written testimony for the FCIC, Hearing on the Impact of the Financial Crisis— Sacramento, session 2: Mortgage Origination, Mortgage Fraud and Predatory Lending in the Sacramento Region, September 23, 2010, p. 2. 41. Gary Crabtree, testimony before the FCIC, Hearing on the Impact of the Financial Crisis— Greater Bakersfield, session 4: Local Housing Market, September 7, 2010, transcript, p. 172. 42. Complaint, People of the State of New York v. First American Corporation and First American eAppraiseIT (N.Y. Sup. Ct. November 1, 2007), pp. 3, 7, 8. 43. Martin Eakes, quoted in Richard A. Oppel Jr. and Patrick McGeehan, “Along with a Lender, Is Citigroup Buying Trouble?” New York Times , October 22, 2000. 44. Pam Flaherty, quoted in Erick Bergquist, “Judging Citi, a Year Later: Subprime Reform ‘on Track’; Critics Unsatisfied ,” American Banker, September 10, 2001. 45. “Citigroup Settles FTC Charges against the Associates Record-Setting $215 Million for Subprime Lending Victims,” Federal Trade Commission press release, September 19, 2002. 46. Mark Olson, interview by FCIC, October 4, 2010. 47. Timothy O’Brien, “Fed Assess Citigroup Unit $70 Million in Loan Abuse,” The New York Times , May 28, 2004. 48. Federal Reserve Board internal staff document, “The Problem of Predatory Lending,” December 5, 2000, pp. 10–13. 49. Federal Reserve Board, Morning Session of Public Hearing on Home Equity Lending, July 27, 2000, opening remarks by Governor Gramlich, p. 9. 50. Scott Alvarez, interview by FCIC, March 23, 2010. 51. Alan Greenspan, written testimony for the FCIC, Hearing on Subprime Lending and Securitiza- tion and Government-Sponsored Enterprises (GSEs), day one, session 1: The Federal Reserve, April 7, 2010, p. 13. 52. Alan Greenspan, quoted in David Faber, And Then the Roof Caved In: How Wall Street’s Greed and Stupidity Brought Capitalism to Its Knees (Hoboken, N.J.: Wiley, 2009), pp. 53–54. 53. “Truth in Lending,” Federal Register 66, no. 245 (December 20, 2001): 65612 (quotation), 65608. 569 54. Robert B. Avery, Glenn B. Canner, and Robert E. Cook, “New Information Reported under HMDA and Its Application in Fair Lending Enforcement,” Federal Reserve Bulletin 91 (Summer 2005): 372. 55. Alan Greenspan, interview by FCIC, March 31, 2010 56. Sheila Bair, testimony before the FCIC, Hearing on Too Big to Fail: Expectations and Impact of Extraordinary Government Intervention and the Role of Systemic Risk in the Financial Crisis, day 2, ses- sion 2: Federal Deposit Insurance Corporation, September 2, 2010, transcript, p. 191. 57. Dolores Smith and Glenn Loney, memorandum to Governor Edward Gramlich, “Compliance In- spections of Nonbank Subsidiaries of Bank Holding Companies,” August 31, 2000. 58. GAO, “Consumer Protection: Federal and State Agencies Face Challenges in Combating Preda- tory Lending,” GAO 04–280 (Report to the Chairman and Ranking Minority Member, Special Commit- tee on Aging, U.S. Senate), January 2004, pp. 52–53. 59. Sandra Braunstein, interview by FCIC, April 1, 2010. Transcript pp. 32–33. 60. Greenspan, interview. 61. Ibid. 62. Edward M. Gramlich, “Booms and Busts: The Case of Subprime Mortgages,” Federal Reserve Bank of Kansas City Economic Review (2007): 109. 63. Edward Gramlich, quoted in Greg Ip, “Did Greenspan Add to Subprime Woes? Gramlich Says Ex- Colleague Blocked Crackdown On Predatory Lenders Despite Growing Concerns,” Wall Street Journal, June 9, 2007. See also Edmund L. Andrews, “Fed Shrugged as Subprime Crisis Spread,” New York Times, December 18, 2007. 64. Patricia McCoy and Margot Saunders, quoted in Binyamin Appelbaum, “Fed Held Back as Evi- dence Mounted on Subprime Loan Abuses,” Washington Post, September 27, 2009. 65. GAO, “Large Bank Mergers: Fair Lending Review Could be Enhanced with Better Coordination,” GAO/GDD-00-16 (Report to the Honorable Maxine Waters and Honorable  Bernard Sanders, House of Representatives), November 1999; GAO, “Consumer Protection:  Federal and State Agencies Face Chal- lenges in Combating Predatory Lending.” 66. “Federal and State Agencies Announce Pilot Project to Improve Supervision of Subprime Mort- gage Lenders,” Joint press release (Fed Reserve Board, OTC, FTC, Conference of State Bank Supervisors, American Association of Residential Mortgage Regulators), July 17, 2007. 67. “Truth in Lending,” pp. 44522–23. “Higher-priced mortgage loans” are defined in the 2008 regula- tions to include mortgage loans whose annual percentage rate exceeds the “average prime offer rates for a comparable transaction” (as published by the Fed) by at least 1.5% for first-lien loans or 3.5% for subordi- nate-lien loans. 68. Alvarez, interview. 69. Raphael W. Bostic, Kathleen C. Engel, Patricia A. McCoy, Anthony Pennington-Cross, and Susan M. Wachter, “State and Local Anti-Predatory Lending Laws: The Effect of Legal Enforcement Mecha- nisms,” Journal of Economics and Business 60 (2008): 47–66. 70. “Lending and Investment,” Federal Register 61, no. 190 (September 30, 1996): 50965. 71. Joseph A. Smith, “Mortgage Market Turmoil: Causes and Consequences,” testimony before the Senate Committee on Banking, Housing, and Urban Affairs, 110th Cong., 1st sess., March 22, 2007, p. 33 (Exhibit B), using data from the Mortgage Asset Research Institute. 72. Lisa Madigan, written testimony for the FCIC, First Public Hearing of the FCIC, day 2, panel 2: Current Investigations into the Financial Crisis—State and Local Officials, January 14, 2010, p.12. 73. Commitments compiled at National Community Reinvestment Coalition, “CRA Commitments” (2007). 74. Josh Silver, NCRC, interview by FCIC, June 16, 2010. 75. Data references based on Reginald Brown, counsel for Bank of America, letter to FCIC, June 16, 2010, p. 2; Jessica Carey, counsel for JPMorgan Chase, letter to FCIC, December 16, 2010; Brad Karp, counsel for Citigroup, letter to FCIC, March 18, 2010, in response to FCIC request; Wells Fargo public commitments 1990–2010, data provided by Wells Fargo to the FCIC. 76. Karp, letter to FCIC, March 18, 2010, in response to FCIC request. 77. Carey, letter to FCIC, December 16, 2010, p. 9; Brad Karp, counsel for JP Morgan, letter to FCIC, fcic_final_report_full--591 Mae and Freddie Mac in the Context of the Mortgage,” February 1, 2010. 199. “HUD Announces New Regulations to Provide $2.4 Trillion in Mortgages for Affordable Hous- ing for 28.1 Million Families,” Department of Housing and Urban Development, press release, October 31, 2000. 200. Mudd, interview. 201. Robert Levin, interview by FCIC, March 17, 2010. 202. “HUD Finalizes Rule on New Housing Goals for Fannie Mae and Freddie Mac,” Department of Housing and Urban Development press release, November 1, 2004. 203. Mudd, testimony before the FCIC, Hearing on Subprime Lending and Securitization and Gov- ernment-Sponsored Enterprises (GSEs), day 3, session: 1 Fannie Mae, April 9, 2010, transcript, pp. 63– 64. 204. See FHFA, “Annual Report to Congress 2009,” pp. 131, 148. The numbers are for mortgage assets + outstanding MBS guaranteed. Total assets + MBS are slightly greater. 205. OFHEO, “2008 Report to Congress,” April 15, 2008. 206. Robert Levin, interview by FCIC, March 17, 2010; Robert Levin, testimony before the FCIC, Hearing on Subprime Lending and Securitization and Government-Sponsored Enterprises (GSEs), day 3, session 1: Fannie Mae, April 9, 2010, transcript, pp. 68–72. 207. Tom Lund, interview by FCIC, March 4, 2010. 208. Dallavecchia, interview. 209. Todd Hempstead, interview by FCIC, March 23, 2010. 210. Kenneth Bacon, interview by FCIC, March 5, 2010. 211. Stephen Ashley, interview by FCIC, March 31, 2010. 212. Levin, interview. 213. Mike Quinn, interview by FCIC, March 10, 2010. 214. Ashley, interview. 215. Armando Falcon, testimony before the FCIC, Hearing on Subprime Lending and Securitization and Government-Sponsored Enterprises (GSEs), day 3, session 2: Office of Federal Housing Enterprise Oversight, April 9, 2010, transcript, pp. 155–56, 192; .written testimony, p. 10. 216. Lockhart, written testimony for the FCIC, April 9, 2010, p. 6;; Lockhart, testimony before the fcic_final_report_full--530 December 3, 2008, 151 in which he said in pertinent part: Only 6 percent of all the higher-priced loans [those that were considered CRA loans because they bore high interest rates associated with their riskier character] were extended by CRA-covered lenders to lower-income borrowers or neighborhoods in their assessment areas , the local geographies that are the primary focus for CRA evaluation purposes. This result undermines the assertion by critics of the potential for a substantial role for the CRA in the subprime crisis. [emphasis supplied] There are two points in this statement that require elaboration. First, it assumes that all CRA loans are high-priced loans. This is incorrect. Many banks, in order to be sure of obtaining the necessary number of loans to attain a satisfactory CRA rating, subsidized the loans by making them at lower interest rates than their risk characteristics would warrant. This is true, in part, because CRA loans are generally loans to low income individuals; as such, they are more likely than loans to middle income borrowers to be subprime and Alt-A loans and thus sought after by FHA, Fannie and Freddie and subprime lenders such as Countrywide; this competition is another reason why their rates are likely to be lower than their risk characteristics. Second, while bank lending under CRA in their assessment areas has probably not had a major effect on the overall presence of subprime loans in the U.S. financial system, it is not the element about CRA that raises the concerns about how CRA operated to increase the presence of NTMs in the housing bubble and in the U.S. financial system generally. There is another route through which CRA’s role in the financial crisis likely to be considerably more significant. In 1994, the Riegle-Neal Interstate Banking and Branching Effi ciency Act for the first time allowed banks to merge across state lines under federal law (as distinct from interstate compacts). Under these circumstances, the enforcement provisions of the CRA, which required regulators to withhold approvals of applications for banks that did not have satisfactory CRA ratings, became particularly relevant for large banks that applied to federal bank regulators for merger approvals. In a 2007 speech, Fed Chairman Ben Bernanke stated that after the enactment of the Riegle-Neal legislation, “As public scrutiny of bank merger and acquisition activity escalated, advocacy groups increasingly used the public comment process to protest bank applications on CRA grounds. In instances of highly contested applications, the Federal Reserve Board and other agencies held public meetings to allow the public and the applicants to comment on the lending records of the banks in question. In response to these new pressures, banks began to devote more resources to their CRA programs.” 152 This modest description, although accurate as far as it goes, does not fully describe the effect of the law and the application process on bank lending practices. In 2007, the umbrella organization for many low-income or community “advocacy groups,” the National Community Reinvestment Coalition, published a report entitled “CRA Commitments” which recounted the substantial success of its members in using the leverage provided by the bank application process to obtain trillions of dollars in CRA lending commitments from banks that had applied to 151 152 Randall Kroszner, Speech at the Confronting Concentrated Poverty Forum, December 3, 2008. Ben S. Bernanke, “The Community Reinvestment Act: Its Evolution and New Challenges,” March 30, 2007, p2. federal regulators for merger approvals. The opening section of the report states (bolded language in the original): 153 CHRG-110hhrg38392--98 Mr. Sires," Thank you, Mr. Chairman. Thank you, Mr. Bernanke, for being here with us today. I just want to follow up on the housing issue. I represent a district that is across from New York, the northern part, the Jersey City area, which has seen a boom of housing over the last few years. With that, the prices really went up high. A lot of people had to resort to subprime lending to get housing, and it created a lot of jobs, a lot of good-paying construction jobs. I do not know whether this is regional, but I have seen the prices of the houses not really going down when we are losing a lot of those jobs that were created. I would just like to know the impact on these construction jobs. I know that approximately 10 percent of the jobs created in this country are through construction. What effect is this going to have on the economy? Do you see it as regional? Because I know they are going to--I have friends in Florida, and they are going through the same process, the same things where good-paying jobs are being lost. Do you see this trend changing? I know mortgages are getting tighter. Subprime is very difficult to get. Home equity loans to create these jobs are impossible in some cases. Do you see this trend changing anytime soon? " CHRG-110hhrg38392--148 Mr. Bernanke," We issued the Regulation Z rules on credit cards in May for comment. It was a very comprehensive review of all the regulations applying both to credit cards and to other revolving credit. The comment period is open until October. After that we will move as expeditiously as possible to issue a final rule that will apply to credit card issuers. We are also, as you know, doing a complete overhaul of Regulation Z as it applies to mortgage lending. We have had a series of hearings on that. We are also, as we did with credit cards, going to do consumer testing to make sure that people can understand the disclosures. That is going to take a while. It will probably be next year in 2008, as we come to some conclusions on that. But in a nearer term, in order to address some of the current issues in the subprime mortgage market, we have taken off a few elements that we think we can move on more quickly relating to solicitation and advertising of mortgages and when you have to give information to consumers, how quickly you have to make those disclosures. So there is some element to that that we think we can move up. The full Regulation Z on mortgage lending, however, is going to still take a while because of the need to do consumer testing. " CHRG-110hhrg38392--31 Mr. Bachus," Thank you. My last question is this: When we looked at the subprime lending problem last year, we found that probably about 3 percent of the brokers and actually, also, not only brokers, but mortgage bankers, people who worked for nationally regulated bankers--about 3 percent of them caused about 90 percent of the mischief and the fraud, and they will lose their licenses in one State. Then they go to another State, and they set up shop, and they are really creating havoc. These are basically--to me, they are criminals, and they are inflicting a tremendous amount of pain. Would you like to comment? I introduced a bill, along with several of my colleagues, which called for a national registration and licensing standard for all mortgage originators. Would you like to comment on that, or on the legislation we introduced? " FinancialCrisisReport--55 Wholesale Channel. According to WaMu, its “wholesale channel” loans were loans that the bank acquired from third party mortgage brokers. These brokers, who were not WaMu employees, located borrowers interested in purchasing a home or refinancing an existing mortgage, and explained available loans that could be underwritten by WaMu. The borrower’s primary, and sometimes sole, contact was with the mortgage broker. The mortgage broker would then provide the borrower’s information to a WaMu loan officer who would determine whether the bank would finance the loan. If the bank decided to finance the loan, the broker would receive a commission for its efforts. Third party mortgage brokers typically received little guidance or training from WaMu, aside from receiving daily “rate sheets” explaining the terms of the loans that WaMu was willing to accept and the available commissions. WaMu treated wholesale loans issued under the WaMu brand as prime loans. Subprime Channel. WaMu also originated wholesale loans through its subprime affiliate and later subsidiary, Long Beach Mortgage Company (Long Beach). Long Beach was a purely wholesale lender, and employed no loan officers that worked directly with borrowers. Instead, its account executives developed relationships with third party mortgage brokers who brought prospective loans to the company, and if Long Beach accepted those loans, received a commission for their efforts. WaMu typically referred to Long Beach as its “subprime channel.” Later, in 2007, when the bank decided to eliminate Long Beach as a separate entity, it rebranded Long Beach as its “Wholesale Specialty Lending” channel. At times, WaMu also acquired subprime loans through “correspondent” or “conduit” channels, which it used to purchase closed loans – loans that had already been financed – from other lenders for investment or securitization. For example, WaMu at times operated a correspondent channel that it referred to as “Specialty Mortgage Finance” and used to purchase subprime loans from other lenders, especially Ameriquest, for inclusion in its investment portfolio. In addition, in 2005, its New York securitization arm, Washington Mutual Capital Corporation, established a “subprime conduit” to purchase closed subprime loans in bulk from other lenders for use in securitizations. At the end of 2006, WaMu reported that its investment portfolio included $4 billion in subprime loans from Long Beach and about $16 billion in subprime loans from other parties. 110 Other Channels. At times, WaMu also originated or acquired loans in other ways. Its “Consumer Direct” channel, for example, originated loans over the phone or internet; borrowers did not need to meet in person with a WaMu loan officer. In addition, in 2004, Washington Mutual Capital Corporation (WCC) set up a conduit to purchase closed Alt A loans in bulk from 109 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, Hearing Exhibit 4/16-82 (hereinafter “IG Report”). 110 See 3/1/2007 Washington Mutual Inc. 10-K filing with the SEC, at 56. other lenders and use them in securitizations. WCC shut down both the Alt A and subprime conduits in April 2008, after it became too difficult to find buyers for new securitizations. 111 CHRG-111shrg52966--17 Mr. Long," Yes, I do think we began to communicate pretty well in the 2006 range, as my colleague says, but let me back up to answer you. I want to make sure I answer your question. As I stated in my written testimony--it is difficult at times to strike that balance of letting a bank keep competitive and innovative at the same time and order a bank to constrain a certain business activity because we believe they are taking on too much risk. It is always a delicate balance and it is something we work hard to do. But I think we did, going back to 2004. I know at the OCC and amongst other regulators, we did begin to see this buildup of risk and this buildup of excessive aggregation of risk. We issued guidance going back to 2004. We had the interagency credit card guidance. We issued guidance on home equity lending, on non-traditional mortgage products, on commercial real estate lending, and then most recently some interagency guidance on complex structured products. As we issued guidance to the industry, our examiners were in the banks and they were examining for this. We frequently cited matters requiring attention and began taking actions, various types of actions, surrounding these guidance. So from 2004 up to 2007, I think we all saw the accumulation of risk. At the OCC, we looked vertically very well into those companies. If there were lessons learned by us, it was probably in two things. Number one, we underestimated the magnitude of the effects of the global shut-down beginning in August of 2007, and we did not rein in the excesses driven by the market. So a real lesson learned, and I think you have heard it in some of the statements and in the GAO report, the ability to look vertically into these companies is good. The ability to look across the companies in terms of the firms we supervise, we need to get better at that, and looking horizontally across the system is something I think we all need to do. A good example of that is in the firms that we supervise, we underestimated the amount of subprime exposure they had. We basically kicked the subprime lenders out of the national banking system. Our banks were underwriting very little of the subprime loans. What we didn't realize is that affiliates and subsidiaries of the banks that we supervised were turning around, buying those loans, structuring them, and bringing that risk back in in another division in the bank, and that is a good example of being able to look horizontally across a company and see that coming. Senator Reed. What inhibited you from looking across these other subsidiaries? " FinancialCrisisReport--173 ARMs, 50% of its subprime loans, and 90% of its home equity loans. 621 WaMu also originated numerous loans with high loan-to-value (LTV) ratios, in which the loan amount exceeded 80% of the value of the underlying property. The Inspectors General determined, for example, that 44% of WaMu’s subprime loans and 35% of its home equity loans had LTV ratios in excess of 80%. 622 Still another problem was that WaMu had high concentrations of its home loans in California and Florida, states that ultimately suffered above-average home value depreciation. 623 WaMu issued loans through its own retail loan offices, through Long Beach, which issued subprime loans initiated by third party mortgage brokers, and through correspondent and conduit programs in which the bank purchased loans from third parties. The Treasury and the FDIC Inspectors General observed that, from 2003 to 2007, 48 to 70% of WaMu’s residential mortgages came from third party mortgage brokers, and that only 14 WaMu employees were responsible for overseeing more than 34,000 third party brokers, 624 requiring each WaMu employee to oversee more than 2,400 third party brokers. When the subprime market collapsed in July 2007, Washington Mutual was left holding a portfolio saturated with high risk, poorly performing loans. Prior to the collapse, WaMu had sold or securitized the majority of the loans it had originated or purchased, undermining the U.S. home loan mortgage market with hundreds of billions of dollars in high risk, poor quality loans. OTS documentation shows that WaMu’s regulators saw what was happening, identified the problems, but then took no enforcement actions to protect either Washington Mutual or the U.S. financial system from the bank’s shoddy lending practices. (2) Overview of Washington Mutual’s Ratings History and Closure An overview of Washington Mutual’s ratings history shows how OTS and the FDIC were required to work together to oversee Washington Mutual, which the two agencies did with varying levels of success. At times, the relationship was productive and useful, while at others they found themselves bitterly at odds over how to proceed. As Washington Mutual’s problems intensified, the working relationship between OTS and the FDIC grew more dysfunctional. From 2004 to 2006, Washington Mutual was a profitable bank and enjoyed a 2 CAMELS rating from both agencies, signifying it was a fundamentally sound institution. In late 2006, as housing prices began to level off for the first time in years, subprime loans began to experience delinquencies and defaults. In part because borrowers were unable to refinance their loans, those delinquencies and defaults accelerated in 2007. The poorly performing loans began to affect the payments supporting subprime mortgage backed securities, which began to incur losses. In July 2007, the subprime market was performing so poorly that the major credit rating agencies suddenly downgraded hundreds of subprime mortgage backed securities, including over 40 issued by Long Beach. The subprime market slowed and then collapsed, and Washington Mutual was suddenly left with billions of dollars in unmarketable subprime loans and securities 621 Id. at 10. 622 Id. 623 Id. at 11. 624 See Thorson prepared statement, at 5, April 16, 2010 Subcommittee Hearing at 105. that were plummeting in value. WaMu stopped issuing subprime loans. In the fourth quarter of 2007, WaMu reported a $1 billion loss. FinancialCrisisReport--264 In the second week of July 2007, S&P and Moody’s initiated the first of several mass rating downgrades, shocking 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, 1020 and two days later downgraded 498 of these securities. 1021 On July 10, Moody’s downgraded 399 subprime RMBS with an original value of $5.2 billion. 1022 By the end of July, S&P had downgraded more than 1,000 RMBS and almost 100 CDO securities. 1023 This volume of rating downgrades was unprecedented in U.S. financial markets. The downgrades created significant turmoil in the securitization markets, as investors were required to sell off RMBS and CDO securities that had lost their investment grade status, RMBS and CDO securities in the investment portfolios of financial firms lost much of their value, and new securitizations were unable to find investors. The subprime RMBS secondary market initially froze and then collapsed, leaving financial firms around the world holding suddenly unmarketable subprime RMBS securities that were plummeting in value. 1024 Neither Moody’s nor S&P produced any meaningful contemporaneous documentation explaining their decisions to issue mass downgrades in July 2007, disclosing how the mass downgrades by the two companies happened to occur two days apart, or analyzing the possible impact of their actions on the financial markets. When Moody’s CEO, Raymond McDaniel, was asked about the July downgrades, he indicated that he could not recall any aspect of the decision- making process. 1025 He told the Subcommittee that he was merely informed that the downgrades would occur, but was not personally involved in the decision. 1026 1020 6/24/2010 supplemental response from S&P to the Subcommittee, Exhibit H, Hearing Exhibit 4/23-108 (7/11/2007 “S&PCORRECT: 612 U.S. Subprime RMBS Classes Put On Watch Neg; Methodology Revisions Announced,” S&P RatingsDirect (correcting the original version issued on 7/10/2007)). 1021 6/24/2010 supplemental response from S&P to the Subcommittee, Exhibit I, Hearing Exhibit 4/23-108 (7/12/2007 “Various U.S. First-Lien Subprime RMBS Classes Downgraded,” S&P’s RatingsDirect). 1022 7/30/2010 supplemental response from Moody’s to the Subcommittee, Hearing Exhibit 4/23-106 (7/12/2007 Moody’s Structured Finance Teleconference and Web Cast, “RMBS and CDO Rating Actions,” at MOODYS- PSI2010-0046899-900). The $5.2 billion also included the original value of 32 tranches that were put on review for possible downgrade that same day. 1023 6/24/2010 supplemental response from S&P to the Subcommittee, at 3, 6, Hearing Exhibit 4/23-108. According to this letter, the July downgrades were not the first to take place during 2007. The letter reports that, altogether in the first six months of 2007, S&P downgraded 739 RMBS and 25 CDOs. These downgrades, however, took place on multiple days over a six-month period. Prior to July, Moody’s had downgraded approximately 480 RMBS during the first six months of 2007 (this figure was calculated by the Subcommittee based on information from Moody’s “Structured Finance: Changes & Confirmations” reports for that time period). 1024 See 3/19/2007 “Subprime Mortgages: Primer on Current Lending and Foreclosure Issues,” report prepared by the Congressional Research Service, Report No. RL33930; 5/2008 “The Subprime Lending Crisis: Causes and Effects of the Mortgage Meltdown,” report prepared by CCH, at 13. 1025 Subcommittee interview of Ray McDaniel (4/6/2010). 1026 Id. At S&P, no emails were produced that explained the decision-making process, but a few indicated that, prior to the mass downgrades, the RMBS Group was required to make a presentation to the chief executive of its parent company about “how we rated the deals and are preparing to deal with the fallout (downgrades).” 3/18/2007 email from Michael Gutierrez to William LeRoy, Hearing Exhibit 4/23-52a; 3/2007 S&P internal email chain, “Pre- empting bad press on the subprime situation,” Hearing Exhibit 4/23-52c. CHRG-111hhrg53241--55 Mr. Hensarling," Mr. Taylor, it is my time. But, with all due respect, you are giving an agency the power to ban products, taking away consumer choice. How do you protect the consumer by taking away their choice? You may disagree, but others believe that you will squash innovation. We will not see the next ATM. We will not see the next set of frequent flyer miles. And so if you think that the members of your organizations are having trouble getting credit now, wait until this legislation is passed, and then you will see real problems. I see my time is up. I yield back. Ms. Waters. [presiding] Thank you very much. I will recognize myself for 5 minutes. Yesterday, in talking with representatives of the banking community, we were admonished for not supporting adjustable rate mortgages. And basically what they said is, you guys don't understand adjustable rate mortgages and how they have helped so many people. It is the same argument we get a lot when people say we don't understand subprime lending. We have never said we are against subprime lending, but there are so many iterations on the subjects. I would like to ask--perhaps you could help me, Mr. Mierzwinski--for a definition of these adjustable rate mortgages. As I understand it, there are option ARMs, and there are products that could reset 6 months, 1 year, 2 years, and when the mortgage is negotiated--and many of these adjustable rate mortgages. They don't look at whether or not the homeowner will be able to afford the mortgage 1 year or 5 months or 5 years from the time that they sign on to these mortgages. And the formula for the increase possibly in interest rates allows something called a margin on top of the interest rates. So you could have an increase in interest rate, plus they can mark up this mortgage another 2, 3, 4 percent. Could you help us with a description of the harmful adjustable rate mortgages? " fcic_final_report_full--598 Freddie Mac Fourth Quarter 2008 Financial Results Supplement, March 11, 2009, p. 15. 19. Edward Pinto, “Memorandum: Sizing Total Federal Government and Federal Agency Contribu- tions to Subprime and Alt-A Loans in U.S. First Mortgage Market as of 6.30.08,” Exhibit 2 with correc- tions through October 11, 2010 (www.aei.org/docLib/PintoFCICTriggersMemo.pdf). The 26.7 million loans include 6.7 million loans in subprime securitizations and another 2.1 million loans in Alt-A securi- tizations, for a total of 8.8 million mortgages in subprime or Alt-A pools, which Pinto calls “self-denomi- nated” subprime and Alt-A, respectively. To these, he adds another 8.8 million loans with FICO scores below 660, which he labels “subprime by characteristic.” He also adds 6.3 million loans at the GSEs that are either interest-only loans, negative amortization loans, or loans with an LTV—including any second mortgage—greater than 90%, which he collectively refers to as “Alt-A by characteristic.” The last addi- tions include an estimated 1.4 million loans insured by the FHA and VA with an LTV greater than 90%— out of a total of roughly 5.5 million FHA and VA loans—and 1.3 million loans in bank portfolios that are inferred to have his defined “Alt-A characteristics.” 20. Fannie Mae 2008 Credit Supplement, p. 5; Freddie Mac Fourth Quarter 2008 Financial Results Supplement, March 11, 2009. 21. Edward Pinto, “Yes, the CRA Is Toxic,” City Journal, Autumn 2009. 22. Neil Bhutta and Glenn Canner, “Did the CRA Cause the Mortgage Market Meltdown?” Federal Reserve Board of Governors, March 2009. The authors use the Home Mortgage Disclosure Act data, which cover roughly 80% of the mortgage market in the United States—see Robert B. Avery, Kenneth P. Brevoort, and Glenn B. Canner, “Opportunities and Issues in Using HMDA Data,” Journal of Real Estate Research 29, no. 4 (October 2007): 351–79. 23. Elizabeth Laderman and Carolina Reid, “Lending in low and moderate income neighborhoods in California: The Performance of CRA Lending During the Subprime Meltdown,” November 26, 2008, working paper to be presented at the Federal Reserve System Conference on Housing and Mortgage Mar- kets, Washington, DC, December 4, 2008. 24. FCIC, “Preliminary Staff Report: The Mortgage Crisis,” April 7, 2010. 25. Bank of America response letter to FCIC, August 20, 2010. 26. John Reed, interview by FCIC, March 4, 2010. 27. Lewis Ranieri, interview by FCIC, July 30, 2010. 28. Nicolas Weill, interview by FCIC, May 11, 2010. 29. Ibid. 30. Nicolas Weill, email to Raymond McDaniel and Brian Clarkson, July 4, 2007. 31. Moody’s Investors Service, “Early Defaults Rise in Mortgage Securitizations,” Structured Finance: Special Report, January 18, 2007, pp. 1, 3. 32. Moody’s Investors Service, “Moody’s Downgrades Subprime First-lien RMBS-Global Credit Re- search Announcement,” July 10, 2007. 33. Weill, interview. 34. FCIC staff estimates, based on analysis of Blackbox data. 35. Data on Bear Stearns provided by JP Morgan to the FCIC. 595 36. Moody’s Investors Service, “Moody’s Downgrades $33.4 billion of 2006 Subprime First-Lien RMBS and Affirms $280 billion Aaa’s and Aa’s,” October 11, 2007; “October 11 Rating Actions Related to 2006 Subprime First-Lien RMBS,” Structured Finance: Special Report, October 17, 2007, pp. 1–2. 37. FCIC staff estimates, based on analysis of Blackbox data. 38. FCIC staff estimates, based on analysis of Moody’s SFDRS data as of April 2010. 39. Moody’s Investors Service, “The Impact of Subprime Residential Mortgage-Backed Securities on Moody’s-Rated Structured Finance CDOs: A Preliminary Review,” Structured Finance: Special Com- ment, March 23, 2007, p. 2. 40. Yuri Yoshizawa, email to Noel Kirnon and Raymond McDaniel, cc Eric Kolchinsky, subject: “CSFB Pipeline information,” March 28, 2007. 41. Moody’s Investors Service, “First Quarter 2007 U.S. CDO Review: Climbing the Wall of Subprime CHRG-110shrg38109--12 Chairman Dodd," That was a standard Senator Bayh set there. Senator Martinez. But I will be very brief, Mr. Chairman. Thank you very much. Chairman Bernanke, welcome, and I again join in the high praise that you have been receiving for your first year on the job. I will simply look forward to hearing your comments as it relates to the housing market, a great concern to me, housing affordability; also, the issue that we dealt with last week in this Committee, which is subprime lending and the rate of defaults in that area; and just in general the effect of the hurricanes in the Gulf Coast, which continue to be an impact on the economies of the Gulf States. So, I look forward to your comments, and thank you for being with us today. " fcic_final_report_full--85 S ubp r i me Mortgage O r i g i nat i ons In 2006, $600 billion of subprime loans were originated, most of which were securitized. That year, subprime lending accounted for 23.5% of all mortgage originations. IN BILLIONS OF DOLLARS 23 . 5% $700 600 500 Subprime share of entire mortgage market Securitized Non-securitized 20 . 9% 22 .7 % 400 10 . 6% 10 . 1% 8 . 3% 300 9 . 5% 9 . 8% 10 .4 % 7. 6% 7.4 % 9 . 2% 200 100 1 .7 % 0 ’ 96 ’ 9 7 ’ 98 ’ 99 ’ 00 ’ 01 ’ 02 ’ 03 ’ 0 4 ’ 05 ’ 06 ’ 0 7 ’ 08 200 7, secur i t i es i ssued e x ceeded or i g i nat i ons . SOURC E: I n s i de M ort gage Fi nance Figure . more familiar with the securitization of these assets, mortgage specialists and Wall Street bankers got in on the action. Securitization and subprime originations grew hand in hand. As figure . shows, subprime originations increased from  billion in  to  billion in . The proportion securitized in the late s peaked at , and subprime mortgage originations’ share of all originations hovered around . Securitizations by the RTC and by Wall Street were similar to the Fannie and Freddie securitizations. The first step was to get principal and interest payments from a group of mortgages to flow into a single pool. But in “private-label” securities (that is, securitizations not done by Fannie or Freddie), the payments were then “tranched” in a way to protect some investors from losses. Investors in the tranches received dif- ferent streams of principal and interest in different orders. Most of the earliest private-label deals, in the late s and early s, used a rudimentary form of tranching. There were typically two tranches in each deal. The less risky tranche received principal and interest payments first and was usually guaran- teed by an insurance company. The more risky tranche received payments second, was not guaranteed, and was usually kept by the company that originated the mortgages. Within a decade, securitizations had become much more complex: they had more tranches, each with different payment streams and different risks, which were tai- lored to meet investors’ demands. The entire private-label mortgage securitization market—those who created, sold, and bought the investments—would become highly dependent on this slice-and-dice process, and regulators and market partici- pants alike took for granted that it efficiently allocated risk to those best able and will- ing to bear that risk. fcic_final_report_full--466 Table 2. 23 Troubled Mortgages, Western Europe and the United States ≥ 3 Month Arrears % Impaired or Doubtful % Foreclosures Year Belgium 0.46% 2009 Denmark 0.53% 2009 France 0.93% 2008 Ireland 3.32% 2009 Italy 3.00% 2008 Portugal 1.17% 2009 Spain 3.04% 0.24% 2009 Sweden 1.00% 2009 UK 2.44% 0.19% 2009 U.S. All Loans 9.47% 4.58% 2009 U.S. Prime 6.73% 3.31% 2009 U.S. Subprime 25.26% 15.58% 2009 Source: European Mortgage Federation (2010) and Mortgage Bankers Association for U.S. Data. The underlying reasons for the outcomes in Professor Jaffee’s data were provided in testimony before the Senate Banking Committee in September 2010 by Dr. Michael Lea, Director of the Corky McMillin Center for Real Estate at San Diego State University: The default and foreclosure experience of the U.S. market has been far worse than in other countries. Serious default rates remain less than 3 percent in all other countries and less than 1 percent in Australia and Canada. Of the countries in this survey only Ireland, Spain and the UK have seen a significant increase in mortgage default during the crisis. There are several factors responsible for this result. First sub-prime lending was rare or non-existent outside of the U.S. The only country with a significant subprime share was the UK (a peak of 8 percent of mortgages in 2006). Subprime accounted for 5 percent of mortgages in Canada, less than 2 percent in Australia and negligible proportions elsewhere. …[T]here was far less “risk layering” or offering limited documentation loans to subprime borrowers with little or no downpayment. There was little “no doc” lending…the proportion of loans with little or no downpayment was less than the U.S. and the decline in house prices in most countries was also less…[L]oans in other developed countries are with recourse and lenders routinely go after borrowers for deficiency judgments. 24 The fact that the destructiveness of the 1997-2007 bubble came from its composition—the number of NTMs it contained—rather than its size is also illustrated by data on foreclosure starts published by the Mortgage Bankers 23 Dwight M. Jaffee, “Reforming the U.S. Mortgage Market Through Private Market Incentives,” Paper prepared for presentation at “Past, Present and Future of the Government Sponsored Enterprises,” Federal Reserve Bank of St. Louis, Nov 17, 2010, Table 4. 24 Dr. Michael J. Lea, testimony before the Subcommittee on Security and International Trade and Finance of the Senate Banking Committee, September 29, 2010, p.6. 461 CHRG-110shrg38109--39 Chairman Dodd," I thank you for that. I am going to turn to my colleague from Alabama, but I will probably send this as a written question, unless one of my colleagues raises it with you here. Back in December, Senator Sarbanes, Senator Allard, Senator Reed, Senator Bunning, Senator Schumer, and myself sent you and other regulators a letter regarding these exotic mortgages. We had a hearing here the other day, and I have talked about this. I am a strong advocate of subprime lending. It has made a huge difference in accessibility to homeownership. I am also simultaneously very concerned about the predatory lending practices that go on. That concern about providing those subprime borrowers with the same kind of protections we do to the prime borrowers is a matter of concern to many of us here on this Committee. The letter we got back, frankly, Mr. Chairman, was a little inadequate. The notion, ``We are thinking about it,'' was nice to know, but I think many of us would like to know they are taking some additional steps. And, again, I will make this a written question to you, but I am very concerned about this issue, and some of the data we are receiving were as many as 2 million of our fellow citizens may be foreclosed out of their homes because of predatory practices. Again, I will not ask you here. I want to turn to Senator Shelby, but I want to raise that issue with you and ask you to be thinking about it because it is an important concern for many of us. Senator Shelby. Senator Shelby. Thank you, Chairman Dodd. Chairman Bernanke, the Federal Open Market Committee has held the Federal funds rate target at 5.25 percent since June 2006. In the FOMC statement following your most recent meeting in January, the FOMC noted, ``the high level of resource utilization has the potential to sustain inflation pressures. The Committee judges that some inflation risks remain.'' Mr. Chairman, what data related to resource utilization will you be paying the closest attention to between now and the next FOMC meeting in March? " CHRG-111shrg54675--41 Mr. Skillern," I would concur with the bankers that, in general, the small banks are well regulated by both their State and primary regulators. I would also disagree, though, that the Federal regulators have done their job well currently. Countrywide, Washington Mutual are both regulated by the OTS. Their subprime predatory lending harmed consumers and collapsed their banks. Wachovia, a national bank regulated by the OCC, crashed itself on exotic mortgage lending. The Federal Reserve has failed to enforce its rules. I am currently in a fight with the OCC to enforce the rules on Santa Barbara Bank and Trust around their refund anticipation loan loss. It is just not happening. So the Federal regulators have lost credibility on their willingness and ability to enforce the existing consumer laws. I do believe that a separate agency with that focus brings standardization of how those rules are applied, can expand it to those agencies that are not covered, and hopefully try to reduce the seemingly conflict of interest that the existing Federal regulators have of enforcing consumer laws. Senator Crapo. Thank you. My time is up. Thank you, Mr. Chairman. " FinancialCrisisReport--87 In response, Mr. Rotella wrote to WaMu’s General Auditor: “This seems to me to be the ultimate in bayonetting the wounded, if not the dead.” 261 Subprime Lending Ends. In September 2007, with investors no longer interested in buying subprime loans or securitizations, WaMu shut down all of its subprime operations. 262 During the prior year, which was their peak, Long Beach and WaMu had securitized $29 billion in subprime loans; by 2007, due to the collapse of the subprime secondary market, WaMu’s volume for the year dropped to $5.5 billion. Altogether, from 2000 to 2007, Long Beach and WaMu had securitized at least $77 billion in subprime loans. 263 When asked about Long Beach at the Subcommittee’s hearing, all of the WaMu former managers who testified remembered its operations as being problematic, and could not explain why WaMu failed to strengthen its operations. Mr. Vanasek, former Chief Risk Officer, testified that Long Beach did not have an effective risk management regime when he arrived at WaMu in 1999, and that it had not developed an effective risk management regime by the time he retired at the end of 2005. 264 Likewise, Mr. Cathcart, who replaced Mr. Vanasek as Chief Risk Officer, testified that Long Beach never developed effective risk management during the course of his tenure. 265 At the April 13 Subcommittee hearing, Senator Levin asked Mr. Vanasek: “Is it fair to say that WaMu is not particularly worried about the risk associated with Long Beach subprime mortgages because it sold those loans and passed the risk on to investors?” Mr. Vanasek replied: “Yes, I would say that was a fair characterization.” 266 Home Loans President David Schneider, who had direct responsibility for addressing the problems at Long Beach, testified that he tried to improve Long Beach, but “ultimately decided … Long Beach was an operation that we should shut down.” 267 WaMu President Steve Rotella also acknowledged the inability of WaMu management to resolve the problems at Long Beach: 260 Id. at JPM_WM02548940-41. 261 8/21/2007 email from Steve Rotella to Randy Melby, JPM_WM04859837, Hearing Exhibit 4/13-20. 262 “Washington Mutual Regulators Timeline,” chart prepared by the Subcommittee, Hearing Exhibit 4/16-1j. 263 “Securitizations of Washington Mutual Subprime Home Loans,” chart prepared by the Subcommittee, Hearing Exhibit 4/13-1c. 264 April 13, 2010 Subcommittee Hearing at 22. 265 Id. 266 Id. at 23. 267 Id. at 55. “We did bring the volume in Long Beach down substantially every quarter starting in the first quarter of 2006. As we went through that process, it became increasingly clear, as I have indicated in here, that the problems in Long Beach were deep and the only way we could address those were to continue to cut back volume and ultimately shut it down.” 268 CHRG-111shrg51290--58 Mr. Bartlett," Yes, I do, Mr. Chairman. Mr. Chairman, lending decisions should not be made by political correctness or by government fiat or by a law or by regulation. Those lending decisions should be based on safety and soundness, good underwriting standards and consumer protection, and every time we get into an attempt to have that, then we sort of skew the outcome. So subprime lending is in and of itself not bad. It is a good thing. We had a large number of terrible abuses, but it shouldn't be therefore outlawed. Second, loans, though, and mortgages should be made for the benefit of consumers by a competitive marketplace where 8,000 lenders or 15,000 lenders compete against each other for the consumers' business. And then those lenders should be regulated for safety and soundness and for consumer protection. But the regulation should not be to design the exact terms and conditions of the loan, as in, well, I think this is what a good loan should be and somebody else says, I think this. The marketplace will do the best job. And then last, and I have some considerable experience with CRA as both a mayor and as a member of the other body, the purpose of CRA has worked quite well. It can be clumsy and so there are exceptions to that, but CRA is the government's requirement that regulated lenders, depository institutions, figure out how they should be making good loans in low-income neighborhoods because that was not occurring prior to CRA in large part, I regret to say, but it was not. So that is the purpose of CRA. That should be kept. It shouldn't be expanded to some other purpose or contracted for other purposes. But that was the underlying purpose and I think that is why the CRA debate is outside this debate that we are having today. " FinancialCrisisInquiry--839 ZANDI: I think two fundamentals—the question being where were the regulators. I think the first point is that the Federal Reserve is the key regulator, and it had a philosophical predisposition towards regulation during this period—had faith in the securitization process that failed us. But, secondly, the regulatory structure also failed us. The Federal Reserve, along with other regulators, would come together and issue interagency guidance with respect to all kinds of lending activity. And this is a very cumbersome process to get consensus among these groups of regulators is very difficult. And to get explicit guidance is nearly impossible. And you can see that, in—with respect to the guidance issued on Alt-A and ultimately subprime, it came well after the fact. So it was this philosophical predisposition but I think it was also the structure of our regulatory framework that doomed us to not having this regulatory oversight. CHRG-111shrg51290--65 Many of these risky mortgage instruments were made in areas where housing was least affordable, such as California, Florida and Arizona, leading to concentrated areas of unsustainable housing values. (See Figures 3 and 4). This concentration of risky loans put the entire local markets at risk, due to the sudden and extreme withdrawal of credit in the aftermath of a bubble.\10\ \10\ See Susan M. Wachter, Andrey D. Pavlov & Zoltan Pozsar, Subprime Lending and Real Estate Markets, in Mortgage and Real Estate Finance__(Stefania Perrucci, ed., Risk Books 2008).--------------------------------------------------------------------------- Figure 3. Geographic Distribution of Interest-Only Loans, 2006.\11\--------------------------------------------------------------------------- \11\ Anthony Pennington-Cross, Mortgage Product Substitution and State Predatory Lending Laws, Presentation at the 2008 Mid-Year Meeting of the American Real Estate and Urban Economics Association, Washington, D.C., May 27, 2008. Figure 4. Geographic Distribution of Low-Documentation Loans, 2006\12\--------------------------------------------------------------------------- \12\ Id. FinancialCrisisReport--88 Community Impact. Long Beach’s poor quality loans not only proved unprofitable for many investors, they were often devastating for the borrowers and their communities. Mr. Killinger testified at the Subcommittee hearing that WaMu, “entered the subprime business with our purchase of Long Beach Mortgage in 1999 to better serve an underserved market.” 269 But the unfortunate result of many Long Beach loans was that they left communities reeling from widespread foreclosures and lost homes. In November 2008, the Office of the Comptroller of the Currency (OCC) which oversees all nationally chartered banks, identified the ten metropolitan areas across the United States with the highest rates of foreclosure for subprime and Alt A mortgages originated from 2005 through 2007. 270 Those ten areas were, in order: Detroit, Cleveland, Stockton, Sacramento, Riverside/San Bernardino, Memphis, Miami/Fort Lauderdale, Bakersfield, Denver, and Las Vegas. The OCC then identified the lenders with the highest foreclosure rates in each of those devastated cities. Long Beach had the worst foreclosure rate in four of those areas, and was near the worst in five more, with the lone exception being Las Vegas. The OCC data also showed that, overall in the ten metropolitan areas, Long Beach mortgages had the second worst foreclosure rate of all the lenders reviewed, with over 11,700 foreclosures at the time of the report. Only New Century was worse. (2) WaMu Retail Lending Washington Mutual’s problems were not confined to its subprime operations; they also affected its retail operations. WaMu loosened underwriting standards as part of its High Risk Lending Strategy, and received repeated criticisms from its regulators, as outlined in the next chapter, for weak underwriting standards, risk layering, excessive loan error and exception rates, appraisal problems, and loan fraud. In August 2007, more than a year before the collapse of the bank, WaMu’s President Steve Rotella emailed CEO Kerry Killinger saying that, aside from Long Beach, WaMu’s prime home loan business “was the worst managed business I had seen in my career.” 271 (a) Inadequate Systems and Weak Oversight One reason for WaMu’s poor lending practices was its failure to adequately monitor the hundreds of billions of dollars of residential loans being issued each year by its own loan 268 Id. at 90. 269 Id. at 86. 270 11/13/2008 “Worst Ten in the Worst Ten,” document prepared by the Office of the Comptroller of the Currency, http://www.occ.treas.gov/news-issuances/news-releases/2009/nr-occ-2009-112b.pdf, Hearing Exhibit 4/13-58. 271 8/23/2007 email from Mr. Rotella to Mr. Killinger, JPM_WM00675851, Hearing Exhibit 4/13-79. personnel. From 1990 until 2002, WaMu acquired more than 20 new banks and mortgage companies, including American Savings Bank, Great Western Bank, Fleet Mortgage Corporation, Dime Bancorp, PNC Mortgage, and Long Beach. WaMu struggled to integrate dozens of lending platforms, information technology systems, staffs, and policies, whose inconsistencies and gaps exposed the bank to loan errors and fraud. fcic_final_report_full--6 From  to , the amount of debt held by the financial sector soared from  trillion to  trillion, more than doubling as a share of gross domestic product. The very nature of many Wall Street firms changed—from relatively staid private partnerships to publicly traded corporations taking greater and more diverse kinds of risks. By , the  largest U.S. commercial banks held  of the industry’s assets, more than double the level held in . On the eve of the crisis in , financial sector profits constituted  of all corporate profits in the United States, up from  in . Understanding this transformation has been critical to the Commis- sion’s analysis. Now to our major findings and conclusions, which are based on the facts con- tained in this report: they are offered with the hope that lessons may be learned to help avoid future catastrophe. • We conclude this financial crisis was avoidable. The crisis was the result of human action and inaction, not of Mother Nature or computer models gone haywire. The captains of finance and the public stewards of our financial system ignored warnings and failed to question, understand, and manage evolving risks within a system essen- tial to the well-being of the American public. Theirs was a big miss, not a stumble. While the business cycle cannot be repealed, a crisis of this magnitude need not have occurred. To paraphrase Shakespeare, the fault lies not in the stars, but in us. Despite the expressed view of many on Wall Street and in Washington that the crisis could not have been foreseen or avoided, there were warning signs. The tragedy was that they were ignored or discounted. There was an explosion in risky subprime lending and securitization, an unsustainable rise in housing prices, widespread re- ports of egregious and predatory lending practices, dramatic increases in household mortgage debt, and exponential growth in financial firms’ trading activities, unregu- lated derivatives, and short-term “repo” lending markets, among many other red flags. Yet there was pervasive permissiveness; little meaningful action was taken to quell the threats in a timely manner. The prime example is the Federal Reserve’s pivotal failure to stem the flow of toxic mortgages, which it could have done by setting prudent mortgage-lending standards. The Federal Reserve was the one entity empowered to do so and it did not. The record of our examination is replete with evidence of other failures: financial institu- tions made, bought, and sold mortgage securities they never examined, did not care to examine, or knew to be defective; firms depended on tens of billions of dollars of borrowing that had to be renewed each and every night, secured by subprime mort- gage securities; and major firms and investors blindly relied on credit rating agencies as their arbiters of risk. What else could one expect on a highway where there were neither speed limits nor neatly painted lines? FinancialCrisisInquiry--819 WALLISON: All right. Well, the disclosure says that they defined subprime loans as subprime loans that they bought from subprime issuers or subprime originators. It doesn’t say that they bought those loans that were subprime in nature from all other kinds of sources, part of which were from ordinary banks and other originators that were regulated originators. CHRG-111shrg57319--506 Mr. Killinger," I believe--yes. Clearly, our policy and what I believe is that at the time when certain loans were sold--all of our loans were sold--that we felt that would be appropriate for the customer. We had put out responsible lending principles, in fact, that require us to make that proactive look. Is this an appropriate product for the customer, and given the times, do we think it is reasonable? That changed when the housing market changed. That is why we pulled back and stopped originating Option ARMs and did the same on certain subprime products, because given what happened to the housing market, those products were no longer appropriate. But at the times when they were part of our arsenal, we thought that they would be appropriate. Senator Kaufman. What do you think, Mr. Rotella? Is the vast majority of products you were selling through mortgage-backed securities were safe for customers? There wasn't any fraud involved. There were no loans ready to be delinquent, anything like that that you know of? " FinancialCrisisInquiry--188 The only reason for these products to have been mass marketed to consumers was for Wall Street, lenders, and brokers to make a huge profit by selling, flipping, and securitizing large numbers of unsustainable mortgages. And the bank regulators who, as many have talked about today, had ample warning about the dangers posed by these loans, either were asleep at the switch or actively encouraging this high-profit, high-risk lending. The impact of foreclosures has been particularly hard on African American and Latino communities. This crisis has widened the already sizable wealth gap between whites and minorities in this country and has wiped out the asset base of entire neighborhoods. The foreclosure crisis was not caused by greedy or risky borrowers. The average subprime loan amount nationally was just over $200,000 and is much lower if you exclude the highest priced markets such as California. A majority of subprime borrowers had credit scores that would qualify them for prime loans with much better terms, and researchers have found that abusive loan terms such as exploding rates and prepayment penalties created an elevated risk of foreclosure even after controlling for differences in borrowers’ credit scores. It’s also not the case that widespread unemployment is in and of itself the reason for the spread of this crisis to the prime market. For the past 30 years, foreclosure rates remained essentially flat during periods of high unemployment because people who lost their jobs could sell their homes or tap into home equity to tide them over. Unemployment is now triggering an unprecedented number of home losses because loan flipping and the housing bubble have left so many families underwater. Most important, it’s crucial to put to rest any idea that the crisis was caused by efforts to extend home ownership opportunities to traditionally underserved communities. Many financial institutions, our own included, have long lent safely and successfully to these communities without experiencing outsize losses. Legal requirements such as those embodied in the CRA had been in effect for more than two decades with no ill effect before the increase in risky subprime loans, and fully 94 percent of all subprime loans were not covered by the CRA. FinancialCrisisReport--50 III. HIGH RISK LENDING: CASE STUDY OF WASHINGTON MUTUAL BANK Washington Mutual Bank, known also as WaMu, rose out the ashes of the great Seattle fire to make its first home loan in 1890. By 2004, WaMu had become one of the nation’s largest financial institutions and a leading mortgage lender. Its demise just four years later provides a case history that traces not only the rise of high risk lending in the mortgage field, but also how those high risk mortgages led to the failure of a leading bank and contributed to the financial crisis of 2008. For many years, WaMu was a mid-sized thrift, specializing in home mortgages. In the 1990s, WaMu initiated a period of growth and acquisition, expanding until it became 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. In 2003, its longtime CEO, Kerry Killinger, said he wanted to do for the lending industry what Wal-Mart and others did for their industries, by catering to middle and lower income Americans and helping the less well off buy homes. 105 Soon after, WaMu embarked on a strategy of high risk lending. By 2006, its high risk loans began incurring record rates of delinquency and default, and its securitizations saw ratings downgrades and losses. In 2007, the bank itself began incurring losses. Its shareholders lost confidence, and depositors began withdrawing funds, eventually causing a liquidity crisis. On September 25, 2008, 119 years to the day of its founding, WaMu was seized by its regulator, the Office of Thrift Supervision (OTS), and sold to JPMorgan Chase for $1.9 billion. Had the sale not gone through, WaMu’s failure might have exhausted the $45 billion Deposit Insurance Fund. Washington Mutual is the largest bank failure in U.S. history. This case study examines how one bank’s strategy for growth and profit led to the origination and securitization of hundreds of billions of dollars in poor quality mortgages that undermined 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. Its fixed rate mortgage originations fell from 64% of its loan originations in 2003, to 25% in 2006, while subprime, Option ARM, and home equity originations jumped from 19% of the originations to 55%. Using primarily loans from its subprime lender, Long Beach Mortgage Corporation, WaMu’s subprime securitizations grew sixfold, increasing from about $4.5 billion in 2003, to $29 billion in securitizations in 2006. From 2000 to 2007, WaMu and Long Beach together securitized at least $77 billion in subprime loans. WaMu also increased its origination of Option ARMs, its flagship product, which 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, including sales to the Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac). In addition, WaMu dramatically increased its origination and securitization of home equity loan products. By 2007, 105 “Saying Yes, WaMu Built Empire on Shaky Loans,” New York Times (12/27/2008) http://www.nytimes.com/2008/12/28/business/28wamu.html?_r=1 (quoting Mr. Killinger: “We hope to do to this industry what Wal-Mart did to theirs, Starbucks did to theirs, Costco did to theirs and Lowe’s-Home Depot did to their industry. And I think if we’ve done our job, five years from now you’re not going to call us a bank.”). home equity loans made up $63.5 billion or 27% of its home loan portfolio, a 130% increase from 2003. fcic_final_report_full--109 In the same FCIC interview, Greenspan recalled that he sat in countless meetings on consumer protection, but that he couldn’t pretend to have the kind of expertise on this subject that the staff had.  Gramlich, who chaired the Fed’s consumer subcommittee, favored tighter super- vision of all subprime lenders—including units of banks, thrifts, bank holding com- panies, and state-chartered mortgage companies. He acknowledged that because such oversight would extend Fed authority to firms (such as independent mortgage companies) whose lending practices were not subject to routine supervision, the change would require congressional legislation “and might antagonize the states.” But without such oversight, the mortgage business was “like a city with a murder law, but no cops on the beat.”  In an interview in , Gramlich told the Wall Street Journal that he privately urged Greenspan to clamp down on predatory lending. Greenspan demurred and, lacking support on the board, Gramlich backed away. Gramlich told the Journal, “He was opposed to it, so I did not really pursue it.”  (Gramlich died in  of leukemia, at age .) The Fed’s failure to stop predatory practices infuriated consumer advocates and some members of Congress. Critics charged that accounts of abuses were brushed off as anecdotal. Patricia McCoy, a law professor at the University of Connecticut who served on the Fed’s Consumer Advisory Council between  and , was famil- iar with the Fed’s reaction to stories of individual consumers. “That is classic Fed mindset,” said McCoy. “If you cannot prove that it is a broad-based problem that threatens systemic consequences, then you will be dismissed.” It frustrated Margot Saunders of the National Consumer Law Center: “I stood up at a Fed meeting in  and said, ‘How many anecdotes makes it real? . . . How many tens [of] thousands of anecdotes will it take to convince you that this is a trend?’”  The Fed’s reluctance to take action trumped the  HUD-Treasury report and reports issued by the General Accounting Office in  and .  The Fed did not begin routinely examining subprime subsidiaries until a pilot program in July , under new chairman Ben Bernanke.  The Fed did not issue new rules under HOEPA until July , a year after the subprime market had shut down. These rules banned deceptive practices in a much broader category of “higher-priced mortgage loans”; moreover, they prohibited making those loans without regard to the borrower’s ability to pay, and required companies to verify income and assets.  The rules would not take effect until October , , which was too little, too late. FinancialCrisisReport--61 Over a five-year period from 2003 to 2008, Washington Mutual Bank shifted its loan originations from primarily traditional 30-year fixed and government backed loans to primarily higher risk home loans. This shift included increased subprime loan activity at Long Beach, more subprime loans purchased through its Specialty Mortgage Finance correspondent channel, and more bulk purchases of subprime loans through its conduit channel for use in securitizations. WaMu also increased its originations and acquisitions of Option ARM, Alt A, and home equity loans. While the shift began earlier, the strategic decision to move toward higher risk loans was not fully articulated to regulators or the Board of Directors until the end of 2004 and the beginning of 2005. 139 In about three years, from 2005 to 2007, WaMu issued hundreds of billions of higher risk loans, including $49 billion in subprime loans 140 and $59 billion in Option ARMs. 141 Data compiled by the Treasury and the FDIC Inspectors General showed that, by the end of 2007, Option ARMs constituted about 47% of all home loans on WaMu’s balance sheet and home equity loans made up $63.5 billion or 27% of its home loan portfolio, a 130% increase from 2003. 142 According to an August 2006 internal WaMu presentation on Option ARM credit risk, from 1999 until 2006, Option ARM borrowers selected the minimum monthly payment more than 95% of the time. 143 The data also showed that at the end of 2007, 84% of the total value of the Option ARMs was negatively amortizing, meaning that the borrowers were going into deeper debt rather than paying off their loan balances. 144 In addition, by the end of 2007, stated income loans – loans in which the bank had not verified the borrower’s income – represented 73% of WaMu’s Option ARMs, 50% of its subprime loans, and 90% of its home equity loans. 145 WaMu also originated numerous loans with high loan-to-value (LTV) ratios, in which the loan amount exceeded 80% of the value of the underlying property. The Treasury and the FDIC Inspectors General determined, for example, that 44% of WaMu’s subprime loans and 35% of its home equity loans had LTV ratios in excess of 80%. 146 Still another problem was that WaMu had high geographic concentrations of its home loans in California and Florida, states that ended up suffering above-average home value depreciation. 147 139 See, e.g., 12/21/2004 “Asset Allocation Initiative: Higher Risk Lending Strategy and Increased Credit Risk Management,” Washington Mutual Board of Directors Discussion, JPM_WM04107995-8008, Hearing Exhibit 4/13- 2b; 1/2005 “Higher Risk Lending Strategy ‘Asset Allocation Initiative,’” submitted to Washington Mutual Board of Directors Finance Committee Discussion, JPM_WM00302975-93, Hearing Exhibit 4/13-2a. 140 “Securitizations of Washington Mutual Subprime Home Loans,” chart prepared by the Subcommittee, Hearing Exhibit 4/13-1c. 141 4/2010 IG Report, at 9, Hearing Exhibit 4/16-82. 142 Id. at 9-10. 143 See 8/2006 Washington Mutual internal report, “Option ARM Credit Risk,” chart entitled, “Borrower-Selected Payment Behavior,” at 7, Hearing Exhibit 4/13-37. The WaMu report also stated: “Almost all Option ARM borrowers select the minimum payment every month with very high persistency, regardless of changes in the interest rates or payment adjustments.” Id. at 2. 144 4/2010 IG Report, at 9, Hearing Exhibit 4/16-82. 145 Id. at 10. 146 Id. 147 Id. at 11. (1) Strategic Direction CHRG-111hhrg55814--296 Mr. Tarullo," So, Congressman, before I was on the Board, I was actually quite critical in my former capacity as an academic of the failure of the Board, indeed of the government more generally, to move to do something about subprime lending problems, both directly in their consumer implications, and indirectly in their safety and soundness implications. And, as you indicate, I think Chairman Bernanke came, when he became chairman, he took a look at those prudential and consumer regulatory issues and under his leadership, the Board, I think, has enacted a good set of mortgage related as well as credit card related regulations. So the short answer I guess to your question is that the Congress can give mandates to agencies and then give authority to agencies, but the decisions that the people leading those agencies make and the context in which they make them matter. And to that degree, I think we all just have to recognize that the policy orientations of appointees to these agencies are important things for you and your colleagues on the other side of the Hill to consider. " FOMC20070131meeting--47 45,MR. DUDLEY.," It’s not that markets won’t work. It’s just the economics of originating subprime loans and selling them into the market would no longer work. In other words, at some point, if the actual capital markets are not willing to accept those subprime mortgages at the right price, then the ability of the person to originate the mortgages and sell them into the market goes away. Now, would this wreck the market? Well, it depends, because some subprime originators can carry these loans on their own books. But the industry is quite fragmented, with a lot of these issuers not having the ability to carry these subprime loans on their books. So that part of the subprime origination market would go away. Some of the monoline subprime originators would be unable to exist if there weren’t a securitized demand for those assets." CHRG-111shrg57319--5 MUTUAL BANK " Mr. Vanasek," OK. Mr. Chairman, Senator Coburn, and distinguished Members of the Committee, thank you for the opportunity to discuss the mortgage and financial crisis from the perspective of a Chief Credit Officer in the sixth-largest bank in this country.--------------------------------------------------------------------------- \1\ The prepared statement of Mr. Vanasek appears in the Appendix on page 134.--------------------------------------------------------------------------- I was the Chief Credit Officer and later the Chief Risk Officer of Washington Mutual during the period of September 1999 to December 2005, when I retired. Prior to serving in this capacity, I had worked for several large banking companies in senior credit-oriented roles, including PNC, First Interstate Bank, Norwest/Wells Fargo. Altogether, I have 38 years of experience in credit-oriented positions and have been fortunate enough to have well-established histories and constructive relationships with all of the major banking regulators. The failure of Washington Mutual occurred in September 2008, nearly 3 years after my retirement, so much of what I will tell you today is historical information about the company's strengths and weaknesses during the years of my direct involvement. Washington Mutual was a reflection of the mortgage industry characterized by very fast growth, rapidly expanding product lines, and deteriorating credit underwriting. This was a hyper-competitive environment in which mistakes were made by loan originators, lending institutions, regulatory agencies, rating agencies, investment banks that packaged and sold mortgage-backed securities, and the institutions that purchased these excessively complex instruments. It was both the result of individual failures and systemic failures fueled by self interest, failure to adhere to lending policies, very low interest rates, untested product innovations, weak regulatory oversight, astonishing rating agency lapses, weak oversight by boards of directors, a cavalier environment on Wall Street, and very poorly structured incentive compensation systems that paid for growth rather than quality. One must also seriously question the wisdom of the elimination of Glass-Steagall and its impact on the securitization market. Washington Mutual was a company that had grown with exceptional speed due to acquisitions primarily in California during the industry crisis of the early 1990s. By 2000, it was a company in search of identity. At one point, the CEO wanted the company to expand the commercial lending area in an effort to earn a higher price earnings ratio on the stock, only to abandon the strategy 3 years later. The focus then shifted to rapidly expanding the branch network by opening as many as 250 locations within 12 months in cities where the company had no previous retail banking experience. Ultimately, this proved to be an unsuccessful strategy due in part to the effort to grow too quickly. The focus then shifted away from the diversification to becoming the so-called low-cost producer in the mortgage industry. This effort was likewise unsuccessful, in large measure due to an expensive undertaking to write a completely new mortgage loan origination and accounting software system that ultimately failed and had to be written off. By mid-2005, the focus had shifted again to becoming more of a higher-risk subprime lender at exactly the wrong time in the housing market cycle. This effort was characterized by statements advocating that the company become either via acquisition or internal growth a dominant subprime lender. In addition to subprime, the company was a large lender of adjustable-rate mortgages, having had 20 years' experience with the product. As in the case of subprime, the product had only been available to a narrow segment of customers. Adjustable-rate mortgages were sold to an ever-wider group of borrowers. Product features were also expanded. Historically, plain vanilla mortgage lending had been a relatively safe business. During the period 1999 to 2003, Washington Mutual mortgage losses were substantially less than one-tenth of one percent, far less than losses of commercial banks. But rapidly increasing housing prices masked the risks of a changing product mix and deteriorating underwriting, in part because borrowers who found themselves in trouble could almost always sell their homes for more than the mortgage amount, at least until 2006 or 2007. There is no one factor that contributed to the debacle. Each change in product features and underwriting was incremental and defended as necessary to meet competition. But these changes were taking place within the context of a rapidly increasing housing price environment and were, therefore, untested in a less favorable economic climate. It was the layering of risk brought about by these incremental changes that so altered the underlying credit quality of mortgage lending which became painfully evident once housing prices peaked and began to decline. Some may characterize the events that took place as a ``perfect storm,'' but I would describe it as an inevitable consequence of consistently adding risk to the portfolio in a period of inflated housing price appreciation. The appetite of Wall Street and investors worldwide created huge demand for high-yielding subprime mortgages that resulted in a major expansion of what was historically a relatively small segment of the business led by Household Finance. The Community Reinvestment Act also contributed by demanding loans--that banks make loans to low-income families, further expanding subprime lending. One obvious question is whether or not these risks were apparent to anyone in the industry or among the various regulatory or rating agencies. There is ample evidence in the record to substantiate the fact that it was clear that the high-risk profile of the entire industry, to include Washington Mutual, was recognized by some but ignored by many. Suffice it to say, meeting growth objectives to satisfy the quarterly expectations of Wall Street and investors led to mistakes in judgment by the banks and the mortgage lending company executives. A more difficult question is why boards of directors, regulatory agencies, and rating agencies were seemingly complacent. Another question may be my personal role and whether I made significant effort to alter the course of lending at Washington Mutual. In many ways and on many occasions, I attempted to limit what was happening. Just a few examples may suffice. I stood in front of thousands of senior Washington Mutual managers and executives in an annual management retreat in 2004 and countered the senior executive ahead of me on the program who was rallying the troops with the company's advertising line, ``The power of yes.'' The implication of that statement was that Washington Mutual would find some way to make a loan. The tag line symbolized the management attitude about mortgage lending more clearly than anything I can tell you. Because I believed this sent the wrong message to the loan originators, I felt compelled to counter the prior speaker by saying to the thousands present that the power of yes absolutely needed to be balanced by the wisdom of no. This was highly unusual for a member of the management team to do, especially in such a forum. In fact, it was so far out of the norm for meetings of this type that many considered my statement exceedingly risky from a career perspective. I made repeated efforts to cap the percentage of high-risk and subprime loans in the portfolio. Similarly, I put a moratorium on non-owner-occupied loans when the percentage of these assets grew excessively due to speculation in the housing market. I attempted to limit the number of stated income loans, loans made without verification of income. But without solid executive management support, it was questionable how effective any of these efforts proved to be. There have been questions about policy and adherence to policy. This was a continual problem at Washington Mutual, where line managers, particularly in the mortgage area, not only authorized but encouraged policy exceptions. There had likewise been issues regarding fraud. Because of the compensation systems rewarding volume versus quality and the independent structure of the originators, I am confident at times borrowers were coached to fill out applications with overstated incomes or net worth to meet the minimum underwriting requirements. Catching this kind of fraud was difficult at best and required the support of line management. Not surprisingly, loan originators constantly threatened to quit and to go to Countrywide or elsewhere if the loan applications were not approved. As the market deteriorated, in 2004, I went to the Chairman and CEO with a proposal and a very strong personal appeal to publish a full-page ad in the Wall Street Journal disavowing many of the then-current industry underwriting practices, such as 100 percent loan-to-value subprime loans, and thereby adopt what I termed responsible lending practices. I acknowledged that in so doing the company would give up a degree of market share and lose some of the originators to the competition, but I believed that Washington Mutual needed to take an industry-leading position against deteriorating underwriting standards and products that were not in the best interests of the industry, the bank, or the consumers. There was, unfortunately, never any further discussion or response to the recommendation. Another way I attempted to counteract the increasing risk was to increase the allowance for loan and lease loss to cover the potential losses. Regrettably, there has been a longstanding unresolved conflict between the SEC and the accounting industry on one side and the banks and the bank regulators regarding reserving methodology. The SEC and accounting profession believed that more transparency in bank earnings is essential to investors and that the way to achieve transparency is to keep reserves at levels reflecting only very recent loss experience. But banking is a cyclical business, which the banks and the bank regulators recognize. It is their belief and certainly my personal belief that building reserves in good times and using those reserves in bad times is the entire purpose of the loan loss reserves. What is more, the investors, the FDIC, and the industry are far better protected reserves that are intended to be sufficient to sustain the institution through the cycle rather than draining reserves at the point where losses are at their lowest point. At one point, I was forced by external auditors to reduce the loan loss reserve of $1.8 billion by $500 million or risk losing our audit certification. As the credit cycle unfolded, those reserves were sorely needed by the institution. In my opinion, the Basel Accord on bank capital requirements repeats the same mistake of using short-term history rather than through-the-cycle information to establish required capital levels, and as such has been a complete and utter failure. The conventional wisdom repeated endlessly in the mortgage industry and at Washington Mutual was that while there had been regional recessions and price declines, there had never been a true national housing price decline. I believe that is debatable. But it was widely believed, and partially on this premise, the industry and Washington Mutual marched forward with more and more subprime high loan-to-value and option payment products, each one adding incrementally to the risk profile. Thank you for your time and attention. I will be happy to address your questions. Senator Levin. Thanks, Mr. Vanasek. Mr. Cathcart. TESTIMONY OF RONALD J. CATHCART,\1\ FORMER CHIEF ENTERPRISE RISK OFFICER (2006-2008), WASHINGTON MUTUAL BANK " FinancialCrisisReport--488 Goldman Sachs Long Cash Subprime Mortgage Exposure, Investments in Subprime Mortgage Loans, and Investments in Subprime Mortgage Backed Securities November 24, 2006 vs. August 31, 2007 - in $ Billions Investments   in   Subprime   Mortgage   Loans Investments   in   Subprime   Mortgage   Backed   Securities Long   Cash   Subprime   Mortgage   Exposure   (Total   of   Loans   and   Securities) 2.862 2.4 0.462 Prepared   by   the   U.S.   Senate   Permanent   Subcommittee   on   Investigations,   April   2010. Data   from   Nov.   7,   2007,   letter   from   Goldman   Sachs   to   the   Securities   and   Exchange   Commission,   GS   MBS ‐ E ‐ 015713460,   at   5   (Exhibit   50). CHRG-110hhrg45625--95 Mr. Bernanke," Well, we really had two stages in this credit cycle. The first stage was the write-downs of subprime and CDOs and those kind of complex instruments. We are now in the stage, with the economy slowing down, where we are seeing increased losses in a variety of things, ranging from car loans and credit cards, to business loans and so on. And that is going to put additional pressure on banks. It is another reason why they are pulling back, building up their reserves, building up their capital, de-leveraging their balance sheets, and that is going to prevent them from providing as much credit as our economy needs. Ms. Velazquez. Thank you. Secretary Paulson, we are hearing about small business loans being called in, and up to a third may have a callable provision and not be delinquent. Lenders are also reducing credit to entrepreneurs, and we are aware that the Federal Reserve reported that 65 percent of lending institutions tightened their lending standards on commercial and industrial loans to small firms. Given these challenging conditions, how will the current proposal specifically address the challenges facing small business? Before, you said in your intervention how this is going to help small businesses. Well, they too are victims now of the financial market mess that we are in. " fcic_final_report_full--470 First, the gradual increase of the AH goals, the competition between the GSEs and the FHA, the effect of HUD’s Best Practices Initiative, and bank lending under the CRA, assured a continuing flow of funds into weaker and weaker mortgages. This had the effect of extending the life of the housing bubble as well as increasing its size. The growth of the bubble in turn disguised the weakness of the subprime mortgages it contained; as housing prices rose, subprime borrowers who might otherwise have defaulted were able to refinance their mortgages, using the equity that had developed in their homes solely through rising home prices. Without the continuous infusion of government or government-directed funds, delinquencies and defaults would have begun showing up within a year or two, bringing the subprime PMBS market to a halt. Instead, the bubble lasted ten years, permitting that market to grow until it reached almost $2 trillion. Second, as housing prices rose in the bubble, it was necessary for borrowers to seek riskier mortgages so they could afford the monthly payments on more expensive homes. This gave rise to new and riskier forms of mortgage debt, such as option ARMs (resulting in negative amortization) and interest-only mortgages. Mortgages of this kind could be suitable for some borrowers, but not for those who were only eligible for subprime loans. Nevertheless, subprime loans were necessary for PMBS, because they generally bore higher interest rates and thus could support the yields that investors were expecting. As subprime loans were originated, Fannie and Freddie were willing consumers of those that might meet the AH goals; moreover, because of their lower cost of funds, they were able to buy the “best of the worst,” the highest quality among the NTMs on offer. These factors—the need for higher yielding loans and the ability of Fannie and Freddie to pay up for the loans they wanted—drove private sector issuers further out on the risk curve as they sought to meet the demands of investors who were seeking exposure to subprime PMBS. From the investors’ perspective, as long as the bubble kept growing, PMBS were offering the high yields associated with risk but were not showing commensurate numbers of delinquencies and defaults. 5. What was Known About NTMs Prior to the Crisis? Virtually everyone who testified before the Commission agreed that the financial crisis was initiated by the mortgage meltdown that began when the housing bubble began to deflate in 2007. None of these witnesses, however, including the academics consulted by the Commission, the representatives of the rating agencies, the offi cers of financial institutions that were ultimately endangered by the mortgage downdraft, regulators and supervisors of financial institutions and even the renowned investor Warren Buffett, 33 seems to have understood the dimensions 33 See Buffett, testimony before the FCIC, June 2, 2010. 465 of the NTM problem or recognized its significance before the bubble deflated. The Commission majority’s report notes that “there were warning signs.” There always are if one searches for them; they are most visible in hindsight, in which the Commission majority, and many of the opinions it cites for this proposition, happily engaged. However, as Michael Lewis’s acclaimed book, The Big Short , showed so vividly, very few people in the financial world were actually willing to bet money— even at enormously favorable odds—that the bubble would burst with huge losses. Most seem to have assumed that NTMs were present in the financial system, but not in unusually large numbers. FinancialCrisisReport--424 Report To Board. On March 26, 2007, Mr. Sparks and Goldman senior executives gave a presentation to Goldman’s Board of Directors regarding the firm’s subprime mortgage business . 1732 The presentation recapped for the Board the various steps the Mortgage Department had taken since December 2006, in response to the deterioration of the subprime mortgage market. 1733 The presentation noted, among other measures, the following steps: “– GS reduces CDO activity – Residual assets marked down to reflect market deterioration – GS reverses long market position through purchases of single name CDS and reductions of ABX – GS effectively halts new purchases of sub-prime loan pools through conservative bids – Warehouse lending business reduced – EPD [early payment default] claims continue to increase as market environment continues to soften.” 1734 By the time this presentation was given to the Board of Directors, Goldman’s Mortgage Department had swung from a $6 billion net long position in December 2006, to a $10 billion net short position in February 2007, and then acted to cover much of that net short. Despite having to sell billions of dollars in RMBS and CDO securities and whole loans at low prices, and enter into billions of dollars of offsetting long CDS contracts, Goldman’s mortgage business managed to book net revenues for the first quarter totaling $368 million. 1735 In a section entitled, “Lessons Learned,” the presentation stated: “Capital markets and financial innovation spread and increase risk,” 1736 an acknowledgment by Goldman that “financial innovation,” which in this context included ABX, CDO, and CDS instruments, had magnified the risk in the U.S. mortgage market. 1732 3/26/2007 Goldman presentation to Board of Directors, “Subprime Mortgage Business,” GS MBS-E- 005565527, Hearing Exhibit 4/27-22. While the final version of the presentation indicated Goldman had an overall net long position in subprime assets by about $900 million, a near-final draft of the presentation indicated that Goldman had an overall net short position of $2.8 billion. 3/16/2007 draft presentation to Board of Directors by Daniel Sparks, “Subprime Mortgage Business,” GS MBS-E-002207710. The primary difference between the two figures appears to be the inclusion in the final version of Goldman ’s net long holdings of Alt A mortgages, even though Alt A assets are not usually considered to be subprime mortgages. Subcommittee interview of David Viniar (4/13/2010). 1733 1734 1735 Id. at 4. Id. at 8 [footnotes defining CDO and CDS omitted]. 9/17/2007 Presentation to Goldman Sachs Board of Directors, Residential Mortgage Business, at 5, GS MBS-E- 001793840, Hearing Exhibit 4/27-41. 1736 3/26/2007 Goldman Sachs presentation to Board of Directors, “Subprime Mortgage Business,” GS MBS-E- 005565527, Hearing Exhibit 4/27-22. (c) Attempted Short Squeeze FinancialCrisisReport--4 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. fcic_final_report_full--559 Report on Recommendations to Curb Predatory Home Mortgage Lending” (June 1, 2000). 40. Federal Reserve Board press release, December 12, 2001. 41. Sheila C. Bair, written testimony for the FCIF, First Public Hearing of the FCIC, day 2, panel 1: Current Investigations into the Financial Crisis—Federal Officials, January 14, 2010, p. 11. 42. Fed Governor Edward M. Gramlich, “Predatory Lending,” remarks at the Housing Bureau for Seniors Conference, , January 18, 2002. 43. Sheila C. Bair, testimony before the FCIC, First Public Hearing of the FCIC, day 2, panel 1: Cur- rent Investigations into the Financial Crisis—Federal Officials, January 14, 2010, transcript, p. 97. 44. Sheila C. Bair, interview by FCIC, March 29, 2010. 45. 2009 Mortgage Market Statistical Annual, 1:220, “Top B&C Lenders in 2000”; 1.223, “Top B&C Lenders in 2003.” 46. Ibid., 1:237, “Subprime Origination by State in 2001”; and 1:235, “Subprime Originations by State in 2003.” 47. Stein, testimony before the FCIC, September 23, 2010, transcript, p. 72. 48. Gail Burks, interview by FCIC, August 30, 2010. 49. Lisa Madigan, written testimony for the FCIC, First Public Hearing of the FCIC, day 1, panel 2: Current Investigations into the Financial Crisis—State and Local Officials, January 14, 2010, p. 4–5; “Home Mortgage Lender settled ‘Predatory Lending’ Charges,” Federal Trade Commission press release, March 21, 2002. 50. 2009 Mortgage Market Statistical Annual, 1:220, “Top 25 B&C Lenders in 2003.” 51. Madigan, written testimony for the FCIC, January 14, 2010, pp. 4–5. 52. Ed Parker, interview by FCIC, May 26, 2010. 53. Prentiss Cox, interview by FCIC, October 15, 2010. 54. Ibid. 55. 2009 Mortgage Market Statistical Annual, 1:45, 47, 49, 51. 56. Alphonso Jackson, interview by FCIC, October 6, 2010. 57. Cox, interview; Madigan, written testimony for the FCIC, January 14, 2010, p. 11. 58. Cox, interview. Madigan, testimony before the FCIC, January 14, 2010, transcript, pp. 121–122. 59. John D. Hawke Jr. and John C. Dugan, written statements for the FCIC, Hearing on Subprime Lending and Securitization and Government-Sponsored Enterprises (GSEs), day 2, session 2: Office of the Comptroller of the Currency, April 8, 2010, pp. 4–5 and pp. 4–8, respectively. 60. Madigan, written testimony for the FCIC, January 14, 2010, pp. 9, 10. 61. Cox, interview. 62. 2009 Mortgage Market Statistical Annual, 1:4, “Mortgage Originations by Product.” Nonprime = Alt-A and subprime combined. 63. Marc S. Savitt, interview by FCIC, November 17, 2010. 64. Rob Barry, Matthew Haggman, and Jack Dolan, “Ex-convicts active in mortgage fraud,” Miami Herald , January 29, 2009. 65. J. Thomas Cardwell, written testimony for the FCIC, Hearing on the Impact of the Financial Cri- sis—Miami, session 3: The Regulation, Oversight, and Prosecution of Mortgage Fraud in Miami, Sep- tember 21, 2010, p. 8. 66. Savitt, interview. 67. Gary Crabtree, written testimony for the FCIC, Hearing on the Impact of the Financial Crisis— Greater Bakersfield, session 4: Local Housing Market, September 7, 2010, p. 6. 68. Ibid. 69. Gary Crabtree, interview by FCIC, August 18, 2010. Crabtree, written testimony for the FCIC, CHRG-110shrg46629--9 STATEMENT OF SENATOR JACK REED Senator Reed. I will not exercise such statesmanlike restraint. Thank you, Mr. Chairman. And thank you, Chairman Bernanke, for joining us today to discuss the state of monetary policy and its reflection on our economy. At the past eight meetings of the FOMC, the Fed has held the Federal Fund rates steady at 5.25 percent. However, significant turmoil in the housing market particularly related to subprime mortgages, a growing trade deficit, and a negative household savings rate continue to pose tremendous challenges to setting monetary policy. I know, Mr. Chairman, you have personally expressed concern about core inflation being higher than is desirable in the long run. But the risk of raising interest rates too high is that a weakening housing sector and rising oil prices may be taking their toll on consumers and businesses alike and slowing down the economy too much already. I look forward to your insights about the kind of policies that are likely to be effective in addressing the challenges we face in this economy and offering real opportunities for growth that provide widespread benefits to the American people. On a systemic level, the weakening housing sector and turmoil in the subprime mortgage market have placed pressure on both investors and borrowers. Bear Stearns has recently announced that two of its hedge funds are now worth nearly nothing after some of its investments in subprime mortgages went bad. Last week both Moody's and Standard & Poor's significantly downgraded ratings on hundreds of subprime related bonds. The ABX Index, which tracks the performance of various classes of subprime related bonds hit new lows yesterday. In the past few months portions of the index that tracked especially risky mortgage bonds with junk grade ratings have been falling. And this is now spread into the portion of the index that track bonds with ratings of AAA or AA. According to Merrill Lynch's latest fund manager survey which polled 186 fund managers controlling $618 billion in assets, 72 percent of managers said that credit or default risk was the biggest threat to financial market stability. I would appreciate hearing your thoughts on some of these events, particularly as they may pertain to the financial accelerator effect you spoke of in Georgia last month and the efforts of the Federal Reserve to monitor some of these risks. Finally, the Federal Reserve has the authority and responsibility to prohibit unfair and deception lending practices. As such, Mr. Chairman, I was pleased to hear that the Fed will likely propose additional rules under the Home Ownership and Equity Protection Act, HOEPA, to provide consumers with better protections through bans on some mortgage purchases. Additionally, I understand that the Fed will join other regulators in a pilot project to monitor the practices of nondepository subprime mortgage firms. I am interested in your perspective on what additional actions the Federal Reserve will be taking to meet the regulatory portion of its mandate. I look forward to your testimony, Mr. Chairman. Thank you. " CHRG-111shrg57319--6 Mr. Cathcart," Chairman Levin, Ranking Member Coburn, and Members of the Committee, thank you for the opportunity to comment on my history with Washington Mutual Bank and to provide a risk management perspective on some root causes of the U.S. financial services crisis.--------------------------------------------------------------------------- \1\ The prepared statement of Mr. Cathcart appears in the Appendix on page 138.--------------------------------------------------------------------------- Before leading the Enterprise Risk Management Group at WaMu, I spent more than 20 years working in risk management positions at World Bank of Canada, Bank One, and CIBC. I joined WaMu's management team in December 2005 and served as the Chief Enterprise Risk Officer through April 2008. When I arrived at WaMu, I inherited a Risk Department that was isolated from the rest of the bank and was struggling to be effective at a time when the mortgage industry was experiencing unprecedented demand for residential mortgage assets. I understood that the regulatory agencies and WaMu's Board of Directors were interested in expanding risk management functions within the company to meet this demand. The general function of risk management is to measure, monitor, and establish parameters to control risk so that the company is prepared for potential loss. In order to meet this objective, during my first few months, I reorganized the department in order to align risk management with the company's business lines and to embed risk managers in each of the four business units. The company's strategic plan to shift its portfolios towards higher margin products was already underway when I arrived at WaMu. Basically, this strategy involved moving away from traditional mortgage lending into alternative lending programs involving adjustable-rate mortgages as well as into subprime products. The strategic shift to higher-margin products resulted in the bank taking on a higher degree of credit risk because there was a greater chance that borrowers would default. In hindsight, the shift to both adjustable-rate Option ARM loans and subprime products was a significant factor in the failure of WaMu and contributed to the financial crisis generally. These products depended on house price appreciation to be viable. When housing prices decelerated, they became problem assets. In early 2006, a high volume of Option ARM loans was being originated and securitized at WaMu and throughout the West Coast mortgage industry. Wall Street had a huge appetite for Option ARMs and WaMu could sell these loans as quickly as it could originate them. With an incentive to bundle and sell large quantities of loans as quickly as possible, banks all over the country, including WaMu, became conduits for the securitization and sale of loans to Wall Street. The banking industry began to move away from the traditional model, where banks held the loans they originated, towards a new model where banks acted as conduits. The demand for securitized mortgage products encouraged poor underwriting, and guidelines which had been established to mitigate and control risk were often ignored. The source of repayment for each mortgage shifted away from the individual and their credit profile to the value of the home. This approach of focusing on the asset rather than on the customer ignores the reality that portfolio performance is ultimately determined by customer selection and credit evaluation. Even the most rigorous efforts to measure, monitor, and control risk cannot overcome poor product design and weak underwriting and organizational practices. Another key component of WaMu's higher-risk strategy involved efforts to increase the company's exposure to the subprime market. These efforts focused on lending to customers who did not meet the credit qualifications to obtain traditional mortgages. In order to be successful, any bank offering subprime products must operate with a high degree of credit discipline. However, the credit performance of Long Beach-originated loans did not meet acceptable risk standards and the high level of early payment defaults suggested poor customer selection and underwriting practices. Risk management, therefore, determined that Long Beach had outsized risk parameters and we implemented standards to tighten them. In the end, WaMu's subprime exposure never reached the levels envisaged in the 2005 strategy. In fact, thanks in part to tightening of controls and risk parameters, these were reduced. Financial conditions in late 2007 and early 2008 deteriorated further in 2007 and 2008. As head of risk, I began to be excluded from key management decisions. By February 2008, I had been so fully isolated that I initiated a meeting with the director, where I advised that I was being marginalized by senior management to the point that I was no longer able to discharge my responsibilities as Chief Enterprise Risk Officer of WaMu. Within several weeks, I was terminated by the chairman. In conclusion, let me identify some of the factors which contributed to the decline of the U.S. financial market. A confluence of factors came together to create unprecedented financial conditions which the market was not equipped to handle. Due to a lack of regulation and lax lending standards, mortgage brokers operated without oversight and underwriting quality suffered as a result. The banking industry's focus shifted from customer selection to asset-based lending as banks became conduits for Wall Street, which could and would securitize whatever mortgage pool the bank originated. Rating agencies and regulators seemed to be lulled into a sense of complacency, and the Government-Sponsored Enterprises opened their risk envelopes and guaranteed and warehoused increasingly risky products. Thank you for the opportunity to share my thoughts and experiences. I look forward to the Subcommittee's review of this matter and I am prepared to answer any questions. Senator Levin. Thank you very much, Mr. Cathcart. We thank you all for your statements, which we have had an opportunity to read. " Mr. Melby,"TESTIMONY OF RANDY MELBY,\1\ FORMER GENERAL AUDITOR, WASHINGTON FinancialCrisisInquiry--809 WALLISON: Thanks very much. Mr. Rosen, Fannie Mae and Freddie Mac have become insolvent. The reason, I think, is that they have large numbers of subprime and Alt-A loans that are failing at very high rates. The numbers that I have seen indicate that they have about 10.7 million subprime loans and Alt-A loans. And that is in addition to about four and a half million FHA, VA loans which are also subprime and Alt-A. January 13, 2010 So that’s about 15 million subprime and Alt-A loans. How do you square that with the idea that the subprime and Alt-A loans originated from irresponsible lenders by unregulated mortgage brokers? CHRG-111shrg57319--200 Mr. Vanasek," I would have to say no, Senator, in the sense that we wanted to impose strict limits in terms of the dollar amounts of various types of loans being made. We found that to be very difficult to do. So there were continuing issues here about the strategy versus the opinion of the credit risk area. Senator Levin. Now, on page B1.4 of that Exhibit 2a, there is a definition of higher-risk lending. It says it consists of ``Consumer Loans to Higher Risk Borrowers,'' including subprime loans, single-family residential, and consumer loans to borrowers ``with low credit scores at origination.'' In the footnote, it says that means FICO scores under 660. Did WaMu, not just Long Beach but did WaMu issue loans to borrowers with FICO scores under 660? Do you know, Mr. Vanasek? " FOMC20070131meeting--43 41,MR. DUDLEY.," It’s quite a bit smaller share of total outstanding because the average life of the subprime mortgage loan, I’m told, is only two or three years. In other words, if your credit quality improves, you will refinance out of your subprime mortgage into a higher quality mortgage. So originations are 24 percent, but the actual number of subprimes that are actually outstanding is much lower." FinancialCrisisReport--92 WaMu did, at times, exercise oversight of its third party brokers. A 2006 credit review of its subprime loans, for example, showed that Long Beach – which by then reported to the WaMu Home Loans Division – had terminated relationships with ten brokers in 2006, primarily because their loans had experienced high rates of first payment defaults requiring Long Beach to repurchase them at significant expense. 292 But terminating those ten brokers was not enough to cure the many problems with the third party loans WaMu acquired. The report also noted that, in 2006, apparently for the first time, Long Beach had introduced “collateral and broker risk” into its underwriting process. 293 WaMu closed down its wholesale and subprime channels in 2007, and its Alt A and subprime securitization conduits in 2008. (b) Risk Layering During the five-year period reviewed by the Subcommittee, from 2004 to 2008, WaMu issued many loans with multiple higher risk features, a practice known as “risk layering.” At the April 13 Subcommittee hearing, Mr. Vanasek, its Chief Risk Officer from 2004 to 2005, testified about the dangers of this practice: “It was the layering of risk brought about by these incremental changes that so altered the underlying credit quality of mortgage lending which became painfully evident once housing prices peaked and began to decline. Some may characterize the events that took place as a ‘perfect storm,’ but I would describe it as an inevitable consequence of consistently adding risk to the portfolio in a period of inflated housing price appreciation.” 294 Stated Income Loans. One common risk layering practice at WaMu was to allow borrowers to “state” the amount of their annual income in their loan applications without any direct documentation or verification by the bank. Data compiled by the Treasury and the FDIC IG report showed that, by the end of 2007, 50% of WaMu’s subprime loans, 73% of its Option ARMs, and 90% of its home equity loans were stated income loans. 295 The bank’s acceptance of unverified income information came on top of its use of loans with other high risk features, such 291 Id. at 58615. 292 12/2006 “Home Loans – SubPrime Quarterly Credit Risk Review,” JPM_WM04107374, Hearing Exhibit 4/13- 14. 293 Id. at JPM_WM04107375. 294 April 13, 2010 Subcommittee Hearing at 16. 295 4/2010 IG Report, at 10, Hearing Exhibit 4/16-82. as borrowers with low credit scores or the use of low initial teaser interest rates followed by much higher rates. CHRG-110hhrg34673--223 Mr. Bernanke," Consumer debt has risen quite a bit. It is rising more slowly recently mostly because home mortgages aren't rising as quickly due to the flattening out of prices and the slower amount of home purchase. Generally speaking, though, as we said in the testimony, households are in reasonable financial shape. Offsetting their debt is an increase in wealth; the stock market is up. House prices over the last few years have gone up a lot, and so many people have a considerable amount of equity in their home. And moreover, the strength of the labor market means that the job availability, incomes, wages are also pretty strong. So for the larger part of the population, finances seem reasonably good relative to historical norms. Now, of course, there are always some people who are having problems, and as I noted in testimony, there are some sectors, notably the subprime lending sector, where we were seeing some distress, and we are watching that very carefully. " CHRG-110hhrg41184--209 Mr. Bernanke," Well, the idea of the freeze is to find a strategy by which lenders can work out larger numbers of loans. They are facing an unusual situation. Usually each loan, each foreclosure, each delinquency, is different; it depends on personal circumstances. Here we have a situation where literally hundreds of thousands of families or individuals may be facing foreclosure based on broad macroeconomic phenomenon--basically the decline in house prices and concerns with subprime lending. And the issue is, are there ways to be more efficient in working out loans and at larger scale? A freeze, which is what has been suggested by the HOPE NOW approach, is one way to do that. That could be a way to get more time to work out those loans. Again, it is a voluntary approach that they have come to through discussion. It doesn't address by any means all people in this situation. For example, there are a lot of loans that default even before the interest rate resets. " fcic_final_report_full--108 Fed officials rejected the staff proposals. After some wrangling, in December  the Fed did modify HOEPA, but only at the margins. Explaining its actions, the board highlighted compromise: “The final rule is intended to curb unfair or abusive lending practices without unduly interfering with the flow of credit, creating unnec- essary creditor burden, or narrowing consumers’ options in legitimate transactions.” The status quo would change little. Fed economists had estimated the percentage of subprime loans covered by HOEPA would increase from  to as much as  un- der the new regulations.  But lenders changed the terms of mortgages to avoid the new rules’ revised interest rate and fee triggers. By late , it was clear that the new regulations would end up covering only about  of subprime loans.  Nevertheless, reflecting on the Federal Reserve’s efforts, Greenspan contended in an FCIC inter- view that the Fed had developed a set of rules that have held up to this day.  This was a missed opportunity, says FDIC Chairman Sheila Bair, who described the “one bullet” that might have prevented the financial crisis: “I absolutely would have been over at the Fed writing rules, prescribing mortgage lending standards across the board for everybody, bank and nonbank, that you cannot make a mortgage unless you have documented income that the borrower can repay the loan.”  The Fed held back on enforcement and supervision, too. While discussing HOEPA rule changes in , the staff of the Fed’s Division of Consumer and Com- munity Affairs also proposed a pilot program to examine lending practices at bank holding companies’ nonbank subsidiaries,  such as CitiFinancial and HSBC Finance, whose influence in the subprime market was growing. The nonbank subsidiaries were subject to enforcement actions by the Federal Trade Commission, while the banks and thrifts were overseen by their primary regulators. As the holding company regulator, the Fed had the authority to examine nonbank subsidiaries for “compliance with the [Bank Holding Company Act] or any other Federal law that the Board has specific jurisdiction to enforce”; however, the consumer protection laws did not ex- plicitly give the Fed enforcement authority in this area.  The Fed resisted routine examinations of these companies, and despite the sup- port of Fed Governor Gramlich, the initiative stalled. Sandra Braunstein, then a staff member in the Fed’s Consumer and Community Affairs Division and now its direc- tor, told the FCIC that Greenspan and other officials were concerned that routinely examining the nonbank subsidiaries could create an uneven playing field because the subsidiaries had to compete with the independent mortgage companies, over which the Fed had no supervisory authority (although the Fed’s HOEPA rules applied to all lenders).  In an interview with the FCIC, Greenspan went further, arguing that with or without a mandate, the Fed lacked sufficient resources to examine the nonbank subsidiaries. Worse, the former chairman said, inadequate regulation sends a mis- leading message to the firms and the market; if you examine an organization incom- pletely, it tends to put a sign in their window that it was examined by the Fed, and partial supervision is dangerous because it creates a Good Housekeeping stamp.  But if resources were the issue, the Fed chairman could have argued for more. The Fed draws income from interest on the Treasury bonds it owns, so it did not have to ask Congress for appropriations. It was always mindful, however, that it could be sub- ject to a government audit of its finances. fcic_final_report_full--111 COMMUNITYLENDING PLEDGES: “WHAT WE DO IS REAFFIRM OUR INTENTION ” While consumer groups unsuccessfully lobbied the Fed for more protection against predatory lenders, they also lobbied the banks to invest in and loan to low- and mod- erate-income communities. The resulting promises were sometimes called “CRA commitments” or “community development” commitments. These pledges were not required under law, including the Community Reinvestment Act of ; in fact, they were often outside the scope of the CRA. For example, they frequently involved lending to individuals whose incomes exceeded those covered by the CRA, lending in geographic areas not covered by the CRA, or lending to minorities, on which the CRA is silent. The banks would either sign agreements with community groups or else unilaterally pledge to lend to and invest in specific communities or populations. Banks often made these commitments when courting public opinion during the merger mania at the turn of the st century. One of the most notable promises was made by Citigroup soon after its merger with Travelers in : a  billion lending and investment commitment, some of which would include mortgages. Later, Citi- group made a  billion commitment when it acquired California Federal Bank in . When merging with FleetBoston Financial Corporation in , Bank of Amer- ica announced its largest commitment to date:  billion over  years. Chase an- nounced commitments of . billion and  billion, respectively, in its mergers with Chemical Bank and Bank One. The National Community Reinvestment Coali- tion, an advocacy group, eventually tallied more than . trillion in commitments from  to ; mortgage lending made up a significant portion of them.  Although banks touted these commitments in press releases, the NCRC says it and other community groups could not verify this lending happened.  The FCIC sent a series of requests to Bank of America, JP Morgan, Citigroup, and Wells Fargo, the nation’s four largest banks, regarding their “CRA and community lending com- mitments.” In response, the banks indicated they had fulfilled most promises. Ac- cording to the documents provided, the value of commitments to community groups was much smaller than the larger unilateral pledges by the banks. Further, the pledges generally covered broader categories than did the CRA, including mortgages to minority borrowers and to borrowers with up-to-median income. For example, only  of the mortgages made under JP Morgan’s  billion “community devel- opment initiative” would have fallen under the CRA.  Bank of America, which would count all low- and moderate-income and minority lending as satisfying its pledges, stated that just over half were likely to meet CRA requirements. Many of these loans were not very risky. This is not surprising, because such broad definitions necessarily included loans to borrowers with strong credit histories—low income and weak or subprime credit are not the same. In fact, Citigroup’s  pledge of  billion in mortgage lending “consisted of entirely prime loans” to low- and moderate-income households, low- and moderate-income neighborhoods, and mi- nority borrowers. These loans performed well.  JP Morgan’s largest commitment to a community group was to the Chicago CRA Coalition:  billion in loans over  years. Of loans issued between  and , fewer than  have been -or-more- days delinquent, even as of late .  Wachovia made  billion in mortgage loans between  and  under its  billion in unilateral pledges: only about . were ever more than  days delinquent over the life of the loan, compared with an estimated national average of .  The better performance was partly the result of Wachovia’s lending concentration in the relatively stable Southeast, and partly a re- flection of the credit profile of many of these borrowers. FinancialCrisisInquiry--240 WALLISON: All right. Well, the disclosure says that they defined subprime loans as subprime loans that they bought from subprime issuers or subprime originators. It doesn’t say that they bought those loans that were subprime in nature from all other kinds of sources, part of which were from ordinary banks and other originators that were regulated originators. ROSEN: It is true. But, again, the vast majority of origination of the subprime mortgages came from unregulated lenders, most of who are gone now. Again, there are numbers that you should, as a commission, get those numbers, of course. WALLISON: And those numbers will be supplied to the commission, and I am hoping that the commission will look at them very seriously. Are you aware, also, that Fannie and Freddie reported their 10 million subprime loans as prime loans? ROSEN: I’m not aware of that, no. WALLISON: Yes, well, that is also something that they admitted in that 10-Q report. So it is—it’s important, I think, for us to have the right data in mind when we try to make a decision on these questions. Ms. Gordon, we talked about—you talked about CRA. You are, I assume, familiar with an organization called the National Community Reinvestment Coalition? GORDON: Yes. WALLISON: CHRG-110hhrg46591--390 Mr. Ryan," Well, clearly many of the underlying assets in these problematic structures were subprime or Alt-A mortgages, mostly subprime. " FinancialCrisisReport--97 In response to this information, WaMu’s chief risk officer wrote that the impact on the bank “argues in favor of holding off on implementation until required to act for public relations … or regulatory reasons.” Because OTS gave the bank more than six months to come into compliance with the NTM Guidance, WaMu continued qualifying high risk borrowers using the lower interest rate, originating billions of dollars in new loans that would later suffer significant losses. WaMu’s risk-layering practices went beyond its use of stated income loans, high LTV ratios, and the qualification of borrowers using low initial interest rates. The bank also allowed its loan officers to issue large volumes of high risk loans to borrowers who did not occupy the homes they were purchasing or had large debt-to-income ratios. 315 On top of those risks, WaMu concentrated its loans in a small number of states, especially California and Florida, increasing the risk that a downturn in those states would have a disproportionate impact upon the delinquency rates of its already high risk loans. At one point in 2004, Mr. Vanasek made a direct appeal to WaMu CEO Killinger, urging him to scale back the high risk lending practices that were beginning to dominate not only WaMu, but the U.S. mortgage market as a whole. Despite his efforts, he received no response: “As the market deteriorated, in 2004, I went to the Chairman and CEO with a proposal and a very strong personal appeal to publish a full-page ad in the Wall Street Journal disavowing many of the then-current industry underwriting practices, such as 100 percent loan-to-value subprime loans, and thereby adopt what I termed responsible lending practices. I acknowledged that in so doing the company would give up a degree of market share and lose some of the originators to the competition, but I believed that Washington Mutual needed to take an industry-leading position against deteriorating underwriting standards and products that were not in the best interests of the industry, the bank, or the consumers. There was, unfortunately, never any further discussion or response to the recommendation.” 316 (c) Loan Fraud Perhaps the clearest evidence of WaMu’s shoddy lending practices came when senior management was informed of loans containing fraudulent information, but then did little to stop the fraud. 315 See, e.g., OTS document, “Hybrid ARM Lending Survey” (regarding WaMu), undated but the OTS Examiner-in- Charge estimated it was prepared in March or mid-2007, JPM_WM03190673 (“For Subprime currently up to 100% LTV/CLTV with 50% DTI is allowed for full Doc depending on FICO score. Up to 95% LTV/CLTV is allowed with 50% DTI for Stated Doc depending on FICO score. … For No Income Verification, No Income No Ratio, and No Income No Asset only up to 95% LTV/CLTV is allowed.”). 316 April 13, 2010 Subcommittee Hearing at 17. fcic_final_report_full--97 CREDIT EXPANSION CONTENTS Housing: “A powerful stabilizing force” ...............................................................  Subprime loans: “Buyers will pay a high premium” ............................................  Citigroup: “Invited regulatory scrutiny” ..............................................................  Federal rules: “Intended to curb unfair or abusive lending” ................................  States: “Long-standing position” ..........................................................................  Community-lending pledges: “What we do is reaffirm our intention” ................  Bank capital standards: “Arbitrage” ....................................................................  By the end of , the economy had grown  straight quarters. Federal Reserve Chairman Alan Greenspan argued the financial system had achieved unprecedented resilience. Large financial companies were—or at least to many observers at the time, appeared to be—profitable, diversified, and, executives and regulators agreed, pro- tected from catastrophe by sophisticated new techniques of managing risk. The housing market was also strong. Between  and , prices rose at an an- nual rate of .; over the next five years, the rate would hit ..  Lower interest rates for mortgage borrowers were partly the reason, as was greater access to mort- gage credit for households who had traditionally been left out—including subprime borrowers. Lower interest rates and broader access to credit were available for other types of borrowing, too, such as credit cards and auto loans. Increased access to credit meant a more stable, secure life for those who managed their finances prudently. It meant families could borrow during temporary income drops, pay for unexpected expenses, or buy major appliances and cars. It allowed other families to borrow and spend beyond their means. Most of all, it meant a shot at homeownership, with all its benefits; and for some, an opportunity to speculate in the real estate market. As home prices rose, homeowners with greater equity felt more financially secure and, partly as a result, saved less and less. Many others went one step further, borrow- ing against the equity. The effect was unprecedented debt: between  and , mortgage debt nationally nearly doubled. Household debt rose from  of dispos- able personal income in  to almost  by mid-. More than three-quarters  of this increase was mortgage debt. Part of the increase was from new home pur- chases, part from new debt on older homes. fcic_final_report_full--457 SUMMARY Although there were many contributing factors, the housing bubble of 1997- 2007 would not have reached its dizzying heights or lasted as long, nor would the financial crisis of 2008 have ensued, but for the role played by the housing policies of the United States government over the course of two administrations. As a result of these policies, by the middle of 2007, there were approximately 27 million subprime and Alt-A mortgages in the U.S. financial system—half of all mortgages outstanding—with an aggregate value of over $4.5 trillion. 4 These were unprecedented numbers, far higher than at any time in the past, and the losses associated with the delinquency and default of these mortgages fully account for the weakness and disruption of the financial system that has become known as the financial crisis. Most subprime and Alt-A mortgages are high risk loans. A subprime mortgage is a loan to a borrower who has blemished credit, usually signified by a FICO credit score lower than 660. 5 Typically, a subprime borrower has failed in 4 Unless otherwise indicated, all estimates for the number of subprime and Alt-A mortgages outstanding, as well as the use of specific terms such as loan to value ratios and delinquency rates, come from research done by Edward Pinto, a resident fellow at the American Enterprise Institute. Pinto is also a consultant to the housing finance industry and a former chief credit offi cer of Fannie Mae. Much of this work is posted on both my and Pinto’s scholar pages at AEI as follows: http://www.aei.org/docLib/Pinto-Sizing- Total-Exposure.pdf , which accounts for all 27 million high risk loans; http://www.aei.org/docLib/ Pinto-Sizing-Total-Federal-Contributions.pdf , which covers the portion of these loans that were held or guaranteed by federal agencies and the four large banks that made these loans under CRA; and http:// www.aei.org/docLib/Pinto-High-LTV-Subprime-Alt-A.pdf , which covers the acquisition of these loans by government agencies from the early 1990s. The information in these memoranda is fully cited to original sources. These memoranda were the data exhibits to a Pinto memorandum submitted to the FCIC in January 2010, and revised and updated in March 2010 (collectively, the “Triggers memo”). 5 One of the confusing elements of any study of the mortgage markets is the fact that the key definitions have never been fully agreed upon. For many years, Fannie Mae treated as subprime loans only those that it purchased from subprime originators. Inside Mortgage Finance , a common source of data on the mortgage market, treated and recorded as subprime only those loans reported as subprime by the originators or by Fannie and Freddie. Other loans were recorded as prime, even if they had credit scores that would have classified them as subprime. However, a FICO credit score of less than 660 is generally regarded as a subprime loan, no matter how originated. That is the standard, for example, used by the Offi ce of the Comptroller of the Currency. In this statement and in Pinto’s work on this issue, loans that are classified as subprime by their originators are called “self-denominated” subprime loans, and loans to borrowers with FICO scores of less than 660 are called subprime by characteristic. Fannie and Freddie reported only a very small percentage of their loans as subprime, so in effect the subprime loans acquired by Fannie and Freddie should be added to the self-denominated subprime loans originated by others in order to derive something closer to the number and principal amount of the subprime loans outstanding in the financial system at any given time. One of the important elements of Edward Pinto’s work was to show that Fannie and Freddie, for many years prior to the financial crisis, were buying loans that should have been classified as subprime because of the borrowers’ credit scores and not simply because they were originated by subprime lenders. Fannie and Freddie did not do this until after they were taken over by the federal government. This lack of disclosure on the part of the GSEs appears to have been a factor in the failure of many market observers to foresee the potential severity of the mortgage defaults when the housing bubble deflated in 2007. 451 the past to meet other financial obligations. Before changes in government policy in the early 1990s, most borrowers with FICO scores below 660 did not qualify as prime borrowers and had diffi culty obtaining mortgage credit other than through the Federal Housing Administration (FHA), the government’s original subprime lender, or through a relatively small number of specialized subprime lenders. An Alt-A mortgage is one that is deficient by its terms. It may have an adjustable rate, lack documentation about the borrower, require payment of interest only, or be made to an investor in rental housing, not a prospective homeowner. Another key deficiency in many Alt-A mortgages is a high loan-to-value ratio—that is, a low downpayment. A low downpayment for a home may signify the borrower’s lack of financial resources, and this lack of “skin in the game” often means a reduced borrower commitment to the home. Until they became subject to HUD’s affordable housing requirements, beginning in the early 1990s, Fannie and Freddie seldom acquired loans with these deficiencies. FinancialCrisisReport--73 The April 16, 2006 “Home Loans Discussion” presentation by Home Loans President David Schneider, discussed above, also confirms WaMu’s ongoing efforts to shift its loan business toward high risk lending. Page four of that presentation, entitled, “Shift to Higher Margin Products,” shows two pie charts under the heading, “WaMu Volume by Product.” 190 One chart depicts loan volume for 2005, and the second chart depicts projected loan volume for 2008: WaMu Volume By Product $ In Billions 191 Home Equity $4B 2% Govt $8B 4% Subprime $34B 16% Fixed $69B 33% Alt-A $1B 0% New Product $13B 5% Home Equity $30B Alt A $24B 10% 2008 Fixed $4B 2% Hyb/ARM $38B 17% 13% Option ARM $63B Option ARM $63B 31% Hyb/ARM $28B 13% Subprime $70B 30% 23% $206 Billion $232 Billion These charts demonstrate WaMu’s intention to increase its loan originations over three years by almost $30 billion, focusing on increases in high risk loan products. Subprime originations, for example, were expected to grow from $34 billion in 2005 to $70 billion in 2008; Alt A originations were projected to grow from $1 billion in 2005 to $24 billion in 2008; and 189 Id. at 319. 190 4/18/2006 “Home Loans Discussion Board of Directors Meeting,” WaMu PowerPoint presentation, JPM_WM00690890-901 at 894, Hearing Exhibit 4/13-3. 191 Id. [formatted for clarity]. 2005 fcic_final_report_full--139 Overall, while the mortgages behind the subprime mortgage–backed securities were often issued to borrowers that could help Fannie and Freddie fulfill their goals, the mortgages behind the Alt-A securities were not. Alt-A mortgages were not gener- ally extended to lower-income borrowers, and the regulations prohibited mortgages to borrowers with unstated income levels—a hallmark of Alt-A loans—from count- ing toward affordability goals.  Levin told the FCIC that they believed that the pur- chase of Alt-A securities “did not have a net positive effect on Fannie Mae’s housing goals.”  Instead, they had to be offset with more mortgages for low- and moderate- income borrowers to meet the goals. Fannie and Freddie continued to purchase subprime and Alt-A mortgage–backed securities from  to  and also bought and securitized greater numbers of riskier mortgages. The results would be disastrous for the companies, their share- holders, and American taxpayers. COMMISSION CONCLUSIONS ON CHAPTER 7 The Commission concludes that the monetary policy of the Federal Reserve, along with capital flows from abroad, created conditions in which a housing bub- ble could develop. However, these conditions need not have led to a crisis. The Federal Reserve and other regulators did not take actions necessary to constrain the credit bubble. In addition, the Federal Reserve’s policies and pronouncements encouraged rather than inhibited the growth of mortgage debt and the housing bubble. Lending standards collapsed, and there was a significant failure of accounta- bility and responsibility throughout each level of the lending system. This in- cluded borrowers, mortgage brokers, appraisers, originators, securitizers, credit rating agencies, and investors, and ranged from corporate boardrooms to individ- uals. Loans were often premised on ever-rising home prices and were made re- gardless of ability to pay. The nonprime mortgage securitization process created a pipeline through which risky mortgages were conveyed and sold throughout the financial system. This pipeline was essential to the origination of the burgeoning numbers of high- risk mortgages. The originate-to-distribute model undermined responsibility and accountability for the long-term viability of mortgages and mortgage-related se- curities and contributed to the poor quality of mortgage loans. (continues) (continued) CHRG-111shrg57319--20 Mr. Cathcart," Correct. Senator Levin. Now, this high-risk strategy of WaMu, the shift from low risk to high risk, was first implemented in 2004. From 2003 to 2006, subprime originations were up, and securitizations were up even more. They had doubled from 2005 to 2006, according to this chart, and that is based on WaMu's statistics. Presumably, that was because WaMu was acquiring subprime loans through its subprime conduit or other channels or even taking subprime loans from the WaMu portfolio and securitizing them. Is that correct? " CHRG-111shrg51290--39 Chairman Dodd," Thank you very much. Senator Shelby? Senator Shelby. Thank you. If we make bad loans and they are securitized, you don't have bad securities. That is a given, is it not? And that is where we are today, isn't it? Ms. Seidman, the suitability standard for credit products, in your written testimony, you state, quote, ``the difference between a good product and a bad one can be subtle, especially if the consumer doesn't know where to look.'' You then suggested that perhaps a suitability standard such as the one used in the securities arena should be fashioned for consumer credit transactions. Who would be the person charged with carrying out that standard? Would it be the loan officers in a bank? How would this apply to credit card transactions and so forth? And how would the regulators enforce this provision? Ms. Seidman. I think--first of all, with respect to mortgage lending, most mortgage lending, particularly purchase money mortgages, is still done on a face-to-face basis and I see no difference in terms of the responsibility that a loan officer or a broker or somebody else would have with respect to the suitability of a mortgage product compared to the securities side. In fact, it is probably the case that the originator of the mortgage should be acquiring at least as much information as the broker acquires in order to understand what product is right. The credit card situation is somewhat more difficult, but I do think that in general, or in the old days, at least, one actually had to fill out a fairly extensive form in order to be able to get a credit card. I think that there are ways of determining from that kind of information--what is my income source, what other kinds of debts do I have--whether a credit card of one type or another is the most appropriate for that consumer. You know, we would have to work it through. There would be uncertainty, but this is not rocket science. This is really not very far away from the ability to pay standard. It just says, not only should you look at whether in the worst possible circumstances the borrower could pay, but also try to figure out what is good for that borrower. Senator Shelby. Professor McCoy, the subject would be the GSE affordable lending practices. You explain in your testimony, Professor McCoy, why you believe reckless lenders will crowd out good lenders. A variety of Federal efforts are aimed at providing borrowers alternatives. For instance, Fannie Mae and Freddie Mac have often claimed as their mission right here in this Committee the expansion of responsible home ownership, which we have supported--responsible home ownership. Do you believe that Fannie Mae and Freddie Mac's purchase of private-label subprime mortgage-backed securities added to borrowers' options for responsible home ownership? Ms. McCoy. Senator Shelby, first of all, while Fannie and Freddie starting around 2005 joined the party with respect to origination standards, they didn't start the party. They were one of these conventional good guys who---- Senator Shelby. They got on the truck, didn't they? Ms. McCoy. They got on the truck, but they didn't start it and it is really the private-label market that started it. I did find it highly problematic that Fannie and Freddie purchased as part of their investment portfolios subprime mortgage-backed securities. They were among many other global investors, part of the glut of money that drove the securitization crisis and the drop in lending standards, but they do not deserve sole blame. Senator Shelby. Sure. So the rationale for the GSEs providing liquidity to the subprime market, although later, rather than focusing on the purchase of whole loans, exacerbated that problem, did it not? Ms. McCoy. Yes, I think that is right. But the purchase of loans by Fannie and Freddie is a very, very important device and I wouldn't want that to be compromised in the efforts to remove the investment portfolio authority. Senator Shelby. Absolutely. I agree with that. But on the other hand, they should purchase good loans or responsible loans, shouldn't they? Ms. McCoy. Yes. Yes. And they were doing that around 2000. They were---- Senator Shelby. Oh, they were doing great for a while. Ms. McCoy. Right. Senator Shelby. But---- Ms. McCoy. Things changed. Senator Shelby. They got on the truck. Sure. Mr. Bartlett, you would suppose that financial institutions have strong incentives well beyond legal compliance to treat their customers well, treat them fairly, and to maintain long-term relationships. In other words, you take care of your customers and your customers will be around. In other words, consumer protection should amount to consumer retention, is what people try to do, I hope. Yet it seems that financial institutions sometimes have not chosen to pursue this course. How can we realign the incentives so that they will be realigned in the future? " fcic_final_report_full--472 Much of the Commission majority’s report, which criticizes firms, regulators, corporate executives, risk managers and ratings agency analysts for failure to perceive the losses that lay ahead, is sheer hindsight. It appears that information about the composition of the mortgage market was simply not known when the bubble began to deflate. The Commission never attempted a serious study of what was known about the composition of the mortgage market in 2007, apparently satisfied simply to blame market participants for failing to understand the risks that lay before them, without trying to understand what information was actually available. The mortgage market is studied constantly by thousands of analysts, academics, regulators, traders and investors. How could all these people have missed something as important as the actual number of NTMs outstanding? Most market participants appear to have assumed in the bubble years that Fannie and Freddie continued to adhere to the same conservative underwriting policies they had previously pursued. Until Fannie and Freddie were required to meet HUD’s AH goals, they rarely acquired subprime or other low quality mortgages. Indeed, the very definition of a traditional prime mortgage was a loan that Fannie and Freddie would buy. Lesser loans were rejected, and were ultimately insured by FHA or made by a relatively small group of subprime originators and investors. Although anyone who followed HUD’s AH regulations, and thought through their implications, would have realized that Fannie and Freddie must have been shifting their buying activities to low quality loans, few people had incentives to uncover the new buying pattern. Investors believed that there was no significant risk in MBS backed by Fannie and Freddie, since they were thought (correctly, as it turns out) to be implicitly backed by the federal government. In addition, the GSEs were exempted by law from having to file information with the Securities and Exchange Commission (SEC)--they agreed to file voluntarily in 2002--leaving them free from disclosure obligations and questions from analysts about the quality of their mortgages. When Fannie voluntarily began filing reports with the SEC in 2003, it disclosed 35 Fannie Mae, 2010 Second Quarter Credit Supplement, http://www.fanniemae.com/ir/pdf/sec/2010/ q2credit_summary.pdf. 36 “Moody’s Projects Losses of Almost Half of Original Balance from 2007 Subprime Mortgage Securities,” http://seekingalpha.com/article/182556-moodys-projects-losses-of-almost-half-of-original- balance-from-2007-subprime-mortgage-securities. 467 that 16 percent of its credit obligations on mortgages had FICO scores of less than 660—the common definition of a subprime loan. There are occasionally questions about whether a FICO score of 660 is the appropriate dividing line between prime and subprime loans. The federal bank regulators use 660 as the dividing line, 37 and in the credit supplement it published for the first time with its 2008 10-K, Fannie included loans with FICO scores below 660 to disclose its exposure to loans that were other than prime. As of December 31, 2008, borrowers with a FICO of less than 660 had a serious delinquency rate about four times that for borrowers with a FICO equal to or greater than 660 (6.74% compared to 1.72%). 38 Fannie did not point out in its filing that a FICO score of less than 660 was considered a subprime loan. Although at the end of 2005 Fannie was exposed to $311 billion in subprime loans it reported in its 2005 10-K (not filed with the SEC until May 2, 2007) that: “The percentage of our single-family mortgage credit book of business consisting of subprime mortgage loans or structured Fannie Mae MBS backed by subprime mortgage loans was not material as of December 31, 2005.”[emphasis supplied] 39 Fannie was able to make this statement because it defined subprime loans as loans it purchased from subprime lenders. Thus, in its 2007 10-K report, Fannie stated: “Subprime mortgage loans are typically originated by lenders specializing in these loans or by subprime divisions of large lenders, using processes unique to subprime loans. In reporting our subprime exposure, we have classified mortgage loans as subprime if the mortgage loans are originated by one of these specialty lenders or a subprime division of a large lender .” 40 [emphasis supplied] The credit scores on these loans, and the riskiness associated with these credit scores, were not deemed relevant. Accordingly, as late as its 2007 10-K report, Fannie was able to make the following statements, even though it is likely that at that point it held or guaranteed enough subprime loans to drive the company into insolvency if a substantial number of these loans were to default: FinancialCrisisReport--65 The December 2004 presentation also defined higher risk lending on the basis of expanded underwriting criteria and multiple risk layering: “Expanded Criteria -‘No Income’ loan documentation type -All Manufactured Housing loans … Multiple Risk Layering in SF[R] and 1 st lien HEL/HELOC loans -Higher A- credit score or lacking LTV as strong compensating factor and -An additional risk factor from at least three of the following: -Higher uncertainty about ability to pay or ‘stated income’ documentation type -higher uncertainty about willingness to pay or collateral value[.]” 165 This document indicates that WaMu considered a mortgage to be higher risk if it lacked documentation regarding the borrower’s income, described as a “no income” or “stated income” loan. WaMu held billions of dollars in loans on its balance sheet. 166 Those assets fluctuated in value based on the changes in the interest rate. Fixed rate loans, in particular, incurred significant interest rate risk, because on a 30-year fixed rate mortgage, for example, WaMu agreed to receive interest payments at a certain rate for 30 years, but if the prevailing interest rate went up, WaMu’s cost of money increased and the relative value of the fixed mortgages on its balance sheet went down. WaMu used various strategies to hedge its interest rate risk. One way to incur less interest rate risk was for WaMu to hold loans with variable interest rates, such as Hybrid ARMs typical of WaMu’s subprime lending, or Option ARMs, WaMu’s flagship “prime” product. These adjustable rate mortgages paid interest rates that, after the initial fixed rate period expired, were typically pegged to the Cost of Funds Index (COFI) or the Monthly Treasury Average (MTA), two common measures of prevailing interest rates. 163 See, e.g., 10/8/1999 “Interagency Guidance on High LTV Residential Real Estate Lending,” http://www.federalreserve.gov/boarddocs/srletters/1993/SR9301.htm, and discussion of high LTV loans in section D(2)(b), below. 164 12/21/2004 “Asset Allocation Initiative: Higher Risk Lending Strategy and Increased Credit Risk Management,” Washington Mutual Board of Directors Presentation, JPM_WM04107995-8008 at 7999, Hearing Exhibit 4/13-2b. 165 Id. This slide lists only the two additional risk factors quoted, despite referring to “at least three of the following.” 166 See 9/25/2008 “OTS Fact Sheet on Washington Mutual Bank,” Dochow_Darrel-00076154_001 (“Loans held: $118.9 billion in single-family loans held for investment – this includes $52.9 billion in payment option ARMs and $16.05 billion in subprime mortgage loans”). (4) Gain on Sale FinancialCrisisReport--193 The memorandum identified several matters that required resolution prior to a WaMu purchase of Long Beach, including the establishment of pre- and post-funding loan quality reviews that were already in place at the bank. The memorandum also stated that Long Beach management had “worked diligently to improve its operation and correct significant deficiencies … reported in prior years,” and observed, “there is definitely a new attitude and culture.” 724 OTS continued to review Long Beach’s lending practices and found additional deficiencies throughout the year. Those deficiencies included errors in loan calculations of debt- to-income ratios, lack of documentation to support the reasonableness of borrower income on stated income loans, and lack of explanation of a borrower’s ability to handle payment shock on loans with rising interest rates. 725 OTS also determined that Long Beach’s newly created portfolio of subprime loans “had attributes that could result in higher risk” than WaMu’s existing subprime loan portfolio. 726 Nevertheless, in December 2005, OTS examiners wrote that, even though Long Beach was “engaged in a high-risk lending activity and we are not yet fully satisfied with its practices,” they recommended approving WaMu’s purchase of the company with certain conditions. 727 Those conditions included WaMu’s reconsidering its high risk lending concentration limits, including “stated income loans with low FICOs and high LTV ratios”; WaMu’s assurance that Long Beach would comply with certain loan guidance; a WaMu commitment to continue to bring down its loan exception and error rates; and a WaMu commitment to ensure its Enterprise Risk Management division would provide a “countervailing balance” to “imprudent” desires to expand Long Beach’s subprime lending. 728 About the same time as this memorandum was completed, OTS learned that, during the fourth quarter of 2005, Long Beach had been required to repurchase tens of millions of dollars of loans it had sold to third parties due to early payment defaults. 729 By December, this unexpected wave of repurchases had overwhelmed Long Beach’s repurchase reserves, leading to a reserve shortfall of nearly $75 million. Altogether in the second half of 2005, Long Beach had to repurchase loans with about $837 million in unpaid principal, and incurred a net loss of about 724 Id. See also 5/19/2005 OTS email, “LBMC Fair Lending,” OTSWMS05-005 0002002, Hearing Exhibit 4/16-20 (“I would not … feel comfortable with their moving [Long Beach] under the thrift without some conditions”). 725 See 12/21/2005 OTS internal memorandum by OTS examiners to OTS Deputy Regional Director Darrel Dochow, OTSWMS06-007 0001009-16, Hearing Exhibit 4/16-31. 726 Id. at OTSWMS06-007 0001011. 727 See 12/21/2005 OTS internal memorandum by OTS examiners to OTS Deputy Regional Director Darrel Dochow, OTSWMS06-007 0001009-16, Hearing Exhibit 4/16-31. 728 Id. at OTSWMS06-007 0001015-16. 729 See 10/3/2005 OTS Report of Examination, OTSWMS06-010 0002530, Hearing Exhibit 4/16-94 [Sealed Exhibit] (noting that, after a field visit to Long Beach that concluded in December 2005, OTS learned that loan repurchases had surged: “Subsequent to our on-site field visit, management informed us that loan repurchases had increased considerably. … Management indicated that approximately $0.6 billion in loans were repurchased during the fourth quarter of 2005 out of approximately $13.2 billion in total whole loan sales. The gross financial impact at December 31, 2005, was $72.3 million.”); 1/20/2006 email from Darrel Dochow to Michael Finn and others, with chart, OTSWMS06-007 0001020 to 1021 (describing Long Beach repurchases). $107 million. 730 In response, its auditor, Deloitte and Touche, cited Long Beach for a CHRG-111shrg57322--327 Mr. Birnbaum," I believe what I referred to in my opening statement was the subprime market. Senator Tester. OK. So based on subprime, did it change your view of the mortgage-backed securities? " CHRG-110hhrg34673--126 Mr. Bernanke," To some extent, that is correct. It is certainly the case that subprime lenders, certainly the legitimate subprime lenders, are not looking to have foreclosures. It is bad for their business--they lose money--and we have seen some failures of small lenders, and we have seen credit default swaps that measure the risk of subprime mortgages, those spreads widen considerably, and so, clearly, it is not in the interest of lenders to make bad loans. " FOMC20070509meeting--6 4,MR. DUDLEY.," There is definitely some spillover into alt-A, but alt-A delinquencies and losses are a fraction of subprime. If you compare the characteristics of alt-A loans with those of subprime loans, you’ll see the same easing of underwriting standards in the alt-A market that occurred in the subprime market and almost identical characteristics of the underwriting standards except for one difference—the FICO score. The FICO score for alt-A is much higher. Apparently, the FICO score is pretty important because the losses for alt-A are a fraction of those on subprimes. But there are data that show some spillover." fcic_final_report_full--509 Table 7. 105 GSE Purchases of Subprime and Alt-A loans $ in billions 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 1997-2007 Subprime PMBS Subprime $3* $18* $18* $11* $16* $38 $82 $180 $169 $110 $62 $707 $37 $83 $74 $65 $159 $206 $262 $144 $139 $138 $195 $1,502 loans** Alt-A PMBS Unk. Unk, Unk. Unk. Unk. $18 $12 $30 $36 $43 $15 $154 Alt-A loans*** Unk. Unk, Unk. Unk. Unk. $66 $77 $64 $77 $157 $178 $619 High LTV $32 $44 $62 $61 $84 $87 $159 $123 $126 $120 $226 $1,124 loans**** Total***** $72 $145 $154 $137 $259 $415 $592 $541 $547 $568 $676 $4,106 *Total purchases of PMBS for 1997-2001 are known. Subprime purchases for these years were estimated based upon the percentage that subprime PMBS constituted of total PMBS purchases in 2002 (57%). **Loans where borrower’s FICO <660. *** Fannie and Freddie used their various affordable housing programs and individual lender variance programs (many times in conjunction with their automated underwriting systems once these came into general use in the late-1990s) to approve loans with Alt-A characteristics. However, they generally did not classify these loans as Alt-A. Classification as Alt-A started in the early-1990s. There is an unknown number of additional loans that had higher debt ratios, reduced reserves, loosened credit requirements, expanded seller contributions, etc. The volume of these loans is not included. ****Loans with an original LTV or original combined LTV >90% (given industry practices, this effectively means >=95%). Data to estimate loans with CLTV.>90% is unavailable prior to 2003. Amounts for 2003-2007 are grossed up by 60% to account for the impact of loans with a CLTV >90%. These estimates are based on disclosures by Fannie and Freddie that at the end of 2007 their total exposures to loans with an LTV or CLTV >90% was 50% and 75% percent respectively higher than their exposure to loans with an LTV >90%. Fannie reports on p. 128 of its 2007 10-K that 15% of its entire book had an original combined LTV >90%. Its Original LTV percentage >90% (without counting the impact of any 2nd mortgage simultaneously negotiated) is 9.9%. Freddie reports on p60 of its Q2:2008 10 Q that 14% of its portfolio had an original combined LTV >90%. Its OLTV percentage >90% (without counting any simultaneous 2nd) is 8%. While Fannie and Freddie purchased only the first mortgage, these loans had the same or higher incidence of default as a loan with an LTV of >90%. *****Since loans may have more than one characteristic, they may appear in more than one category. Totals are not adjusted to take this into account. The claim that the GSEs loosened their underwriting standards in order to compete specifically with “Wall Street” can be easily dismissed—unless the Commission majority and others who have made this statement are including Countrywide (which was based in California) or other subprime lenders in the term “Wall Street.” Assuming, however, that the Commission majority and other commentators have been using the term Wall Street to apply to the commercial and investment banks that operate in the financial markets of New York, the data shows that Wall Street was not a significant participant in the subprime PMBS market between 2004 and 2007 or at any time before or after those dates. The top five players in 2004 were subprime lenders Ameriquest ($55 billion) and Countrywide ($40 billion), followed by Lehman Brothers ($27 billion), GMAC RFC ($26 billion), and New Century ($22 billion). Other than Lehman, some other Wall Street firms were scattered through the list of the top 25, but were not significant players as a group. In 2005, the biggest year for subprime issuances, the five leaders were the same, and the total for all Wall Street institutions was $137 billion, or about 27 105 Id. 505 percent of the $508 billion issued that year. 106 In 2006, Lehman had dropped out of the top five and Countrywide had taken over the leadership among the issuers, but Wall Street’s share had not significantly changed. By the middle of 2007, the PMBS market had declined to such a degree that the market share numbers were meaningless. However, in that year the GSEs’ market share in NTMs increased because they had to continue buying NTMs—even though others had defaulted or left the business—in order to comply with the AH goals. Accordingly, if Fannie had ever loosened its lending standards to compete with some group, that group was not Wall Street. fcic_final_report_full--253 Some members were concerned about the lack of transparency around hedge funds, the consequent lack of market discipline on valuations of hedge fund hold- ings, and the fact that the Federal Reserve could not systematically collect informa- tion from hedge funds because they were outside its jurisdiction. These facts caused members to be concerned about whether they understood the scope of the problem. During the same meeting, FOMC members noted that the size of the credit deriv- atives market, its lack of transparency and activities related to subprime debt could be a gathering cloud in the background of policy. Meanwhile, Bear Stearns executives who supported the High-Grade bailout did not expect to lose money. However, that support was not universal—CEO James Cayne and Earl Hedin, the former senior managing director of Bear Stearns and BSAM, were opposed, because they did not want to increase shareholders’ potential losses.  Their fears proved accurate. By July, the two hedge funds had shrunk to al- most nothing: High-Grade Fund was down ; Enhanced Leverage Fund, .  On July , both filed for bankruptcy. Cioffi and Tannin would be criminally charged with fraud in their communications with investors, but they were acquitted of all charges in November . Civil charges brought by the SEC were still pending as of the date of this report. Looking back, Marano told the FCIC, “We caught a lot of flak for allowing the funds to fail, but we had no option.”  In an internal email in June, Bill Jamison of Fed- erated Investors, one of the largest of all mutual fund companies, referred to the Bear Stearns hedge funds as the “canary in the mine shaft” and predicted more market tur- moil.  As the two funds were collapsing, repo lending tightened across the board. Many repo lenders sharpened their focus on the valuation of any collateral with po- tential subprime exposure, and on the relative exposures of different financial institu- tions. They required increased margins on loans to institutions that appeared to be exposed to the mortgage market; they often required Treasury securities as collateral; in many cases, they demanded shorter lending terms.  Clearly, the triple-A-rated mortgage-backed securities and CDOs were not considered the “super-safe” invest- ments in which investors—and some dealers—had only recently believed. FinancialCrisisReport--6 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 Failure: 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. FinancialCrisisReport--510 S&P. 99.89% of the underlying assets were downgraded.” 2188 (b) Goldman ’s Conflicts of Interest In late 2006 and 2007, Goldman’s securitization business was marked, not just by its hard sell tactics, but also by multiple conflicts of interest in which Goldman’s financial interests were opposed to those of its clients. The following examples illustrate the problem. (i) Conflicts of Interest Involving RMBS Securities In 2006 and 2007, Goldman originated 27 CDO and 93 RMBS securitizations. Beginning in December 2006, Goldman originated and aggressively marketed some of these securities at the same time that subprime and other high risk loans were defaulting at alarming rates, the subprime and CDO markets were deteriorating, and Goldman was shorting subprime mortgage assets. At times, Goldman originated and sold RMBS securities that it knew had poor quality loans that were likely to incur abnormally high rates of default. At times, Goldman went further and sold RMBS securities to customers at the same time it was shorting the securities and essentially betting that they would lose value. Two examples illustrate how Goldman constructed and sold poor quality RMBS securities and profited from the decline of the very securities it had sold to its clients. Long Beach RMBS. The first example involves Washington Mutual Bank (WaMu) and its subprime lender, Long Beach Mortgage Corporation. WaMu, Long Beach, and Goldman had collaborated on at least $14 billion in loan sales and securitizations. 2189 In February 2006, Long Beach had a $2 billion warehouse account with Goldman, which was the largest of Goldman’s warehouse accounts at that time. 2190 Long Beach was known within the industry for originating some of the worst performing subprime mortgages in the country. As explained in Chapter III, in 2005, a surge of early payment defaults in its subprime loans required Long Beach to repurchase over $837 million of nonperforming loans from investors, as well as book a $107 million loss. 2191 Similar EPD problems affected its loans in 2006 and 2007. WaMu reviews and audits of Long Beach, as well as examinations by the Office of Thrift Supervision, repeatedly identified serious deficiencies in its lending practices, including lax underwriting standards, unacceptable loan error and exception rates, weak risk management, appraisal problems, inadequate oversight of third party brokers selling loans to the firm, and loan fraud. While these reviews were not available to the public, the performance of Long Beach paper was. Long Beach securitizations had among the worst credit losses in the 2188 10/26/2007 email from Goldman salesman to Michael Swenson, “ABACUS 2007-AC1 – Marketing Points (INTERNAL ONLY) [T-Mail], ” GS MBS-E-016034495. 2189 2190 2191 See “List of W aMu-Goldman Loans Sales and Securitizations,” Hearing Exhibit 4/13-47b. 2/13/2006 Goldman chart, “Current W arehouse Facilities and Funded Balances, ” GS MBS-E-001157934. See Chapters III and IV, above. industry from 1999-2003; in 2005 and 2006, Long Beach securities were among the worst performing in the market. 2192 FinancialCrisisReport--170 Long Beach. One of WaMu’s acquisitions, in 1999, was Long Beach Mortgage Company (Long Beach), a subprime lender that became a source of significant management, asset quality, and risk problems. Long Beach’s headquarters were located in Long Beach, California, but as a subsidiary of Washington Mutual Inc., the parent holding company of Washington Mutual Bank, it was subject to regulation by the State of Washington Department of Financial Institutions and the FDIC. Long Beach’s business model was to purchase subprime loans from third party mortgage brokers and lenders and then sell or securitize the loans for sale to investors. For the first seven years, from 1999 to 2006, OTS had no direct jurisdiction over Long Beach, since it was a subsidiary of WaMu’s parent holding company, but not a subsidiary of the bank itself. OTS was limited to reviewing Long Beach indirectly by examining its effect on the holding company and WaMu. In late 2003, OTS examiners took greater notice of Long Beach after WaMu’s legal department halted Long Beach’s securitizations while it helped the company strengthen its internal controls. As many as 4,000 Long Beach loans were of such poor quality that three quarters of them could not be sold to investors. In 2005, Long Beach experienced a surge in early payment defaults, was forced to repurchase a significant number of loans, lost over $107 million, and overwhelmed its loss reserves. Washington Mutual requested permission to make Long Beach a division of the bank, so that it could assert greater control over Long Beach’s operations, and in March 2006, OTS approved the purchase with conditions. In 2006, Long Beach experienced another surge of early payment defaults and was forced to repurchase additional loans. When Long Beach loans continued to have problems in 2007, Washington Mutual eliminated Long Beach as a separate operation and rebranded it as a Washington Mutual “Wholesale Specialty Lending” division. In August 2007, after the collapse of the subprime secondary market, WaMu stopped offering subprime loans and discontinued the last vestiges of the Long Beach operation. High Risk Lending. In 2004, Washington Mutual shifted its strategy toward the issuance and purchase of higher risk home loans. OTS took note of the strategic shift in WaMu’s 2004 ROE: “Management provided us with a copy of the framework for WMI’s 5-year (2005-2009) strategic plan [which] contemplates asset growth of at least 10% a year, with assets increasing to near $500 billion by 2009.” 609 608 See 3/15/2004 OTS Report of Examination, at OTSWMS04-0000001482, Hearing Exhibit 4/16-94 [Sealed Exhibit]. See also, e.g., 12/17/2004 email exchange among WaMu executives, “Risks/Costs to Moving GSE Share to FH,” JPM_WM05501400, Hearing Exhibit 4/16-88 (noting that Fannie Mae “is well aware of our data integrity issues (miscoding which results in misdeliveries, expensive and time consuming data reconciliations), and has been exceedingly patient.”). 609 See 3/15/2004 OTS Report of Examination, at OTSWMS04-0000001509, Hearing Exhibit 4/16-94 [Sealed Exhibit]. CHRG-110hhrg41184--61 Mrs. Maloney," Thank you very much, and welcome, Mr. Bernanke. New problems in the economy are popping up like a not-very-funny version of Whack-a-mole, as Alan Blinder, a former Vice Chair of the Fed, recently observed, and yesterday's news was no exception with their wholesale inflation soaring consumer confidence falling and home foreclosures are spiking and falling sharply. Added to this, many people believe that the next shoe to fall will be credit card debt, which is securitized in a very similar way as the subprime debt. And, as you know, the Fed has a statutory mandate to protect consumers from unfair lending practices. But there is a widespread perception that the Federal Reserve and Congress did not do enough or act quickly enough to correct dangerous and abusive practices in the subprime mortgage market. Many commentators are now saying that credit cards will be the next area of consumer credit where over-burdened borrowers will no longer be able to pay their bills. We see a situation with our constituents where many responsible cardholders, folks who pay their bills on time and do not go over their limit, are sinking further and further into a quicksand of debt, because card companies are raising interest rates any time, any reason, retroactively, and in some cases quite dramatically--30 percent on existing balances--and there are very, I'd say scary, parallels between the subprime mortgage situation and what is now happening with credit cards. In your response to Chairwoman Biggert's question on what the most important thing a consumer needs to know about their credit card you responded, and I quote: ``Consumers need to know their interest rate and how it varies over time.'' You also mentioned that it is important for consumers to know how their interest rate works. I have introduced legislation with Chairman Frank and 62 of our colleagues that would track your proposed changes to Regulation Z to always give consumers 45 days notice before any rate increase. But it would also give consumers the ability to opt out of the new terms by closing their account and paying off their balance at existing terms. Would you agree that this notice and consumer choice would allow consumers to know their interest rate and how it varies over time and how it works? " CHRG-111hhrg54867--180 Secretary Geithner," I agree that is what--the basic--what happened to housing prices was partly facilitated by what happened to subprime mortgages made everything more perilous and worse. There were other things happening than simply the subprime. " CHRG-111shrg51290--63 PREPARED STATEMENT OF PATRICIA A. McCOY George J. and Helen M. England Professor of Law University of Connecticut School of Law March 3, 2009 Chairman Dodd and Members of the Committee: Thank you for inviting me here today to discuss the problem of restructuring the financial regulatory system. I applaud the Committee for exploring bold new approaches to financial regulation on the scale needed to address our nation's economic challenges. In my remarks today, I propose transferring consumer protection responsibilities in the area of consumer credit from Federal banking regulators to a single, dedicated agency whose sole mission is consumer protection. This step is essential for three reasons. First, during the housing bubble, our current system of fragmented regulation drove lenders to shop for the easiest legal regime. Second, the ability of lenders to switch charters put pressure on banking regulators--both State and Federal--to relax credit standards. Finally, banking regulators have routinely sacrificed consumer protection for short-term profitability of banks. Creating one, dedicated consumer credit regulator charged with consumer protection would establish uniform standards and enforcement for all lenders and help eliminate another death spiral in lending. Although I examine this issue through the lens of mortgage regulation, my discussion is equally relevant to other forms of consumer credit, such as credit cards and payday lending. The reasons for the breakdown of the home mortgage market and the private-label market for mortgage-backed securities are well known by now. Today, I wish to focus on lax lending standards for residential mortgages, which were a leading cause of today's credit crisis and recession. Our broken system of mortgage finance and the private actors in that system--ranging from mortgage brokers, lenders, and appraisers to the rating agencies and securitizers--bear direct responsibility for this breakdown in standards. There is more to the story, however. In 2006, depository institutions and their affiliates, which were regulated by Federal banking regulators, originated about 54 percent of all higher-priced home loans. In 2007, that percentage rose to 79.6 percent.\1\ In some states, mortgages originated by State banks and thrifts and independent nonbank lenders were regulated under State anti-predatory lending laws. In other states, however, mortgages were not subject to meaningful regulation at all. Consequently, the credit crisis resulted from regulatory failure as well as broken private risk management. That regulatory failure was not confined to states, moreover, but pervaded Federal banking regulation as well.--------------------------------------------------------------------------- \1\ Robert B. Avery, Kenneth P. Brevoort & Glenn B. Canner, The 2007 HMDA Data, Fed. Res. Bull. A107, A124 (Dec. 2008), available at http://www.federalreserve.gov/pubs/bulletin/2008/pdf/hmda07final.pdf.--------------------------------------------------------------------------- Neither of these phenomena--the collapse in lending criteria and the regulatory failure that accompanied it--was an accident. Rather, they occurred because mortgage originators and regulators became locked in a competitive race to the bottom to relax loan underwriting and risk management. The fragmented U.S. system of financial services regulation exacerbated this race to the bottom by allowing lenders to shop for the easiest regulators and laws. During the housing bubble, consumers could not police originators because too many loan products had hidden risks. As we now know, these risks were ticking time bombs. Lenders did not take reasonable precautions against default because they able to shift that to investors through securitization. Similarly, regulators failed to clamp down on hazardous loans in a myopic attempt to boost the short-term profitability of banks and thrifts. I open by examining why reckless lenders were able to take market share away from good lenders and good products. Next, I describe our fragmented financial regulatory system and how it encouraged lenders to shop for lenient regulators. In part three of my remarks, I document regulatory failure by Federal banking regulators. Finally, I end with a proposal for a separate consumer credit regulator.I. Why Reckless Lenders Were Able To Crowd Out the Good During the housing boom, the residential mortgage market was relatively unconcentrated, with thousands of mortgage originators. Normally, we would expect an unconcentrated market to provide vibrant competition benefiting consumers. To the contrary, however, however, highly risky loan products containing hidden risks--such as hybrid adjustable-rate mortgages (ARMs), interest-only ARMs, and option payment ARMs--gained market share at the expense of safer products such as standard fixed-rate mortgages and FHA-guaranteed loans.\2\--------------------------------------------------------------------------- \2\ A hybrid ARM offers a 2- or 3-year fixed introductory rate followed by a floating rate at the end of the introductory period with substantial increases in the rate and payment (so-called ``2-28'' and ``3-27'' mortgages). Federal Reserve System, Truth in Lending, Part II: Proposed rule; request for public comment, 73 Fed. Reg. 1672, 1674 (January 9, 2008). An interest-only mortgage allows borrowers to defer principal payments for an initial period. An option payment ARM combines a floating rate feature with a variety of payment options, including the option to pay no principal and less than the interest due every month, for an initial period. Choosing that option results in negative amortization. Department of the Treasury et al., Interagency Guidance on Nontraditional Mortgage Product Risks: Final guidance, 71 Fed. Reg. 58609, 58613 (Oct. 4, 2006).--------------------------------------------------------------------------- These nontraditional mortgages and subprime loans inflicted incalculable harm on borrowers, their neighbors, and ultimately the global economy. As of September 30, 2008, almost 10 percent of U.S. residential mortgages were 1 month past due or more.\3\ By year-end 2008, every sixth borrower owed more than his or her home was worth.\4\ The proliferation of toxic loans was the direct result of the ability to confuse borrowers and to shop for the laxest regulatory regime.\5\--------------------------------------------------------------------------- \3\ See Mortgage Bankers Association, Delinquencies Increase, Foreclosure Starts Flat in Latest MBA National Delinquency Survey (Dec. 5, 2008), available at www.mbaa.org/NewsandMedia/PressCenter/66626.htm. \4\ Michael Corkery, Mortgage `Cram-Downs' Loom as Foreclosures Mount, Wall St. J., Dec. 31, 2008. \5\ The discussion in this section was drawn, in part, from Patricia A. McCoy, Andrey D. Pavlov, & Susan M. Wachter, Systemic Risk through Securitization: The Result of Deregulation and Regulatory Failure,__Conn. L. Rev. __(forthcoming 2009) and Oren Bar-Gill & Elizabeth Warren, Making Credit Safer,__ U. Penn. L. Rev. __ (forthcoming 2009).---------------------------------------------------------------------------A. The Growth in Dangerous Mortgage Products During the housing boom, hybrid subprime ARMs, interest-only mortgages, and option payment ARMs captured a growing part of the market. We can see this from the growth in nonprime mortgages.\6\ Between 2003 and 2005, nonprime loans tripled from 11 percent of all home loans to 33 percent.\7\--------------------------------------------------------------------------- \6\ I use the term ``nonprime'' to refer to subprime loans plus other nontraditional mortgages. Subprime mortgages carry higher interest rates and fees and are designed for borrowers with impaired credit. Nontraditional mortgages encompass a variety of risky mortgage products, including option payment ARMs, interest-only mortgages, and reduced documentation loans. Originally, these nontraditional products were offered primarily in the ``Alt-A'' market to people with near-prime credit scores but intermittent or undocumented income sources. Eventually, interest-only ARMs and reduced documentation loans penetrated the subprime market as well. \7\ FDIC Outlook, Breaking New Ground in U.S. Mortgage Lending (Summer 2006), available at www.fdic.gov/bank/analytical/regional/ro20062q/na/2006_summer04.html. --------------------------------------------------------------------------- If we unpack these numbers, it turns out that hybrid ARMs, interest-only mortgages, and option payment ARMs accounted for a growing share of nonprime loans over this period. Option payment ARMs and interest-only mortgages went from 3 percent of all nonprime originations in 2002 to well over 50 percent by 2005. (See Figure 1). Low- and no-documentation loans increased from 25 percent to slightly over 40 percent of subprime loans over the same period. By 2004 and continuing through 2006, about three-fourths of the loans in subprime securitizations consisted of hybrid ARMs.\8\--------------------------------------------------------------------------- \8\ See generally McCoy, Pavlov & Wachter, supra note 5; FDIC Outlook, Breaking New Ground in U.S. Mortgage Lending (Summer 2006), available at www.fdic.gov/bank/analytical/regional/ro20062q/na/2006_summer04.html. --------------------------------------------------------------------------- Figure 1. Growth in Nontraditional Mortgages, 2002-2005\9\--------------------------------------------------------------------------- \9\ FDIC Outlook, Breaking New Ground in U.S. Mortgage Lending (Summer 2006), available at www.fdic.gov/bank/analytical/regional/ro20062q/na/2006_summer04.html. As the product mix of nonprime loans became riskier and riskier, two default indicators for nonprime loans also increased substantially. Loan-to-value ratios went up and so did the percentage of loans with combined loan-to-value ratios of over 80 percent. This occurred even though the credit scores of borrowers with those loans remained relatively unchanged between 2002 and 2006. At the same time, the spreads of rates over the bank cost of capital tightened. To make matters worse, originators layered risk upon risk, with borrowers who were the most at risk obtaining low equity, no-amortization, reduced documentation loans. (See Figure 2). Figure 2. Underwriting Criteria for Adjustable-Rate Mortgages, 2002- 2006 CHRG-111shrg57319--446 Mr. Rotella," Thank you. Chairman Levin, Ranking Member Coburn, and distinguished Subcommittee Members, thank you for inviting me to testify and for sharing these remarks with you. This is my first public statement since the FDIC seized Washington Mutual in September 2008, so I want to be clear about the key factors that led to an elevated level of risk at WaMu during the financial crisis, risks that were created over many years prior to my arrival at WaMu in 2005.--------------------------------------------------------------------------- \1\ The prepared statement of Mr. Rotella appears in the Appendix on page 169.--------------------------------------------------------------------------- I also want to summarize how the team that I was a part of recognized those risks and made solid progress in proactively reducing them. In particular, I want to be very clear on the topic of high-risk lending, this Subcommittee's focus today. High-risk mortgage lending in WaMu's case, primarily Option ARMs and subprime loans through Long Beach Mortgage, a subsidiary of WaMu, were expanded and accelerated at explosive rates starting in the early 2000s, prior to my hiring in 2005. In 2004 alone, the year before I joined, Option ARMs were up 124 product, and subprime lending was up 52 percent. As the facts in my written statement to this Subcommittee show, those extraordinary rates ceased after 2005, and we then reduced total high-risk mortgage volume substantially every year after that. Total high-risk lending was not expanded and did not accelerate after 2005, as some have reported. The facts show the opposite. I provide my statement to you from my vantage point as a 30-year veteran in financial services, from nearly 18 years at JP Morgan Chase, and as WaMu's chief operating officer for 3\1/2\ years. When I joined WaMu in 2005, the company had over $340 billion in assets. As a nationally chartered thrift, WaMu had already developed a high concentration of mortgage risk relative to more diversified banks. And as I noted, the company had been accelerating its growth in higher-risk mortgage products and, in addition, it had serious operating deficiencies, particularly in mortgage lending. WaMu's concentration risk was particularly acute because nearly 60 percent of its mortgage loans were from California and Florida, which had experienced large and unsustainable home price increases. What happened at WaMu was principally the combined effect of those risks developed over almost two decades, which would be magnified and stressed by the extreme market conditions of late 2007 and 2008. The team that I was a part of worked very hard to adjust to a rapidly changing environment and addressed those risks. As public data shows, we reduced the absolute size of WaMu's mortgage business, including new production, total high-risk lending, and its portfolio every year after 2005 and by a substantial amount in aggregate. We made progress in diversifying the company and had plans to do more, but there simply was not enough time to complete the enormous transformational change needed in a $340 billion thrift given the collapse of the housing market roughly 2 years after we started. In fairness to all concerned, few experts, including the Chairman of the Federal Reserve Board and the Secretary of the Treasury, anticipated what occurred in the housing market and the economy as a whole. Now, I would like to provide you with a bit more detail about WaMu. Prior to 2005, when I joined the company, WaMu had been growing its mortgage business at an accelerating rate. By 2003, it was the No. 2 mortgage lender with a market share of over 11 percent, and its subprime volume had been growing by nearly 50 percent every year from 2001 forward until 2005. WaMu's stated strategy was similar to many firms with large mortgage units during the pre-crisis economy. With the benefit of hindsight, that strategy was ill advised. As the financial crisis conclusively established, credit risk was mispriced for a declining housing market. In 2003 and 2004, the company's mortgage business experienced very serious risk management and operating missteps. A management shake-up ensued, and it was around this time that a new executive team began to take shape, including my hiring in 2005. That team believed that with enough time and effort, WaMu could resolve its issues and take its place among the country's finest financial institutions. I and others recognized that due to WaMu's combination of risks, changes needed to be made. As the market softened, we began to migrate the company away from its mortgage legacy. By the end of 2005, we were making solid progress, and by the time of the seizure, WaMu's market share in mortgages had been cut by nearly two-thirds, from over 11 percent to about 4 percent, and we had shut down Long Beach and Option ARM lending. Far from accelerating or expanding, as some large competitors did during this time, we were slowing and contracting faster than the market as a whole. Looking back now, of course, I would have tried to move even faster than we did in the areas where I had direct control. Unfortunately, after the capital markets stopped operating in the third quarter of 2007, we were unable to execute on aspects of our strategy. Subsequently, the decline in the housing market accelerated, and it was not long before the financial crisis was in full swing. We continued our efforts as the team raised capital, and, in fact, the day the company was seized, our primary regulator, the OTS, determined that WaMu was well capitalized. All of us wanted the opportunity to finish what we had started in 2005. I thank you for inviting me here today, and I look forward for your questions. Senator Levin. Thank you very much, Mr. Rotella. Mr. Killinger. TESTIMONY OF KERRY K. KILLINGER,\1\ FORMER PRESIDENT, CHIEF EXECUTIVE OFFICER, AND CHAIRMAN OF THE BOARD, WASHINGTON MUTUAL CHRG-111hhrg54868--61 Mr. Smith," I will try. First of all, sir, if I might say so, we have just had a financial meltdown under subprime. The States were all over subprime for years. No one has ever said, to my knowledge, that the State regulation caused the subprime crisis. In fact, if anything, the State regulation was on top of the subprime crisis before anybody else. It is astonishing to me to hear the regulators of enterprises that have lost billions of dollars somehow related to subprime say they weren't involved then. This is an astonishing proposition. It seems to me in cases where there are appropriate Federal standards or where Federal standards are enforced, the States have other things to do right now than fry these fish. We will work with the Federal Government. We have worked with the Federal Government on the SAFE Act. We thank you for adopting that. Forty-nine States have adopted similar legislation to license mortgage originators so that we can get our arms around this issue, and we have been doing this stuff for years. So I think it is really quite unfair to say that allowing States to have higher standards to protect consumers somehow damages the financial system. " fcic_final_report_full--458 Given the likelihood that large numbers of subprime and Alt-A mortgages would default once the housing bubble began to deflate in mid- 2007—with devastating effects for the U.S. economy and financial system—the key question for the FCIC was to determine why, beginning in the early 1990s, mortgage underwriting standards began to deteriorate so significantly that it was possible to create 27 million subprime and Alt-A mortgages. The Commission never made a serious study of this question, although understanding why and how this happened must be viewed as one of the central questions of the financial crisis. From the beginning, the Commission’s investigation was limited to validating the standard narrative about the financial crisis—that it was caused by deregulation or lack of regulation, weak risk management, predatory lending, unregulated derivatives and greed on Wall Street. Other hypotheses were either never considered or were treated only superficially. In criticizing the Commission, this statement is not intended to criticize the staff, which worked diligently and effectively under diffi cult circumstances, and did extraordinarily fine work in the limited areas they were directed to cover. The Commission’s failures were failures of management. 1. Government Policies Resulted in an Unprecedented Number of Risky Mortgages Three specific government programs were primarily responsible for the growth of subprime and Alt-A mortgages in the U.S. economy between 1992 and 2008, and for the decline in mortgage underwriting standards that ensued. The GSEs’ Affordable Housing Mission. The fact that high risk mortgages formed almost half of all U.S. mortgages by the middle of 2007 was not a chance event, nor did it just happen that banks and other mortgage originators decided on their own to offer easy credit terms to potential homebuyers beginning in the 1990s. In 1992, Congress enacted Title XIII of the Housing and Community Development Act of 1992 6 ( the GSE Act), legislation intended to give low and 6 Public Law 102-550, 106 Stat. 3672, H.R. 5334, enacted October 28, 1992. 453 moderate income 7 borrowers better access to mortgage credit through Fannie Mae and Freddie Mac. This effort, probably stimulated by a desire to increase home ownership, ultimately became a set of regulations that required Fannie and Freddie to reduce the mortgage underwriting standards they used when acquiring loans from originators. As the Senate Committee report said at the time, “The purpose of [the affordable housing] goals is to facilitate the development in both Fannie Mae and Freddie Mac of an ongoing business effort that will be fully integrated in their products, cultures and day-to-day operations to service the mortgage finance needs of low-and-moderate-income persons, racial minorities and inner-city residents.” 8 The GSE Act, and its subsequent enforcement by HUD, set in motion a series of changes in the structure of the mortgage market in the U.S. and more particularly the gradual degrading of traditional mortgage underwriting standards. Accordingly, in this dissenting statement, I will refer to the subprime and Alt-A mortgages that were acquired because of the affordable housing AH goals, as well as other subprime and Alt-A mortgages, as non-traditional mortgages, or NTMs CHRG-111shrg57319--550 Mr. Killinger," Like subprime, but which we did not execute on. Senator Levin. Well, you executed on a bunch of high-risk products. You have Option ARMs, subprime, home equity. You executed on them. " FinancialCrisisInquiry--64 But I would say I would be more complacent when I saw something had AAA than if it had a AA or a AA then had a single A. So to that extent, I also must have been deferring to a rating agency. HOLTZ-EAKIN: And to close my time, I’d like to just ask Mr. Dimon to go back to the mortgage underwriting and your observations on how many—how so many bad mortgages could be written in the United States and the decline in lending standards . DIMON: Right. So it’s really not a mystery, and it’s kind of surprising. High LTV—a long time ago you did 80 percent loan to value loans. With proper appraisals it went to 85 percent, 90, 95, 100, even higher than that. Second is in the old days you had to verify your income, show a tax return or a pay stub and make sure the income was there. And there was more and more reliance on FICO scores and people saying, “I earned this.” The third is that it went lower and lower on credit. So call it subprime, Alt-A, but basically as these things were taking place, they were more—more on credit. And you never saw losses in these new products, because home prices were going up, people were making money. And—and in addition to this, I think it’s also true there were some bad products and some bad actors and excess speculation. HOLTZ-EAKIN: Can you talk specifically about the bad products and bad actors? DIMON: Well, I think as it turned out, you know, option ARMs were not a great product. I think certain subprime, Alt-A products weren’t great products. I think there were some—there were some unscrupulous mortgage salesmen and mortgage brokers. And, you know, some people missold. And there was a lot of speculation, far too many people buying second and third homes using these things, as opposed to the place you’re going to live. CHRG-111shrg57319--103 Mr. Vanasek," And some subprime mortgage loans purchased from others, namely Ameriquest, were retained on the balance sheet. They tended to be higher quality subprime loans and they were monitored very closely. I held quarterly business reviews with every business unit reviewing their delinquencies and growth and changes in policies and so forth in an effort to maintain control of the growth. Senator Coburn. So basically, you were buying higher-quality subprime loans from competitors than what you were selling into the market? " FinancialCrisisReport--231 Washington Mutual was not the only failed thrift overseen by OTS. In 2008, OTS closed the doors of five thrifts with combined assets of $354 billion. 878 Another seven thrifts holding collective assets of $350 billion were sold or declared bankruptcy. 879 Virtually all of these thrifts conducted high risk lending, accumulated portfolios with high risk assets, and sold high risk, poor quality mortgages to other financial institutions and investors. At the Subcommittee hearing, the Treasury Inspector General testified that, after completing 17 reviews and working on another 33 reviews of a variety of failed financial institutions, he could say that OTS’ lack of enforcement action was “not unique to WaMu” and lax enforcement by the relevant federal banking regulator was “not unique to OTS.” 880 Mortgage lenders other than banks also failed. Many of these mortgage lenders had operated as private firms, rather than as depository institutions, and were not overseen by any federal or state bank regulator. Some were overseen by the SEC; others were not overseen by any federal financial regulator. Some became large companies handling billions of dollars in residential loans annually, yet operated under minimal and ineffective regulatory oversight. When residential loans began to default in late 2006, and the subprime securitization market dried up in 2007, these firms were unable to sell their loans, developed liquidity problems, and went out of business. Together, these failed mortgage lenders, like the failed thrifts, contributed to systemic risk that damaged the U.S. banking system, U.S. financial markets, and the U.S. economy as a whole. (a) Countrywide Countrywide Financial Corporation, now a division of Bank of America and known as Bank of America Home Loans, was formerly the largest independent mortgage lender in the United States and one of the most prolific issuers of subprime mortgages. 881 For a number of years, Countrywide operated as a national bank under the OCC. In March 2007, it converted to a thrift charter and operated for its last 18 months under the regulatory supervision of OTS. 882 At its height, Countrywide had approximately $200 billion in assets, 62,000 employees, and issued in excess of $400 billion in residential mortgages each year. In 2008, Countrywide originated 878 1/2009 Center for Responsible Lending report, “The Second S&L Scandal,” at 1, Hearing Exhibit 4/16-84. 879 Id. 880 April 16, 2010 Subcommittee Hearing at 18 (Testimony of Treasury IG Thorson). The Treasury IG also reviewed, for example, failed banks overseen by the OCC. 881 See, e.g., “Mortgage Lender Rankings by Residential Originations,” charts prepared by MortgageDaily.com, http://www.mortgagedaily.com/MortgageLenderRanking.asp (indicating Countrywide was one of the top three issuers of U.S. residential mortgages from 2003 to 2008); “A Mortgage Crisis Begins to Spiral, and the Casualties Mount,” New York Times (3/5/2007). 882 3/5/2007 OTS press release, “OTS Approves Countrywide Application,” http://www.ots.treas.gov/_files/777014.html. nearly 20% of all mortgages in the United States. 883 But in August 2008, after the collapse of the subprime secondary market, Countrywide could no longer sell or securitize its subprime loans and was unable to obtain replacement financing, forcing the bank into a liquidity crisis. 884 By the end of the summer of 2008, it would have declared bankruptcy, but for its sale to Bank of FinancialCrisisReport--268 The evidence shows that analysts within Moody’s and S&P were aware of the increasing risks in the mortgage market in the years leading up to the financial crisis, including higher risk mortgage products, increasingly lax lending standards, poor quality loans, unsustainable housing prices, and increasing mortgage fraud. Yet for years, neither credit rating agency heeded warnings – even their own – about the need to adjust their processes to accurately reflect the increasing credit risk. Moody’s and S&P began issuing public warnings about problems in the mortgage market as early as 2003, yet continued to issue inflated ratings for RMBS and CDO securities before abruptly reversing course in July 2007. Moody’s CEO testified before the House Committee on Oversight and Government Reform, for example, that Moody’s had been warning the market continuously since 2003, about the deterioration in lending standards and inflated housing prices. “Beginning in July 2003, we published warnings about the increased risks we saw and took action to adjust our assumptions for the portions of the residential mortgage backed securities (“RMBS”) market that we were asked to rate.” 1036 Both S&P and Moody’s published a number of articles indicating the potential for deterioration in RMBS performance. 1037 For example, in September 2005, S&P published a report entitled, “Who Will Be Left Holding the Bag?” The report contained this strong warning: “It’s a question that comes to mind whenever one price increase after another – say, for ridiculously expensive homes – leaves each succeeding buyer out on the end of a longer 1036 Prepared statement of Raymond W. McDaniel, Moody’s Chairman and Chief Executive Officer, “Credit Rating Agencies and the Financial Crisis,” before the U.S. House of Representatives Committee on Oversight and Government Reform, Cong.Hrg. 110-155 (10/22/2008), at 1 (hereinafter “10/22/2008 McDaniel prepared statement”). 1037 See, e.g., 6/24/2010 supplemental response from S&P to the Subcommittee, Hearing Exhibit 4/23-108 (4/20/2005 Subprime Lenders: Basking in the Glow of A Still-Benign Economy, but Clouds Forming on the Horizon” S&P; 9/13/2005 “Simulated Housing Market Decline Reveals Defaults Only in Lowest-Rated U.S. RMBS Transactions,” S&P; and 1/19/2006 “U.S. RMBS Market Still Robust, But Risks Are Increasing and Growth Drivers Are Softening” S&P). “Housing Market Downturn in Full Swing,” Moody’s Economy.com (10/4/2006); 1/18/2007 “Special Report: Early Defaults Rise in Mortgage Securitization,” Moody’s ; and 9/21/2007 “Special Report: Moody’s Subprime Mortgage Servicer Survey on Loan Modifications,” Moody’s. See 10/22/2008 McDaniel prepared statement at 13-14. In addition, in March 2007 Moody’s warned of the possible effect that downgrades of subprime mortgage backed securities might have on its structured finance CDOs. See 3/2007 “The Impact of Subprime Residential Mortgage-Backed Securities on Moody’s-Rated Structured Finance CDOs: A Preliminary Review,” Moody’s. and longer limb: When the limb finally breaks, who’s going to get hurt? In the red-hot U.S. housing market, that’s no longer a theoretical riddle. Investors are starting to ask which real estate vehicles carry the most risk – and if mortgage defaults surge, who will end up suffering the most.” 1038 FOMC20070131meeting--174 172,MS. BIES.," Thank you, Mr. Chairman. Like several of you, I’m going to focus on housing and what we’re seeing in the banking sector and in mortgage performance. Since the last meeting, I am feeling better about the housing market in the aggregate. It looks as though home sales are stabilizing for the fourth quarter. On the whole, home sales actually did go up a bit. The inventory of new homes for sale has now fallen for five months through December, and mortgage applications for home purchases continue to move above the levels of last summer, when they hit bottom. The National Association of Realtors is estimating that existing home sales have already bottomed out, and homebuilder sentiment improved in three of the four past months. But even if sales really have stabilized, the inventory of homes for sale still must be worked down before construction and growth resume in this market. Given that some existing homes have likely been pulled off the market in light of slower sales and moderating housing prices, this inventory correction period will probably continue into 2008. I think this is particularly true in markets such as Florida, as First Vice President Barron mentioned, where a large amount of speculative investment occurred during the boom period—with three to five years of excess construction from the investor side. So those homes still have to be worked through. Asset quality in the consumer sector as a whole is very good. We have come through one of the most benign periods. The exception, as Bill mentioned in his presentation earlier today, is the subprime market. When you dissect it, you see that prime mortgage delinquencies are flat and subprime mortgages at a fixed rate are flat. The whole problem is in subprime ARMs, which are running into difficulties. The four federal regulatory agencies are looking harder at some of these subprime products. We started reviewing 2/28 mortgages, and now we’re looking at and testing some other products. We’re finding that the issues are getting more troublesome the further we dig into these products. To put the situation in perspective, subprime ARMs are a very small part of the whole mortgage market. As Vincent mentioned, subprime is about 13 percent, and the ARM piece of the subprime is about half to two-thirds, so we’re talking perhaps around 8 percent of the aggregate mortgages outstanding. We’re seeing that the borrowers who got into these during the teaser periods now are seeing tremendous payment shocks. For example, 2/28s that are going from the fixed two-year period to the adjustment period basically had their interest rates double, so they’re going from a 5 percent handle to a 10 percent handle, and the borrowers don’t have the discretionary income to absorb that. This type of mortgage was sold to a lot of subprime borrowers on the idea that they are lending vehicles to repair credit scores. You will show that you are going to pay during the early period, and then you can refinance and get a lower long-term rate, so you’ll never pay the jump. But we’re finding that some of these mortgages have significant prepayment penalties, and so to refinance and get the better terms, some borrowers are getting into difficulty. Because of the moderation in housing prices, these borrowers haven’t built up enough equity to absorb the prepayment penalty. So the problem stems from a combination of factors. There are a lot of spins on these products, but we’re trying to take an approach based on principles in looking at what’s really happening. I also want to mention that, although the ownership of the mortgages is very diffuse and so we’re not seeing any real concentrated risk, particularly in banking, we do need to pay more attention to where the mortgage-servicing exposures are. The servicing of these mortgages that are securitized is concentrated in certain institutions. Clearly, when you have such a high level of delinquencies and potential defaults, all profitability in servicing is gone. So there could be some charge-offs in these securitized mortgages. Also, I think all of you have noticed the number of mortgage brokers that have closed up shop in the past six months because they couldn’t get enough liquidity or capital to repurchase the early defaults of these recent pools. That is really shrinking the origination pocket. I should also say that, with the exception of the subprime ARM mortgages, we feel very good about overall credit quality. When I look at the economy as a whole, I also see that except for housing construction and autos, the rest of the economy is sound. The recent growth in employment and the strong wage growth give me comfort that the income growth of consumers is there to mitigate some of the wealth effects that we may have with moderating housing prices. But I also share the concerns that some of you mentioned here, and that President Yellen spoke of in a speech, about the issue regarding productivity trends and wage growth, and determining how fast the economy is growing. Productivity is going to have to grow faster to absorb the higher wage growth, particularly as employment growth continues strong, and I think the slack in the skilled labor force is getting very, very limited. When I think, in aggregate, about the data since our last meeting, I feel a little better about inflation because it appears to be moderating, but I’m not jumping for joy because we need a few more months. However, the growth information has been, instead of mixed as at the last meeting, generally stronger, and that does make me feel better. In net, then, based on the recent information, I’m even a bit further along on the side that the risks have moved higher for inflation than on the side of the risk of a slowdown in the economy. Thank you, Mr. Chairman." FOMC20070321meeting--11 9,MS. MINEHAN.," This is a continuation of the same question because I was intrigued by your chart that shows 2006 sixty-day and over delinquencies for subprime ARMs tracking with 2001. I don’t recall the world as we know it coming to an end in the subprime market in 2001, but I also wonder how big the subprime market was and how much it might have been characterized by some of the rather difficult practices that we know went on, particularly from the middle of ’06 through the end of the year." CHRG-110hhrg41184--122 Mr. Bernanke," And we are looking forward this year, trying to estimate what is going to happen this year, and a lot of it depends on what happens to the price of oil. If oil flattens out, we will do better, but if it continues to rise at that rate in 2007, it will be hard to maintain low inflation, I agree. Mr. Moore of Kansas. Thank you, Mr. Chairman. We face significant challenges in the housing market that have led in part to serious problems in the credit markets and our larger economy. Some of these problems begin as a result of predatory lending practices, which reached epidemic proportions in recent years, and took millions of dollars from American households of the equity in their homes and undermining the economic vitality of our neighborhoods. Approximately 1.8 million subprime borrowers will be facing resetting adjustable rate mortgages over the next couple of years, unless the government or the lending industry helps them modify the terms of their loan in some other form. I don't support a government bailout for all these homeowners, particularly for wealthy investors and speculators who borrowed against the equity in their homes, betting on profits from a soaring housing market. But I do believe we need to make a strong effort to help lower-income homeowners, who were the victims of predatory lenders, refinance in order to stay in their homes. If foreclosures, Mr. Chairman, continue to rise, what impact do you believe this will have or could have on the economy in the next couple of years? " FinancialCrisisReport--198 In mid-2005, an internal FDIC memorandum discussed the increased risk associated with the new types of higher risk mortgage loans being issued in the U.S. housing market: “Despite the favorable history, we believe recent lending practices and buyer behavior have elevated the risk of residential lending. Concerns are compounded by significantly increased investor activity and new loan products that allow less creditworthy borrowers to obtain mortgages. The new loan products of most concern include Option Adjustment Rate Mortgage (ARM) Loans, Interest Only (IO) Loans, and Piggyback Home Equity Loans.” 753 WaMu offered all three types of loans, in addition to subprime loans through Long Beach. In 2007, an FDIC memorandum again identified WaMu’s high risk home loans as its “primary risk,” singling out both its subprime and Option ARM loans: “SFR [Single Family Residential loan] credit risk remains the primary risk. The bank has geographic concentrations, moderate exposure to subprime assets, and significant exposure to mortgage products with potential for payment shock. … The bank’s credit culture emphasized home price appreciation and the ability to perpetually refinance. … In the past, the bank relied on quarterly sales of delinquent residential loans to manage its non performing assets. The bank’s underwriting standards were lax as management originated loans under an originate to sell model. When the originate to sell model collapsed in July 2007 for private and subprime loans, management was no longer able to sell non performing assets. Consequently, non performing assets are now mounting, and the bank’s credit risk mitigation strategy is no longer effective.” 754 From 2004 to 2008, the FDIC assigned LIDI ratings to WaMu that indicated a higher degree of risk at the bank than portrayed by the bank’s CAMELS ratings. LIDI ratings are intended to convey the degree of risk that a bank might cause loss to the Deposit Insurance Fund, with A being the best rating and E the worst. 755 The FDIC IG explained the difference between LIDI and CAMELS ratings as follows: “LIDI ratings consider future risks at an institution, where CAMELS rating, in practice, are more point-in-time measures of performance.” 756 As 753 7/5/2005 memorandum from FDIC Associate Director John H. Corston to FDIC Associate Director Michael Zamorski, “Insured Institutions’ Exposures to a Housing Slowdown,” FDIC_WAMU_000015114, Hearing Exhibit 4/16-51b. 754 FDIC Washington Mutual Bank LIDI Report, Q307, FDIC_WAMU_000014851, Hearing Exhibit 4/16-94 [Sealed Exhibit]. 755 An A rating indicates a “low risk” of concern that an institution will cause a loss to the Deposit Insurance Fund, a B rating indicates an “ordinary level of concern,” a C rating indicates a “more than an ordinary level of concern,” a D rating conveys a “high level of concern,” and an E rating conveys “serious concerns.” See prepared statement of FDIC IG Rymer at 5 (chart showing FDIC LIDI ratings descriptions), April 16, 2010 Subcommittee Hearing, at 124 (showing FDIC LIDI ratings description). 756 Id. early as 2004, the FDIC viewed WaMu as having higher levels of risk than indicated by its CAMELS ratings. This chart shows the comparable ratings over time: fcic_final_report_full--513 Finally, there are Fannie’s own reports about its acquisitions of subprime loans. According to Fannie’s 10-K reports for 2004 (which, as restated, covered periods through 2006) and 2007, Fannie’s acquisition of subprime loans barely increased from 2004 through 2007. These are the numbers: Table 9. 111 Fannie Mae’s Acquisition of Subprime Loans, 2004-2007 2004 2005 2006 2007 FICO <620 5% 5% 6% 6% FICO 620-<660 11% 11% 11% 12% These percentages are consistent with Fannie’s effort to comply with the gradual increase in the AH goals during the years 2004 through 2007; they are not consistent with an effort to substantially increase its purchases of subprime mortgages in order to compete with firms like Countrywide that were growing their market share through securitizing subprime and other loans. Finally, Fannie’s 2005 10-K (which, as restated and filed in May 2007, also covered 2005 and 2006), contains a statement similar to that made in 2006, confirming that the GSE made no effort to compete for subprime loans (except as necessary to meet the AH goals), and that in fact it lost market share by declining to do so in 2004, 2005 and 2006: [I]n recent years, an increasing proportion of single-family mortgage loan originations has consisted of non-traditional mortgages such as interest-only mortgages, negative- amortizing mortgages and sub-prime mortgages, and demand for traditional 30-year fixed-rate mortgages has decreased. We did not participate in large amounts of these non-traditional mortgages in 2004, 2005 and 2006 because we determined that the pricing offered for these mortgages often offered insuffi cient compensation for the additional credit risk associated with these mortgages. These trends and our decision not to participate in large amounts of these non-traditional mortgages contributed to a significant loss in our share of new single-family mortgages-related securities issuances to private-label issuers during this period, with our market share decreasing from 45.0% in 2003 to 29.2% in 2004, 23.5% in 2005 and 23.7 in 2006. 112 [emphasis supplied] Accordingly, despite losing market share to Countrywide and others in 2004, 2005 and 2006, Fannie did not attempt to acquire unusual numbers of subprime loans in order to regain this share. Instead, it continued to acquire only the subprime and other NTM loans that were necessary to meet the AH goals. That the AH goals were Fannie’s sole motive for acquiring NTMs is shown by the firm’s actions after the PMBS market collapsed in 2007. At that point, Fannie’s market share began to rise as Countrywide and others could not continue to issue PMBS. Nevertheless, despite the losses on subprime loans that were beginning to show up in the markets, Fannie continued to buy NTMs until they were taken over by the government in 111 Fannie Mae, 2004 10-K. These totals do not include Fannie’s purchases of subprime PMBS. http://www.fanniemae.com/ir/pdf/sec/2004/2004_form10K.pdf;jsessionid=N3RRJCZPD5SOVJ2FQSH SFGI , p.141 and Fannie’s 2007 10-K, http://www.fanniemae.com/ir/pdf/sec/2008/form10k_022708.pdf ;jsessionid=N3RRJCZPD5SOVJ2FQSHSFGI , p.127. 112 Fannie Mae, 2005 10-K, p.37. 509 FOMC20070628meeting--76 74,MS. LIANG.," Subprime adjustable-rate loans are about 9 percent of outstandings, and subprime fixed loans are another 5 percent of outstandings. That would be 9 percent of the $10 trillion in total mortgages." CHRG-111shrg57322--120 Mr. Sparks," Well, this particular deal I think in hindsight was a second-lien subprime deal, so it did not perform well. Senator Kaufman. Would it concern you that the subprime deals, 50 percent of them are stated income loans? " FinancialCrisisReport--289 In contrast to decades of actual performance data for 30-year mortgages with fixed interest rates, the new subprime, high risk products had little to no track record to predict their rates of default. In fact, Moody’s RMBS rating model was not even used to rate subprime mortgages until December 2006; prior to that time, Moody’s used a system of “benchmarking” in which it rated a subprime mortgage pool by comparing it to other subprime pools Moody’s had already rated. 1118 Lack of Data During Era of Stagnant or Falling Home Prices. In addition, the models operated with subprime data for mortgages that had not been exposed to stagnant or falling housing prices. As one February 2007 presentation from a Deutsche Bank investment banker explained, the models used to calculate “subprime mortgage lending criteria and bond subordination levels are based largely on performance experience that was mostly accumulated since the mid-1990s, when the nation’s housing market has been booming.” 1119 A former managing director in Moody’s Structured Finance Group put it this way: “[I]t was ‘like observing 100 years of weather in Antarctica to forecast the weather in Hawaii.” 1120 In September 2007, after the crisis had begun, an S&P executive testified before Congress that: “[W]e are fully aware that, for all our reliance on our analysis of historically rooted data that sometimes went as far back as the Great Depression, some of that data has proved no longer to be as useful or reliable as it has historically been.” 1121 The absence of relevant data for use in RMBS modeling left the credit rating agencies unable to accurately predict mortgage default and loss rates when housing prices stopped climbing. The absence of relevant performance data for high risk mortgage products in an era of stagnant or declining housing prices impacted the rating of not only RMBS transactions, but also CDOs, which typically included RMBS securities and relied heavily on RMBS credit ratings. Lack of Investment. One reason that Moody’s and S&P lacked relevant loan performance data for their RMBS models was not simply that the data was difficult to obtain, but 1117 9/30/2007 email from Belinda Ghetti to David Tesher, and others, Hearing Exhibit 4/23-33. 1118 See 2008 SEC Examination Report for Moody’s Investor Services Inc., PSI-SEC (Moodys Exam Report)-14- 0001-16, at 3. 1119 2/2007 “Shorting Home Equity Mezzanine Tranches,” Deutsche Bank Securities Inc., DBSI_PSI_EMAIL01988773-845, at 776. See also 6/4/2007 FDIC memorandum from Daniel Nuxoll to Stephen Funaro, “ALLL Modeling at Washington Mutual,” FDIC_WAMU_000003743-52, at 47 (“Virtually none of the data is drawn from an episode of severe house price depreciation. Even introductory statistics textbooks caution against drawing conclusions about possibilities that are outside the data. A model based on data from a relatively benign period in the housing market cannot produce reliable inferences about the effects of a housing price collapse.”). 1120 “Triple-A Failure,” New York Times (4/27/2008). 1121 Prepared statement of Vickie Tillman, S&P Executive Vice President, “The Role of Credit Rating Agencies in the Structured Finance Market,” before U.S. House of Representatives Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises, Cong.Hrg. 110-62 (9/27/2007), S&P SEN-PSI 0001945-71, at 46-47. that both companies were reluctant to devote the resources needed to improve their modeling, despite soaring revenues. FinancialCrisisReport--476 As established earlier in the Report, all of Goldman’s securitization activities from 2006 to 2007 took place against the backdrop of a subprime mortgage market that, in Goldman’s view, was in distress and worsening. On December 7, 2006, for example, Mr. Sparks sent this gloomy assessment to senior executive Thomas Montag: “Generally, originators are struggling with EPDs [early payment defaults] which require them to buy back loans and take losses – thinly capitalized firms can’t take much of it. Lower margins and volumes are also causing pain. Ownit [a mortgage originator] ... closed Monday. Premiums for these originators – all of whom are for sale – are rapidly falling. ... Likely fall-out – more originators close and spreads in related sectors widen.” 2009 A week later, on December 13, 2006, Mr. Sparks repeated his negative view of the subprime mortgage market before senior Goldman executives on the Firmwide Risk Committee. The committee minutes described his report as follows: “Dan Sparks: Noted the stress in the subprime market; Concern around ‘06 originators, as two more failed last week; Concern around early payment defaults, $5BN in loans to subprime borrowers, warehouse lines to 6 subprime lenders, and $16MM in ‘06 residual positions and alt-a and subprime residual positions from ‘04-‘05; Street aggressively putting back early payment defaults to originators thereby affecting the originator’s business. Rumors around more failures are in the market.” 2010 On December 14, 2006, CFO David Viniar held a meeting with senior Mortgage Department executives, reviewed their mortgage related holdings, and directed them to offset the risk posed by declining values. 2011 The Mortgage Department then initiated its first multi-billion- dollar net short positions in 2007, essentially betting that subprime mortgage related assets would fall in value. In early 2007, Mr. Sparks made increasingly dire predictions about the decline in the subprime mortgage market and issued emphatic instructions to his staff about the need to get rid of subprime loans and other assets. On February 8, 2007, for example, Mr. Sparks wrote: 2009 2010 2011 See 12/7/2006 email from Daniel Sparks to Tom Montag, “Subprime Volatility,” GS MBS-E-010931233. 12/13/2006 Firmwide Risk Committee December 13 Minutes, GS MBS-E-009582963-64. For more information about this December 14 meeting, see discussion in Section C(4)(b), above. “Subprime environment – bad and getting worse. Everyday is a major fight for some aspect of the business (think whack-a-mole). . . . [P]ain is broad (including investors in certain GS- issued deals).” 2012 FinancialCrisisReport--226 In October 2008, after Washington Mutual failed, the OTS Examiner-in-Charge at the bank, Benjamin Franklin, deplored OTS’ failure to prevent its thrifts from engaging in high risk lending because “the losses were slow in coming”: “You know, I think that once we (pretty much all the regulators) acquiesced that stated income lending was a reasonable thing, and then compounded that with the sheer insanity of stated income, subprime, 100% CLTV [Combined Loan-to-Value], lending, we were on the figurative bridge to nowhere. Even those of us that were early opponents let ourselves be swayed somewhat by those that accused us of being ‘chicken little’ because the losses were slow in coming, and let[’]s not forget the mantra that ‘our shops have to make these loans in order to be competitive’. I will never be talked out of something I know to be fundamentally wrong ever again!!” 860 Failure to Consider Financial System Impacts. A related failing was that OTS took a narrow view of its regulatory responsibilities, evaluating each thrift as an individual institution without evaluating the effect of thrift practices on the financial system as a whole. The U.S. Government Accountability Office, in a 2009 evaluation of how OTS and other federal financial regulators oversaw risk management practices, concluded that none of the regulators took a systemic view of factors that could harm the financial system: “Even when regulators perform horizontal examinations across institutions in areas such as stress testing, credit risk practices, and the risks of structured mortgage products, they do not consistently use the results to identify potential system risks.” 861 Evidence of this narrow regulatory focus includes the fact that OTS examiners carefully evaluated risk factors affecting home loans that WaMu kept on its books in a portfolio of loans held for investment, but paid less attention to the bank’s portfolio of loans held for sale. OTS apparently reasoned that the loans held for sale would soon be off WaMu’s books so that little analysis was necessary. From 2000 to 2007, WaMu securitized about $77 billion in subprime 860 10/7/2008 email from OTS Examiner-in-Charge Benjamin Franklin to OTS Examiner Thomas Constantine, Franklin_Benjamin-00034415, Hearing Exhibit 4/16-14. 861 3/18/2009 Government Accountability Office, “Review of Regulators’ Oversight of Risk Management Systems at a Limited Number of Large, Complex Financial Institutions,” Testimony of Orice M. Williams, Hearing Exhibit 4/16-83 (GAO reviewed risk management practices of OTS, as well as the Federal Reserve, the Office of the Comptroller of the Currency, the SEC, and self-regulatory organizations.). loans, mostly from Long Beach, as well as about $115 billion in Option ARM loans. 862 Internal documents indicate that OTS did not consider the problems that could result from widespread defaults of poorly underwritten mortgage securities from WaMu and other thrifts. CHRG-111shrg52619--78 Mr. Smith," On behalf of the States, I will say that with regard to the mortgage issue, for example, the State response to the mortgage issue may have been imperfect, and it may not have been complete. In North Carolina, we started addressing predatory lending in 1999. I would say that I think that the actions of State AGs and State regulators should have been and ought to be in the future, market information in assessing systemic risk ought to be taken into account. And I think this has not been done in the past. Again, I do not claim that we are perfect. I do claim that we are closer to the market as a rule than our colleagues in the Federal Government. And I think we have something to add if we are allowed to add it. So I hope as we go forward, sir, the State role in consumer protection will be acknowledged and it will be given a chance to do more. Senator Merkley. OK. Well, let me just close with this comment since my time is up. The comment that this issue has had robust attention--I believe, Mr. Polakoff, you made that--WAMU was a thrift. Countrywide was a thrift. On the ground, it does not look like anything close to robust regulation of consumer issues. I will say I really want to applaud the Fed for the actions they took over subprime lending, their action regarding escrow for taxes and insurance, their addressing of abusive prepayment penalties, the ending of liar loans in subprime. But I also want to say that from the perspective of many folks on the ground, one of the key elements was booted down the road, and that was the yield spread premiums. Just to capture this, when Americans go to a real estate agent, they have all kinds of protection about conflict of interest. But when they go to a broker, it is a lamb to the slaughter. That broker is being paid, unbeknownst to the customer is being paid proportionally to how bad a loan that consumer gets. And that conflict of interest, that failure to address it, the fact that essentially kickbacks are involved, results in a large number of our citizens, on the most important financial transaction of their life, ending up with a subprime loan rather than a prime loan. That is an outrage. And I really want to encourage you, sir, in your new capacity to carry this conversation. The Fed has powers that it has not fully utilized. I do applaud the steps it has taken. And I just want to leave with this comment: that the foundation of so many families financially is their homes, and that we need to provide superb protections designed to strengthen our families, not deregulation or loose regulations designed for short-term profits. Thank you. Senator Reed. Senator Johanns. Senator Johanns. Thank you very much. I am not even exactly certain who I direct this to, so I am hoping that you all have just enough courage to jump in and offer some thoughts about what I want to talk about today. As I was sitting here and listening to the great questioning from my colleague, the response to one of the questions was that we do make a risk assessment when there is a merger. We make an assessment as to the risk that is being taken on by this merger. And I sit here, I have to tell you, and I think to myself, well, if it is working that well, how did we end up where we are at today? So that leads me to these questions. The first one is, who has the authority, or does the authority exist for somebody to say that the sheer size of what we end up with poses a risk to our overall national, if not international economy, because you have got so many eggs in one basket that if your judgment is wrong about the risk assessment, you are not only wrong a little bit, you are wrong in a very magnificent sort of way. So who has that authority? Does that authority exist, and if it doesn't, should it exist? " FinancialCrisisReport--487 Reduced RMBS Business. By the end of 2007, Goldman had substantially reduced its RMBS securitization business. In November 2007, in response to a request, Goldman provided specific data to the SEC about the decrease in its inventory of subprime mortgage loans and RMBS securities. Goldman informed the SEC that the value of its subprime loan inventory had dropped from $7.8 billion on November 24, 2006, to $462 million on August 31, 2007. Over the same time period, the value of its inventory of subprime RMBS securities had dropped from $7.2 billion to 2064 4/11/2007 email to Jon Egol, “GSAMP 2006-S3 – Computational Materials for W achovia (external),” GS MBS- E-003322028 [emphasis in original]. $2.4 billion, a two-thirds reduction. 2065 The graph below, which was prepared by the Subcommittee using the data provided by Goldman to the SEC, illustrates the rapid decline in Goldman’s subprime holdings. 2066 [SEE CHART NEXT PAGE: Goldman Sachs Long Cash Subprime Mortgage Exposure , prepared by the Permanent Subcommittee on Investigations, Hearing Exhibit 163.] 2065 11/7/2007 letter from Sarah Smith, Controller and Chief Accounting Officer to SEC, at 5, GS MBS-E- 015713460, Hearing Exhibit 4/27-50. Goldman issued its final RM BS securitization for the year in August 2007. 2066 4/2010 “Goldman Sachs Long Cash Subprime Mortgage Exposure, Investments in Subprime Mortgage Loans, and Investments in Subprime Mortgage Backed Securities November 24, 2006 vs. August 31, 2007 in $ Billions, ” chart prepared by the Subcommittee, Hearing Exhibit 4/27-163. 14 12 10 8 6 4 2 0 15 7.8 7.2 CHRG-111shrg57319--11 Mr. Cathcart," No, sir. Senator Levin. Thank you. Now, since Long Beach was exclusively a subprime lender, its loans were all high risk in a sense. I gather that subprime loans are high risk for a number of reasons. Is that correct? " FOMC20070321meeting--5 3,MR. FISHER.," Bill, you talked about subprime mortgages in some detail but not about alt-A mortgages in great detail. My understanding is, and I just want to check to see whether I’m correct, that 20 percent of the 2006 purchase-dollar originations were alt-A, roughly the same percentage as subprime. It’s my further understanding that 81 percent of the alt-A originations were no- documentation or low-documentation loans. How much confidence do you have—and I can tell by your reaction that there’s a question—that alt-A mortgages are not as perilous as subprimes? If you don’t have confidence or if they are perilous, what consequences might ensue?" FinancialCrisisReport--192 Beach] really outdid themselves with finishes as one of the top 4 worst performers from 1999 through 2003. For specific ARM deals, [Long Beach] made the top 10 worst deal list from 2000 thru 2002. … Although underwriting changes were made from 2002 thru 2004, the older issues are still dragging down overall performance. … At 2/05, [Long Beach] was #1 with a 12% delinquency rate. Industry was around 8.25%.” 720 Six months later, after conducting a field visit, an OTS examiner wrote: “Older securitizations of [Long Beach] continue to have some issues due to previously known underwriting issues in some vintages. The deterioration in these older securitizations is not unexpected.” 721 Purchase of Long Beach. In 2005, Washington Mutual Bank proposed purchasing Long Beach from its holding company so that Long Beach would become a wholly owned subsidiary of the bank. In making the case for the purchase, which required OTS approval, WaMu contended that making Long Beach a subsidiary would give the bank greater control over Long Beach’s operations and allow it to strengthen Long Beach’s lending practices and risk management, as well as reduce funding costs and administrative expenses. In addition, WaMu proposed that it could replace its current “Specialty Mortgage Finance” program, which involved purchasing subprime loans for its portfolio primarily from Ameriquest, with a similar loan portfolio provided by Long Beach. 722 In June 2005, an OTS examiner expressed concerns about the purchase in an internal memorandum to OTS regional management and recommended that the purchase be conditioned on operational improvements: “At the start of this examination, it was our intent to perform a review of the operation of [Long Beach] with the expectation that [Washington Mutual Inc.] or the bank would be requesting approval to move [Long Beach] as an operating subsidiary of the bank. Such a move would obviously place the heightened risks of a subprime lending operation directly within the regulated institution structure. Because of the high profile nature of the business of [Long Beach] and its problematic history, we believe that any and all concerns regarding the subprime operation need to be fully addressed prior to any move.” 723 720 4/14/2005 OTS internal email, OTSWME05-012 0000806, Hearing Exhibit 4/16-19. 721 10/3/2005 OTS Holding Company Field Visit Report of Examination, at OTSWMS06-010 00002532, Hearing Exhibit 4/16-94 [Sealed Exhibit]. 722 See 12/21/2005 OTS internal memorandum by OTS examiners to OTS Deputy Regional Director, at OTSWMS06-007 0001011, Hearing Exhibit 4/16-31. 723 6/3/2005 OTS memorandum from Rich Kuczek to Darrel Dochow, “Long Beach Mortgage Corporation (LBMC) Review,” OTSWMS06-007 0002683, Hearing Exhibit 4/16-28. FinancialCrisisInquiry--506 WALLISON: Thanks very much, Mr. Chairman. Mr. Mayo, as an analyst at banks, how many subprime mortgages did you think were outstanding in our economy, and many of them held by banks, in 2008? What percentage of the total number of mortgages were subprime or Alt A? In other words, non-prime in some way? CHRG-111hhrg51585--128 Mr. Royce," Now, you saw the investments, the $6 billion in subprime exposure by Lehman; you saw the fact that they owned a subprime mortgage originator, B&C Mortgage. Is there a reason specifically why Orange County was not, after its experience in 1994, not investing in Lehman or not utilizing Lehman in 2008? " FinancialCrisisReport--312 In 2007, Fitch Ratings decided to conduct a review of some mortgage loan files to evaluate the impact of poor lending standards on loan quality. On November 28, 2007, Fitch issued a report entitled, “The Impact of Poor Underwriting Practices and Fraud in Subprime RMBS Performance.” After reviewing a “sample of 45 subprime loans, targeting high CLTV [combined loan to value] [and] stated documentation loans, including many with early missed payments,” Fitch reported that it decided to summarize information about the impact of fraud, as well as lax lending standards, on the mortgages. Fitch explained: “[t]he result of the analysis was disconcerting at best, as there was the appearance of fraud or misrepresentation in almost every file.” 1214 To address concerns about fraud and lax underwriting standards generally, S&P considered a potential policy change in November 2007 that would give an evaluation of the quality of services provided by third parties more influence in the ratings process. An S&P managing director wrote: “We believe our analytical process and rating opinions will be enhanced by an increased focus on the role third parties can play in influencing loan default and loss performance. … [W]e’d like to set up meetings where specific mortgage originators, investment banks and mortgage servicers are discussed. We would like to use these meetings to share ideas with a goal of determining whether loss estimates should be altered based upon your collective input.” 1215 An S&P employee who received this announcement wrote to a colleague: “Should have been doing this all along.” 1216 S&P later decided that its analysts would also review specific loan originators that supplied loans for the pool. Loans issued by originators with a reputation for issuing poor quality loans, including loans marked by fraud, would be considered a greater credit risk and ratings for the pool containing the loans would reflect that risk. S&P finalized that policy in November 2008. 1217 As part of its ratings analysis, S&P now ranks mortgage originators based on the past historical performance of their loans and factors the assessment of the originator into credit enhancement levels for RMBS. 1218 1213 “Moody’s: They Lied to Us,” New York Times (1/25/2008), http://norris.blogs.nytimes.com/2008/01/25/moodys-they-lied-to-us/. 1214 11/28/2007 “The Impact of Poor Underwriting Practices and Fraud in Subprime RMBS Performance,” report prepared by Fitch Ratings, at 4, Hearing Exhibit 4/23-100. 1215 11/15/2007 email from Thomas Warrack to Michael Gutierrez, and others, Hearing Exhibit 4/23-34. 1216 11/15/2007 email from Robert Mackey to Michael Gutierrez, and others, Hearing Exhibit 4/23-34. 1217 6/24/2010 supplemental letter from S&P to the Subcommittee, Exhibit W, Hearing Exhibit 4/23-108 (11/25/2008 “Standard & Poor’s Enhanced Mortgage Originator and Underwriting Review Criteria for U.S. RMBS,” S&P’s RatingsDirect). 1218 Id. CHRG-110shrg50415--29 Mr. Stein," Good afternoon. Chairman Dodd and Members of the Committee, thank you for the opportunity to testify. In the middle part of this decade, Wall Street demand led to literally trillions of dollars of subprime and Alt-A loans to be originated. What was interesting about it was that Wall Street paid more the more dangerous the loan was. For example, in 2004, Countrywide, if they gave a borrower a fixed-rate conventional mortgage, they received 1 percent. If they put that exact same borrower in a subprime loan, they received 3.5 percent. It is not a surprise that they paid their originators more if they put that borrower in the more expensive loan, the one that statistically has been shown more likely to cause a foreclosure. Wall Street then bundled these mortgages into mortgage-backed securities, and credit rating agencies, paid by the issuers only when they are issued, found many too many of them to be AAA quality. And then they were sold around the world. In 2006, the top five investment banks earned $1.7 billion in revenues structuring and packaging these subprime mortgage-backed securities. These are the loans that helped cause the housing bubble, and what they have in common, the subprime and the Alt-A loans, are that they start at what seems like an affordable level, but built into the structure of the loan is unsustainability. They start cheaper, but then they get more expensive. There is no free lunch in a mortgage. And that is what they have in common, and that helped build the housing bubble because people were put in a larger loan than they could actually afford, and on the flip side, once the bubble burst, it caused the massive foreclosures that we have now because when the housing bubble was going up, that unsustainability was masked. Once people could not afford the mortgage, they could refinance or they could sell. When the bubble comes back down, they no longer have those options, and that is why we have the foreclosure crisis that we have today. This leaves the question: This is what Wall Street was doing. Where were the regulators? I will not repeat what has been said. I will just identify a couple, and my testimony goes into more regulatory failings. The first is the Federal Reserve. Back in 2000, my boss testified, and Chairman Leach, I remember him saying that the Federal Reserve is AWOL because they received the authority to prevent abusive lending in 1994 and had not used it. The second one that I would like to mention is the Office of Thrift Supervision. They allowed Washington Mutual and IndyMac to push abusive mortgages until they failed and did not even put them on the watchlist until right before they failed, so the FDIC could not clean them up sooner. It is clear now that a lack of common-sense rules, like how about only making a loan if the borrower can afford it, actually impeded the flow of credit beyond anybody's wildest dreams. Many of us who were trying to get the regulators to crack down on predatory lending abuses were fighting a defensive action in Congress, saying don't preempt the State laws that are there, since the proposed bills would have made the situation worse. And the regulators would always say, ``We cannot stop the free flow of credit,'' and we can see the results today. Since the problem is rooted in excessive foreclosures, the solutions must start there. I would like to identify five very briefly. The first is that Congress should lift the ban on judicial loan modifications, which would allow hundreds of thousands of families to have their loans restructured and stay in their homes at no cost to taxpayers. We are spending $700 billion when we can do something that is free. In Chapter 13 bankruptcy, the only secure debt that cannot be modified is the home on the principal residence, whereas loans on a yacht or investment property can be modified now. I would like to illustrate that point for a second. If you consider Candace Weaver, who is a school teacher from Wilmington, North Carolina, in 2005 her husband had a heart attack, and she refinanced her mortgage with a lender called BMC. She received what seemed like a reasonable rate, a little bit high, 8.9 percent. Two years later, it turns out--she was not told this--it was an exploding 2-28 subprime mortgage. The rate goes up to 11.9 percent, which she just could not afford. She was diagnosed with kidney cancer and had surgery scheduled. She called the servicer and said, ``I cannot make my July payment. This payment is too high. I can barely make it. But I cannot make the July payment because of surgery.'' The servicer said, ``I am sorry. I cannot even talk to you until you are delinquent.'' She had the surgery, became delinquent because she could not keep it up, called again, and they said, ``We cannot talk to you until you are in foreclosure.'' Then she can't keep up, she actually goes into foreclosure, calls again, and they say, ``OK, we will give you a repayment plan. Make your current payments of 11.9 percent, and on top of that catch up the past payments that you did not make,'' which she could not do. The bankruptcy judge cannot help her even though she could afford a market rate mortgage. Consider, on the other hand, Lehman Brothers. They were among the biggest purchasers and securitizers of subprime loans, earning hundreds of millions of dollars. They were a huge investor in these mortgages at 30:1 leverage, which caused their failure, and hurt everybody. Finally, they owned a mortgage lender named BMC, the exact same lender that is potentially costing Ms. Weaver her home--hopefully not because she has representation now. The Wall Street Journal investigated BMC Mortgage and found widespread falsification of tax forms, cutting and pasting documents, forging signatures, ignoring underwriter warnings. Lehman Brothers last month, as everybody knows, went to bankruptcy court. They can have their debts restructured, but Ms. Weaver cannot. The second thing I would focus on is for Treasury under the TARP program to maximize loan modifications, as some of the Senators have mentioned. Whenever Treasury buys equity in a bank, buys securities from a bank, buys a whole loan or controls a whole loan, they should do the streamlined modification program that Sheila Bair is doing at FDIC. What she does is target an affordable payment, first by reducing the interest rate, then by extending the term, then by reducing principal if you need to. And they should focus on a 34-percent debt-to-income ratio, which is the target in the Attorney General settlement with Bank of America over Countrywide. The other thing that they should do, which I think you had something to do with, Senator Dodd, is to guarantee modified mortgages, which would be cost-effective, but you need to make sure that the mortgage is modified well. But that could be a powerful tool. The third thing I would suggest is go ahead and merge OTS into OCC. They have not proven up to the challenge. Fourth, the Federal Reserve should extend their HOEPA rules to cover yield-spread premiums, broker upselling, and, second, extend the subprime protections to nontraditional mortgages. Those are problematic now, too. And, finally, Congress should pass the Homeownership Preservation and Protection Act--two things to mention there--that Senator Dodd sponsored and many Members of the Committee co-sponsored. This would stop abuses. First, no preemption. If there is preemption, there should not be a bill because the States are doing all they can. And, second, if anything is clear by now, it is that Wall Street will pay best money for mortgages and loans that help their short-term profits and that originators will supply those if they are paid well for it. But that is not necessarily the same thing as a long-term sustainable mortgage for the homebuyer. Purchasers need a continuing financial incentive to ensure good lending through the imposition of strong assignee liability. Thank you very much. " FinancialCrisisReport--180 We are concerned further that the current market environment is masking potentially higher credit risk.” 658 Two months later, in May 2006, an OTS examiner wrote: “During the prior examination, we noted numerous instances of underwriters exceeding underwriting guidelines, errors in income calculations, errors in debt-to-income (DTI) calculations, lack of sufficient mitigating factors for credit-quality related issues, and insufficient title insurance coverage on negative amortization loans. … [U]nderwriting errors [] continue to require management’s attention.” 659 While OTS was documenting its concerns, however, it is apparent in hindsight that the agency tempered its criticism. The OTS examiner who authored the memo found that in his review, none of the negatively amortizing loans he analyzed for safety and soundness carried an “exception,” meaning it “probably should not have been made.” 660 Many of the loans made in this time period would later default. Another OTS Findings Memorandum the same month concluded: “Overall, we concluded that the number and severity of underwriting errors noted remain at higher than acceptable levels.” 661 The 2006 OTS ROE for the year concluded: “[S]ubprime underwriting practices remain less than satisfactory. … [T]he number and severity of underwriting exceptions and errors remain at higher than acceptable levels. … The findings of this judgmental sample are of particular concern since loans with risk layering … should reflect more, rather than less, stringent underwriting.” 662 2007 Lending Deficiencies. In 2007, the problems with WaMu’s lending standards were no better, and the acceleration of high risk loan delinquencies and defaults threatened serious consequences. By July 2007, the major credit rating agencies had begun mass ratings downgrades of hundreds of mortgage backed securities, the subprime secondary market froze, and WaMu was left holding billions of dollars worth of suddenly unmarketable subprime and other high risk loans. In September, the OTS ROE for the year concluded: “Underwriting policies, procedures, and practices were in need of improvement, particularly with respect to stated income lending. Based on our current findings, and the 658 3/14/2006 OTS Report of Examination, at 19, OTSWMEF-0000047030, Hearing Exhibit 4/16-94 [Sealed Exhibit]. 659 5/23/2006 OTS Findings Memorandum, “Home Loan Underwriting,” OTSWMS06-008 0001299, Hearing Exhibit 4/16-33. 660 Id. 661 5/25/2006 OTS Findings Memorandum, “Loan Underwriting Review - Long Beach Mortgage,” OTSWMS06- 008 0001243, Hearing Exhibit 4/16-35. 662 8/26/2006 OTS Report of Examination, at OTSWMS06-008 0001680, Hearing Exhibit 4/16-94 [Sealed Exhibit]. fact that a number of similar concerns were raised at prior examinations, we concluded that too much emphasis was placed on loan production, often at the expense of loan quality.” 663 FinancialCrisisReport--179 OTS officials attended a Board meeting to address this and other concerns. Yet a few months later, in June, an OTS examiner wrote: “We continue to have concerns regarding the number of underwriting exceptions and with issues that evidence lack of compliance with Bank policy.” 655 The examination findings memorandum also noted that, while WaMu tried to make changes, those changes produced “only limited success” and loan underwriting remained “less than satisfactory.” 656 In August 2005, the OTS ROE for the year indicated that the lending standards problem had not been resolved: “[W]e remain concerned with the number of underwriting exceptions and with issues that evidence lack of compliance with bank policy …. [T]he level of deficiencies, if left unchecked, could erode the credit quality of the portfolio. Our concerns are increased with the risk profile of the portfolio is considered, including concentrations in Option ARM loans to higher-risk borrowers, in low and limited documentation loans, and loans with subprime or higher-risk characteristics. We are concerned further that the current market environment is masking potentially higher credit risk.” 657 2006 Lending Deficiencies. The same problems continued into 2006. In March 2006, OTS issued the same strong warning about WaMu’s loan portfolio that it had provided in August 2005: “We believe the level of delinquencies, if left unchecked, could erode the credit quality of the portfolio. Our concerns are increased when the risk profile of the portfolio is considered, including concentrations in Option ARMS to higher-risk borrowers, in low and limited documentation loans, and loans with subprime or higher-risk characteristics. 653 10/18/2004 OTS Field Visit Report of Examination, at OTSWMEF-0000047576-78, Hearing Exhibit 4/16-94 [Sealed Exhibit]. 654 2/7/2005 OTS Letter to Washington Mutual Board of Directors on Matters Requiring Board Attention, OTSWMEF-0000047591 [Sealed Exhibit]. 655 6/3/2005 OTS Findings Memorandum, “Single Family Residential Home Loan Review,” OTSWME05-004 0000392, Hearing Exhibit 4/16-26. 656 Id. at OTSWME05-004 0000392. 657 8/29/2005 OTS Report of Examination, at OTSWMS05-004 0001794, Hearing Exhibit 4/16-94 [Sealed Exhibit]. CHRG-110hhrg44901--72 Mr. Bernanke," Well, as we look back on it, we see that there were just some serious failures in the management of risks. There were many firms that had exposure to the housing market in a variety of ways across the firm, including holding mortgages and other ways. And they didn't fully appreciate that in the contingency that the housing boom would turn around, that house prices would begin to drop; they didn't fully appreciate their exposure to that situation. The regulators bear some responsibility on that. It is our job to make sure that they measure and manage their risks appropriately. We have been working on that for a number of years related to bank supervision initiatives like the Basel Initiative, for example, and so on. But it is clear that we need to redouble our efforts to make sure that the risk management is sound, that the underwriting is sound, and that we don't get ourselves into this kind of situation again. Ms. Pryce. Well, you mentioned Basel. Are there further risks ahead to our system and therefore the overall economy that might arise, and the new capital adequacy standards in Basel? You know, if we are trying to have this happen simultaneously, could that create new risk to the system? Effects of a crisis in any overseas market, could that affect our system in a negative way? Further decline in the dollar. There is a list of many things that could potentially happen. One of the things I would like your comment on is the commercial real estate market. You know, many banks astutely avoided the subprime lending, and they instead expanded their commercial real estate lending. So everywhere we turn we see increased vacancy signs and downward pressure on rents. And do we expect another wave of pressure from that market? And are we planning ahead as a country to address these things as opposed to, you know, being reactionary as it seems that we have had to be of late? " fcic_final_report_full--521 In 2008, after its takeover by the government, Fannie Mae finally published a credit supplement to its 2008 10-K, which contained an accounting of its subprime and Alt-A credit exposure. The table is reproduced below in order to provide a picture of the kinds of loans Fannie acquired in order to meet the AH goals. Loans may appear in more than one category, so the table does not reveal Fannie’s total net exposure to each category, nor does it include Fannie’s holdings of non-Fannie MBS or PMBS, for which it did not have loan level data. Note the reference to $8.4 billion in the column for subprime loans. As noted earlier, Fannie classified as subprime only those loans that it purchased from subprime lenders. However, Fannie included loans with FICO scores of less than 660 in the table, indicating that they are not prime loans but without classifying them formally as subprime. In a later credit supplement, filed in August 2009, Fannie eliminated the duplications among the loans in Table 12, and reported that as of June 30, 2009, it held the credit risk on NTMs with a total unpaid principal amount of $2.7 trillion. The average loan amount was $151,000, for a total of 5.73 million NTM loans. 135 This number does not include Fannie’s holdings of subprime PMBS as to which it does not have loan level data. 135 http://www.fanniemae.com/ir/pdf/sec/2009/q2credit_summary.pdf , p.5. 517 CHRG-111shrg57319--243 Mr. Schneider," It was shut down--when Long Beach was shut down, we stopped originating subprime mortgages through brokers, which was the business that Long Beach did. I think that was third quarter of 2007. Senator Levin. OK. Now, the vast majority of Long Beach mortgages, your data shows about 95 percent were sold or securitized. Exhibit 1c,\1\ if you will look at it, is based on WaMu data. The Long Beach Mortgage annual securitizations increased more than tenfold, from $2.5 billion in the year 2000 to more than $29 billion in the year 2006. From 2000 to 2007, Long Beach and WaMu together securitized $77 billion in subprime mortgages, producing mortgage-backed securities. Now, those are the securitization numbers. This is WaMu's own summary of its subprime securitizations as of June 2008.--------------------------------------------------------------------------- \1\ See Exhibit No. 1c, which appears in the Appendix on page 214.--------------------------------------------------------------------------- So Long Beach and WaMu's subprime securitizations doubled from 2005 to 2006, going from $14 to $29 billion. Long Beach at the same time was cutting back on loan originations during 2006, which means that WaMu was purchasing subprime loans from other lenders and mortgage brokers through its conduit and other channels. Is that right so far? Are you with me so far? " fcic_final_report_full--83 In a few cases, such as CitiFinancial, subprime lending firms were part of a bank holding company, but most—including Household, Beneficial Finance, The Money Store, and Champion Mortgage—were independent consumer finance companies. Without access to deposits, they generally funded themselves with short-term lines of credit, or “warehouse lines,” from commercial or investment banks. In many cases, the finance companies did not keep the mortgages. Some sold the loans to the same banks extending the warehouse lines. The banks would securitize and sell the loans to investors or keep them on their balance sheets. In other cases, the finance company itself packaged and sold the loans—often partnering with the banks ex- tending the warehouse lines. Meanwhile, the S&Ls that originated subprime loans generally financed their own mortgage operations and kept the loans on their bal- ance sheets. MORTGAGE SECURITIZATION: “THIS STUFF IS SO COMPLICATED HOW IS ANYBODY GOING TO KNOW? ” Debt outstanding in U.S. credit markets tripled during the s, reaching . tril- lion in ;  was securitized mortgages and GSE debt. Later, mortgage securities made up  of the debt markets, overtaking government Treasuries as the single largest component—a position they maintained through the financial crisis.  In the s mortgage companies, banks, and Wall Street securities firms began securitizing mortgages (see figure .). And more of them were subprime. Salomon Brothers, Merrill Lynch, and other Wall Street firms started packaging and selling “non-agency” mortgages—that is, loans that did not conform to Fannie’s and Fred- die’s standards. Selling these required investors to adjust expectations. With securiti- zations handled by Fannie and Freddie, the question was not “will you get the money back” but “when,” former Salomon Brothers trader and CEO of PentAlpha Jim Calla- han told the FCIC.  With these new non-agency securities, investors had to worry about getting paid back, and that created an opportunity for S&P and Moody’s. As Lewis Ranieri, a pioneer in the market, told the Commission, when he presented the concept of non-agency securitization to policy makers, they asked, “‘This stuff is so complicated how is anybody going to know? How are the buyers going to buy? ’” Ranieri said, “One of the solutions was, it had to have a rating. And that put the rat- ing services in the business.”  Non-agency securitizations were only a few years old when they received a pow- erful stimulus from an unlikely source: the federal government. The savings and loan crisis had left Uncle Sam with  billion in loans and real estate from failed thrifts and banks. Congress established the Resolution Trust Corporation (RTC) in  to offload mortgages and real estate, and sometimes the failed thrifts them- selves, now owned by the government. While the RTC was able to sell . billion of these mortgages to Fannie and Freddie, most did not meet the GSEs’ standards. Some were what might be called subprime today, but others had outright documen- tation errors or servicing problems, not unlike the low-documentation loans that later became popular.  FinancialCrisisInquiry--602 GORDON: January 13, 2010 Good afternoon Chairman Angelides, Vice Chairman Thomas, and members of the commission. Thank you so much for the invitation to participate in this hearing. I’m Julia Gordon, Senior Policy Counsel at the Center for Responsible Lending, a non-profit, non- partisan research and policy organization. We’re an affiliate of the Community—of the Center for Community Self Help—a community development financial institution that makes mortgage loans in lower income communities. At the end of 2006 our organization published a study projecting that one out of five subprime mortgages would fail. At the time we were called “wildly pessimistic.” Given the resulting devastation, we sincerely wish our projections had been wrong. Instead, we were far too optimistic. In this morning’s panel, several of the CEOs talked about some sleepless nights last September right before the government came in to bail out the banks. Right now there’s 6.5 million people having a sleepless night, night after night, because they fear that their family won’t have a roof over their head tomorrow. These families are either late with their payments, or many are already in the foreclosure process. More than two million foreclosures have occurred in the past two years alone, and the problem has spread far beyond the subprime market. By 2014 we expect that up to 13 million foreclosures may have taken place. Beyond the losses to the foreclosed owners themselves, the spill over cost of this crisis are massive. Millions of families who pay their mortgage very month are suffering hundreds of billions of dollars in lost wealth, just because they live close to homes in foreclosure. Those who don’t own homes suffer too. One study found that 40 percent of those who have lost their home due to this crisis are renters who’s landlords were foreclosed on. And of course foreclosures hurt all of us through lost tax revenue, and increased costs for fire, police, and other municipal services. I can summarize my testimony this way. Today’s foreclosure crisis was foreseeable and avoidable. And the loan products offered absolutely no benefit whatsoever to America’s January 13, 2010 consumers over standard loan products. Subprime lending didn’t even increase home ownership. Through 2006 first time home buyers accounted for only 10 percent of all subprime loans. And now in the aftermath of the melt down, there’s been a net loss of home ownership that set us back a decade. The only reason for these products to have been mass marketed to consumers was for Wall Street, lenders, and brokers to make a huge profit by selling, flipping, and securitizing large numbers of unsustainable mortgages. And the bank regulators who, as many have talked about today, had ample warning about the dangers posed by these loans, either were asleep at the switch or actively encouraging this high-profit, high-risk lending. The impact of foreclosures has been particularly hard on African American and Latino communities. This crisis has widened the already sizable wealth gap between whites and minorities in this country and has wiped out the asset base of entire neighborhoods. The foreclosure crisis was not caused by greedy or risky borrowers. The average subprime loan amount nationally was just over $200,000 and is much lower if you exclude the highest priced markets such as California. A majority of subprime borrowers had credit scores that would qualify them for prime loans with much better terms, and researchers have found that abusive loan terms such as exploding rates and prepayment penalties created an elevated risk of foreclosure even after controlling for differences in borrowers’ credit scores. It’s also not the case that widespread unemployment is in and of itself the reason for the spread of this crisis to the prime market. For the past 30 years, foreclosure rates remained essentially flat during periods of high unemployment because people who lost their jobs could sell their homes or tap into home equity to tide them over. Unemployment is now triggering an unprecedented number of home losses because loan flipping and the housing bubble have left so many families underwater. Most important, it’s crucial to put to rest any idea that the crisis was caused by efforts to extend home ownership opportunities to traditionally underserved communities. Many January 13, 2010 financial institutions, our own included, have long lent safely and successfully to these communities without experiencing outsize losses. Legal requirements such as those embodied in the CRA had been in effect for more than two decades with no ill effect before the increase in risky subprime loans, and fully 94 percent of all subprime loans were not covered by the CRA. What caused this problem was, as has been stated by previous panelists, risky loan products that existed for only one purpose. It was these loan products forced repeated refinancings that would continue to line the pockets of originators. It’s also important to note that contrary to what we heard earlier today, Wall Street was not just an impartial ATM giving out money to originators. Wall Street was asking for the riskiest loans. In one New York Times article, a CEO of a lending company told the reporter, “They were paying me more for no-doc loans, so I told my people to have the customers put their W- 2s away.” For the most part, consumers did not ask for these products. These products were push- marketed to consumers. Lenders paid their independent broker originators extra money for placing consumers into interest rates above par, and got even more money for locking them into those rates with prepayment penalties. Both private and public responses to the foreclosure crisis have been too little and too late. The Obama administration has created a promising framework with the Making Home Affordable program, but the program has not lived up to expectations because servicers either can’t or won’t make the necessary modifications. Considerations of both economic recovery and basic fairness demand that we do much more to help. We consider the following four steps to be crucial to mitigating the foreclosure crisis. First, we should ensure that families have adequate equity in their homes to continue with successful home ownership. With one out of four mortgage holders underwater, a modification program will not be successful at avoiding re-defaults unless mortgages are realigned with current values. Yet even as loan modification activity ramps up, principal reduction is still relatively rare. January 13, 2010 The large banks, who own most of the second liens, are locked in a game of chicken with investors and neither of them will agree to write-down their holdings if the other doesn’t. Servicers, for their part, continue to have conflicting financial incentives that sometimes push against the interests of both the borrowers and the loan owners. The administration fears moral hazard, but we did not let very significant moral hazard concerns stop us when we bailed out the banks. Second, we should require all mortgage loan servicers to attempt loss mitigation prior to initiating foreclosure and to document their efforts. As we all now know, voluntary foreclosure prevention programs do not work. Third, we should lift the ban on judicial modifications of primary residence mortgages. Modifications of loans in bankruptcy court is available for vacation homes, farms, commercial real estate and yachts. Permitting judges to modify mortgages on principal residences carries zero cost to the U.S. taxpayer, would address the moral hazard objections to other proposals, and would serve as a stick to the HAMP’s program’s carrots. Fourth, we should make the MHAP program fairer and more effective, especially by stopping the parallel foreclosure process while loans are being evaluated for modifications. And last, I want to talk about what we need to do stop this crisis from happening again. It’s crucial that we create an independent consumer financial protection agency. Federal bank regulators could have prevented this crisis, but regulatory capture, charter arbitrage, the equating of safety and soundness with profitability, and the ghettoization of consumer protection prevented the system from working. Finally, we must enact common sense rules of the road for mortgage origination. It will be truly stunning if we emerge from the wreckage of this foreclosure crisis without instituting a baseline requirement that lenders make only those loans that borrowers have the ability to pay, and without demanding that all participants along the mortgage securitization chain share an interest in the loan’s performance over time. January 13, 2010 We stand ready to assist the commission over the coming year and we look forward to your findings on these matters of utmost importance to America’s families. Thank you very much. CHRG-111hhrg54868--183 Mr. Bachus," Thank you. One thing that we have not--I don't think has come up is the effect of the unregulated subprime affiliates of depository institutions, and I know, Comptroller Dugan, you--at one time, the OCC issued a list of how many of the subprime lenders that failed actually were not regulated by either Federal or State regulators. Would you like to comment on that and the effect that has? " CHRG-111shrg57319--448 Mr. Killinger," Thank you very much, Mr. Chairman and Members of the Subcommittee. I very much appreciate the opportunity to contribute to your investigation of the financial crisis. In addition to my oral testimony, I have submitted extensive written testimony.--------------------------------------------------------------------------- \1\ The prepared statement of Mr. Killinger appears in the Appendix on page 179.--------------------------------------------------------------------------- I was an employee of Washington Mutual for more than 30 years and was honored to be its chief executive officer for 18 of those years. And thanks to the efforts of tens of thousands of our employees, the bank enjoyed many successes over most of that tenure as CEO. However, the financial crisis and the seizure of the bank in September 2008 were devastating to the company, its customers, employees, investors, and communities. And as CEO, I accept responsibility for all of our performance and am deeply saddened by and sorry for what happened. Now, beginning in 2005, 2 years before the financial crisis hit, I was publicly and repeatedly warning of the risks of a potential housing downturn. And we did not just talk about it, but instead we did some things about it. Unlike most of our competitors, we aggressively reduced our residential first mortgage originations by 74 percent, and we cut our home loan staffing in half between 2003 and 2007. Our market shares of prime and subprime loan originations declined by 50 percent over this period. We also deferred plans to grow many of our loan portfolios and instead returned capital to shareholders through share repurchases and cash dividends. We sold 30 percent of our loan servicing portfolio. We reduced and then eliminated broker and correspondent lending. We cut subprime and Option ARM originations dramatically in 2006 and 2007 and eliminated those products in 2008. Now, with the benefit of hindsight, had we known that housing price declines of 40 percent or more would occur in key markets served by the company, we would have taken even more draconian measures. Washington Mutual was a Main Street bank dedicated to serving everyday consumers. Most of our activities centered on providing checking, savings, investment, and credit card services to millions of customers. Our residential lending was a declining part of the company's business since 2003 and contributed only 13 percent of our company's revenues by 2007, and it was focused predominantly on prime borrowers. The company offered a full range of fixed- and adjustable-rate products, and its portfolios performed well over many years, with loss rates significantly below 1 percent per year. Approximately 90 percent of the company's residential first loan portfolio had a loan-to-value at origination of 80 percent or less. Now, higher-risk residential products, like home equity, Option ARM, subprime loans, were not new or exotic, but had been successfully offered to customers for many years. Now, we entered the subprime business with our purchase of Long Beach Mortgage in 1999 to better serve an underserved market. This was a small and declining part of our business since 2005. However, due to growing concerns over the housing market and third-party mortgage brokers, as well as our own operating issues, we greatly reduced subprime originations in 2006 and shut down the business in 2007. We had well-defined and clear policies of fair dealing with customers, and our responsible lending principles were praised by community groups. Our regulator consistently assigned us the highest CRA rating of outstanding, and employees were expected to practice our core values, and violations led to reprimands and terminations. And this is why I am particularly angry when I read that any customer might have been sold an inappropriate product. Now, enterprise risk management was a vital activity for the company. In fact, I created a centralized enterprise risk management group in 2002 and well over 1,300 people were involved in that activity by 2007. The chief enterprise risk officer was placed on the executive committee and reported to the board that the group was adequately staffed and functioned effectively on a quarterly basis. Finally, Washington Mutual should not have been seized and sold for a bargain price, but should have been allowed to work its way through the financial crisis. The company suffered from rising loan losses, but we were working our way through the crisis by reducing operating costs, raising over $10 billion of additional capital, and setting aside substantial loan loss reserves. When I left the bank in early September 2008, capital greatly exceeded regulatory requirements for a well-capitalized bank, deposits were stable, sources of liquidity appeared adequate, and our primary regulator, the OTS, had not directed us to seek additional outside capital nor find a merger partner. So it was with shock and great sadness when I read of the seizure and bargain sale of the company in late September 2008. I believe it was unfair that the company was not given the benefits extended to and actions taken on behalf of other financial institutions. Within days of its seizure, the FDIC insurance limit was raised to $250,000. The FDIC guaranteed bank debt. The Treasury Department announced favorable treatment of tax losses. The Federal Reserve purchased assets and injected massive liquidity into the system. And the TARP program added hundreds of billions of new capital to banks. These measures would have been extraordinarily helpful to Washington Mutual, just as they were to all other banks. And the unfair treatment of the company did not begin with its unnecessary seizure. In July 2008, the company was excluded from the ``Do Not Short'' list, which protected many Wall Street banks from abusive short selling. The company was similarly excluded from the hundreds of meetings and telephone calls between Wall Street executives and policy leaders that ultimately determined the winners and losers in this financial crisis. For those that were part of the inner circle and were too clubby to fail, the benefits were obvious. For those of us outside of the club, the penalty was severe. Now, I have some other suggestions for regulatory reform in my written statement that I would be happy to discuss further, but thank you, and I look forward to answering your questions. And I do request, Mr. Chairman, that my complete statement and any documents referenced in it through this morning be placed into the written record. Senator Levin. It will be placed in the record, as will all the opening statements. We will try a 20-minute first round here. First on the numbers. Mr. Killinger, in your opening statement you said that from 2003 to 2007, WaMu reduced its residential first mortgage originations, reduced its market share, and that may be accurate, but it is misleading in what it leaves out. You made a major shift in your strategy and you reduced your fixed-loan origination in 2003 by almost $200 billion. So most of the reduction in the mortgage business that you were engaged in came through the reduction in the fixed-loan 30-year mortgages that we see on that chart, Exhibit 1i.\1\--------------------------------------------------------------------------- \1\ See Exhibit 1i, which appears in the Appendix on page 223.--------------------------------------------------------------------------- Then if you look at Chart 1c, Exhibit 1c in your book,\2\ you will see that the securitization of your subprime home loans continued to climb right through 2006.--------------------------------------------------------------------------- \2\ See Exhibit 1c, which appears in the Appendix on page 214.--------------------------------------------------------------------------- Now, you have said, I believe, that you reduced significantly the origination of these subprime loans, but is it not true that those numbers on Exhibit 1b \3\ are accurate, that in terms of securitizing you continued to securitize your subprime home loans right through 2006? Is that accurate?--------------------------------------------------------------------------- \3\ See Exhibit 1b, which appears in the Appendix on page 213.--------------------------------------------------------------------------- " FOMC20070131meeting--42 40,VICE CHAIRMAN GEITHNER.," Bill, could you or Dave remind us what share of the total outstanding stock of mortgages consists of subprimes or what share of the housing stock do we think is financed at the subprime level? My recollection is that the share is still small even though it has been a large part of the recent flows." FinancialCrisisInquiry--760 VICE CHAIRMAN THOMAS: Mr. Chairman, I’ll take a—a minute, and then ask the question in terms of the distribution of the commercial loans vis-à-vis subprime and the rest. We had big banks in. Is there a greater strain on community banks in terms of the commercial loans versus the subprime being consolidated, and taken to a higher level? And that I think is something that should cause a lot of concern. Because if you get a collapse at that level, and we haven’t seen the response to recover or protect at that level, you’re going to have a far more fundamental erosion of locales than you would based upon what happened in the subprime. FOMC20070628meeting--75 73,VICE CHAIRMAN GEITHNER., Subprime are? CHRG-111shrg57319--593 Mr. Killinger," We did use them on the transactions, yes. Senator Levin. Now, in your statement, Mr. Killinger, you described how the Office of Thrift Supervision was on site at WaMu and approved of WaMu's actions, like the decision to raise additional capital. You have mentioned them a number of times, always that they were kind of supporting or approving what you did. What you don't mention in your statement was the Office of Thrift Supervision's criticisms of WaMu. From 2004 to 2008, the Office of Thrift Supervision repeatedly leveled serious criticisms of the bank. Here are a couple samples. In 2004, ``several of our recent examinations,'' they wrote, ``concluded that the bank's single family loan underwriting was less than satisfactory due to excessive errors in the underwriting process, loan document preparation, and in associated activities.'' That was May 12, 2004. In 2005, OTS wrote, ``Underwriting exceptions . . . evidence lack of compliance with bank policy. . . . Deficiencies, if left unchecked, could erode the credit quality of the portfolio. Our concerns are increased with the risk profile of the portfolio. . . .'' In 2006, ``subprime underwriting practices remain less than satisfactory. Continuing weaknesses in loan underwriting at Long Beach.'' In 2007, ``too much emphasis was placed on loan production at the expense of loan quality. Subprime underwriting practices remain less than satisfactory. Underwriting exceptions and errors remain above acceptable levels.'' In 2008, ``poor financial performance exacerbated by conditions within management's control, poor underwriting quality, geographic concentrations in problem markets, liberal underwriting policy, risk layering.'' That was presented to the Board of Directors July 15, 2008. So year after year, you have OTS citing the bank for weak lending practices, and I am wondering, were you aware of those criticisms? " CHRG-111shrg57320--72 Mr. Thorson," So did I. Senator Kaufman. I am going to shut up for a minute, just for a minute, and in 50 percent of subprime loans--I mean, here you are dealing with someone who comes into your office and is classified as a subprime loan, and you say to them, ``What is your income?'' And you write it down, and that is it. Would you say that is one of the causes of this meltdown? " CHRG-111shrg54789--178 FINANCIAL PROTECTION AGENCY Although a Consumer Financial Protection Agency (CFPA) would not be a panacea for all current regulatory ills, it would correct many of the most significant structural flaws that exist, realigning the regulatory architecture to reflect the unfortunate lessons that have been learned in the current financial crisis and sharply increasing the chances that regulators will succeed in protecting consumers in the future. A CFPA would be designed to achieve the regulatory goals of elevating the importance of consumer protection, prompting action to prevent harm, ending regulatory arbitrage, and guaranteeing regulatory independence.A. Put consumer protection at the center of financial regulation. Right now, four Federal regulatory agencies are required both to ensure the solvency of the financial institutions they regulate and to protect consumers from lending abuses. \32\ Jurisdiction over consumer protection statutes is scattered over several more agencies, with rules like RESPA and TILA, which both regulate mortgage disclosures, in different agencies.--------------------------------------------------------------------------- \32\ The Office of the Comptroller of the Currency (OCC) and Office of Thrift Supervision (OTC) charter and supervise national banks, and thrifts, respectively. State chartered banks can choose whether to join and be examined and supervised by either the Federal Reserve System or the Federal Deposit Insurance Corporation (FDIC). The FTC is charged with regulating some financial practices (but not safely and soundness) in the nonbank sector, such as credit cards offered by department stores and other retailer.--------------------------------------------------------------------------- Within agencies in which these functions are combined, regulators have often treated consumer protection as less important than their safety and soundness mission or even in conflict with that mission. \33\ For example, after more than 6 years of effort by consumer organizations, Federal regulators are just now contemplating incomplete rules to protect consumers from high-cost ``overdraft'' loans that financial institutions often extend without the knowledge of or permission from consumers. Given the longstanding inaction on this issue, it is reasonable to assume that regulators were either uninterested in consumer protection or viewed restrictions on overdraft loans as an unnecessary financial burden on banks that extend this form of credit, even if it is deceptively offered and financially harmful to consumers. In other words, because regulators apparently decided that their overriding mission was to ensure that the short-term balance sheets of the institutions they regulated were strong, they were less likely to perceive that questionable products or practices (like overdraft loans or mortgage prepayment penalties) were harmful to consumers.--------------------------------------------------------------------------- \33\ Occasionally, safety and soundness concerns have led regulators to propose consumer protections, as in the eventually successful efforts by Federal banking agencies to prohibit ``rent-a-charter'' payday lending, in which payday loan companies partnered with national or out-of-State banks in an effort to skirt restrictive State laws. However, from a consumer protection point-of-view, this multiyear process took far too long. Moreover, the outcome would have been different if the agencies had concluded that payday lending would be profitable for banks and thus contribute to their soundness.--------------------------------------------------------------------------- As mentioned above, recent history has demonstrated that this shortsighted view of consumer protection and bank solvency as competing objectives is fatally flawed. If regulatory agencies had acted to prevent loan terms or practices that harmed consumers, they would also have vastly improved the financial solidity of the institutions they regulated. Nonetheless, the disparity in agencies' focus on consumer protection versus ``safety and soundness'' has been obvious, both in the relative resources that agencies devoted to the two goals and in the priorities they articulated. These priorities frequently minimized consumer protection and included reducing regulatory restrictions on the institutions they oversaw. \34\--------------------------------------------------------------------------- \34\ For example, in 2007 the OTS cited consumer protection as part of its ``mission statement'' and ``strategic goals and vision.'' However, in identifying its eight ``strategic priorities'' for how it would spend its budget in Fiscal Year 2007, only part of one of these priorities appears to be directly related to consumer protection (``data breaches''). On the other hand, OTS identified both ``Regulatory Burden Reduction'' and ``Promotion of the Thrift Charter'' as major strategic budget priorities. Office of Thrift Supervision, ``OMB FY2007 Budget and Performance Plan,'' January 2007.--------------------------------------------------------------------------- Though the link between consumer protection and safety and soundness is now obvious, the two functions are not the same, and do conflict at times. In some circumstances, such as with overdraft loans, a financial product might well be profitable, even though it is deceptively offered and has a financially devastating effect on a significant number of consumers. \35\--------------------------------------------------------------------------- \35\ Testimony of Travis Plunkett, Legislative Director, Consumer Federation of America and Edmund Mierzwinski, Consumer Program Director, U.S. PIRG, Before the Subcommittee on Financial Institutions and Consumer Credit of the U.S. House of Representatives, Committee of Financial Services, March 19, 2009.--------------------------------------------------------------------------- Until recently, regulatory agencies have also focused almost exclusively on bank examination and supervision to protect consumers, which lacks transparency. This process gives bank regulators a high degree of discretion to decide what types of lending are harmful to consumers, a process that involves negotiating behind-the-scenes with bank officials. \36\ Given that multiple regulators oversee similar institutions, the process has also resulted in different standards for products like credit cards offered by different types of financial institutions. In fact, widespread abusive lending in the credit markets has discredited claims by bank regulators like the Comptroller of the Currency that a regulatory process consisting primarily of supervision and examination results in a superior level of consumer protection compared to taking public enforcement action against institutions that violate laws or rules. \37\ Financial regulatory enforcement actions are a matter of public record which has a positive impact on other providers who might be engaged in the same practices and provides information to consumers on financial practices sanctioned by regulators.--------------------------------------------------------------------------- \36\ ``Findings made during compliance examinations are strictly confidential and are not made available to the public except at the OCC's discretion. Similarly, the OCC is not required to publish the results of its safety-and-soundness orders . . . . Thus, the OCC's procedures for compliance examinations and safety-and-soundness orders do not appear to provide any public notice or other recourse to consumers who have been injured by violations identified by the OCC.'' Testimony of Arthur E. Wilmarth, Jr., Professor of Law, George Washington University Law School, before the Subcommittee on Financial Institutions and Consumer Credit of the House Financial Services Committee, April 26, 2007. \37\ `` . . . ours is not an `enforcement-only' compliance regime--far better to describe our approach as `supervision first, enforcement if necessary,' with supervision addressing so many early problems that enforcement is not necessary,'' Testimony of John C. Dugan, Comptroller of the Currency, before the Committee on Financial Services of the U.S. House of Representatives, June 13, 2007.--------------------------------------------------------------------------- Additionally, the debate about the financial and foreclosure crisis often overlooks the fact that predatory lending practices and the ensuing crisis have had a particularly harsh impact on communities of color. African Americans and Latinos suffered the brunt of the predatory and abusive practices found in the subprime market. While predatory and abusive lending practices were not exclusive to the subprime market, because of lax regulation in that sector, most abuses were concentrated there. Several studies have documented pervasive racial discrimination in the distribution of subprime loans. One such study found that borrowers of color were more than 30 percent more likely to receive a higher-rate loan than White borrowers even after accounting for differences in creditworthiness. \38\ Another study found that high-income African Americans in predominantly Black neighborhoods were three times more likely to receive a subprime purchase loan than low-income White borrowers. \39\--------------------------------------------------------------------------- \38\ See Bocian, D.G., K.S. Ernst, and W. Li, ``Unfair Lending: The Effect of Race and Ethnicity on the Price of Subprime Mortgages,'' Center for Responsible Lending, May 2006. \39\ ``Unequal Burden: Income and Racial Disparities in Subprime Lending in America'' (Washington, DC: HUD, 2000).--------------------------------------------------------------------------- African Americans and Latinos receive a disproportionate level of high cost loans, even when they quality for a lower rate and/or prime mortgage. Fannie Mae and Freddie Mac estimated that up to 50 percent of those who ended up with a sub prime loan would have qualified for a mainstream, ``prime-rate'' conventional loan in the first place. \40\ According to a study conducted by the Wall Street Journal, as much as 61 percent of those receiving subprime loans would ``qualify for conventional loans with far better terms.'' \41\ Moreover, racial segregation is linked with the proportion of subprime loans originated at the metropolitan level, even after controlling for percent minority, low credit scores, poverty, and median home value. \42\ The resulting flood of high cost and abusive loans in communities of color has artificially elevated the costs of homeownership, caused unprecedented high rates of foreclosures, and contributed to the blight and deterioration of these neighborhoods. It is estimated that communities of color will realize the greatest loss of wealth as a result of this crisis, since Reconstruction.--------------------------------------------------------------------------- \40\ See the Center for Responsible Lending's ``Fact Sheet on Predatory Mortgage Lending'', at http://www.responsiblelending.org/pdfs/2b003-mortgage2005.pdf, and ``The Impending Rate Shock: A Study of Home Mortgages in 130 American Cities'', ACORN, August 15, 2006, available at www.acorn.org. \41\ See ``Subprime Debacle Traps Even Very Creditworthy'', Wall Street Journal, December 3, 2007. \42\ Squires, Gregory D., Derek S. Hyra, and Robert N. Renner, ``Segregation and the Subprime Lending Crisis'', Paper presented at the 2009 Federal Reserve System Community Affairs Research Conference, Washington, DC (April 16, 2009).--------------------------------------------------------------------------- A CFPA, by contrast, would have as its sole mission the development and effective implementation of standards that ensure that all credit products offered to borrowers are safe and not discriminatory. The agency would then enforce these standards for the same types of products in a transparent, uniform manner. Ensuring the safety and fairness of credit products would mean that the CFPA would not allow loans with terms that are discriminatory, deceptive or fraudulent. The agency should also be designed to ensure that credit products are offered in a fair and sustainable manner. In fact, a core mission of the CFPA would be to ensure the suitability of classes of borrowers for various credit products, based on borrowers' ability to repay the loans they are offered--especially if the cost of loans suddenly or sharply increase, and that the terms of loans do not impose financial penalties on borrowers who try to pay them off. As we've learned in the current crisis, focusing exclusively on consumer and civil rights protection would often be positive for lenders' stability and soundness over the long term. However, the agency would be compelled to act in the best interest of consumers even if measures to restrict certain types of loans would have a negative short-term financial impact on financial institutions.B. Prevent regulatory arbitrage. Act quickly to prevent unsafe forms of credit. The present regulatory system is institution centered, rather than consumer centered. It is structured according to increasingly irrelevant distinctions between the type of financial services company that is lending money, rather than the type of product being offered to consumers. Right now, financial institutions are allowed (and have frequently exercised their right) to choose the regulatory body that oversees them and to switch freely between regulatory charters at the Federal level and between State and Federal charters. Many financial institutions have switched charters in recent years seeking regulation that is less stringent. Two of the most notorious examples are Washington Mutual and Countrywide, \43\ which became infamous for promoting dangerous sub-prime mortgage loans on a massive scale. \44\ Both switched their charters to become thrifts regulated by the Office of Thrift Supervision (OTS). At the Federal level, where major agencies are funded by the institutions they oversee, this ability to ``charter shop,'' has undeniably led regulators like the OTS to compete to attract financial institutions by keeping regulatory standards weak. It has also encouraged the OTS and OCC to expand their preemptive authority and stymie efforts by the States to curb predatory and high-cost lending. The OCC in particular appears to have used its broad preemptive authority over State consumer protections and its aggressive legal defense of that authority as a marketing tool to attract depository institutions to its charter. \45\--------------------------------------------------------------------------- \43\ Of course, following their stunning collapses, Countrywide was acquired by Bank of America and Washington Mutual by Chase, both in regulator-ordered winding-downs. \44\ In fact, several other large national banks have chosen in recent years to convert their State charter to a national charter. Charter switches by JPMorgan Chase, HSBC, and Bank of Montreal (Harris Trust) alone in 2004-05 moved over $1 trillion of banking assets from the State to the national banking system, increasing the share of assets held by national banks to 67 percent from 56 percent, and decreasing the State share to 33 percent from 44 percent. Arthur E. Wilmarth, Jr., ``The OCC's Preemption Rules Threaten to Undermine the Dual Banking System, Consumer Protection and the Federal Reserve Board's role in Bank Supervision'', Proceedings of the 42nd Annual Conference on Bank Structure and Competition (Fed. Res. Bank of Chicago, 2006) at 102, 105-106. \45\ For a detailed analysis, see brief amicus curiae of Center for Responsible Lending et al. in the case currently before the Supreme Court, Cuomo v. Clearinghouse and OCC (08-453) available at http://www.abanet.org/publiced/preview/briefs/pdfs/07-08/08-453_PetitionerAmCu10ConsumerProtectionOrgs.pdf (last visited 21 June 2009) at pp. 20-39.--------------------------------------------------------------------------- When agencies do collaborate to apply consumer protections consistently to the institutions they regulate, the process has been staggeringly slow. As cited in several places in this testimony, Federal regulators dithered for years in implementing regulations to stop unfair and deceptive mortgage and credit card lending practices. One of the reasons for these delays has often been that regulators disagree among themselves regarding what regulatory measures must be taken. The course of least resistance in such cases is to do nothing, or to drag out the process. Although the credit card rule adopted late last year by Federal regulators was finalized over protests from the OCC, these objections were likely one of the reasons that Federal regulators delayed even beginning the process of curbing abusive credit card lending practices until mid-2008. The ``charter shopping'' problem would be directly addressed through the creation of a single CFPA with regulatory authority over all forms of credit. Federal agencies would no longer compete to attract institutions based on weak consumer protection standards or anemic enforcement of consumer rules. The CFPA would be required to focus on the safety of credit products, features and practices, no matter what kind of lender offered them. As for regulatory competition with States, it would only exist to improve the quality of consumer protection. Therefore, the CFPA should be allowed to set minimum national credit standards, which States could then enforce (as well as victimized consumers). States would be allowed to exceed these standards if local conditions require them to do so. If the CFPA sets ``minimum'' standards that are sufficiently strong, a high degree of regulatory uniformity is likely to result. With strong national minimum standards in place, States are most likely to act only when new problems develop first in one region or submarket. States would then serve as an early warning system, identifying problems as they develop and testing policy solutions, which could then be adopted nationwide by the CFPA if merited. Moreover, the agency would have a clear incentive to stay abreast of market developments and to act in a timely fashion to rein in abusive lending because it will be held responsible for developments in the credit market that harm consumers.C. Create an independent regulatory process. The ability of regulated institutions to ``charter shop'' combined with aggressive efforts by Federal regulators to preempt State oversight of these institutions has clearly undermined the independence of the OTS and OCC. This situation is made worse by the fact that large financial institutions like Countrywide were able to increase their leverage over regulators by taking a significant chunk of the agency's budget away when it changed charters and regulators. The OTS and OCC are almost entirely funded through assessments on the institutions they regulate (see Appendix 4). The ability to charter shop combined with industry funding has created a significant conflict-of-interest that has contributed to the agencies' disinclination to consider upfront regulation of the mortgage and consumer credit markets. Given that it supervises the largest financial institutions in the country, the OCC's funding situation is the most troublesome. More than 95 percent of the OCC's budget is financed by assessments paid by national banks, and the twenty biggest national banks account for nearly three-fifths of those assessments. Large, multistate banks were among the most outspoken supporters of the OCC's preemption regulations and were widely viewed as the primary beneficiaries of those rules. In addition to its preemption regulations, the OCC has frequently filed amicus briefs in Federal court cases to support the efforts of national banks to obtain court decisions preempting State laws. The OCC's effort to attract large, multistate banks to the national system have already paid handsome dividends to the agency . . . . Thus, the OCC has a powerful financial interest in pleasing its largest regulated constituents, and the OCC therefore faces a clear conflict of interest whenever it considers the possibility of taking an enforcement action against a major national bank. \46\--------------------------------------------------------------------------- \46\ Testimony of Arthur E. Wilmarth. Jr., Professor of Law, George Washington University Law School, before the Subcommittee on Financial Institutions and Consumer Credit of the House Financial Services Committee, April 26, 2007. The leadership sofa CFPA would be held to account based on its ability to inform consumers and help protect them from unsafe products. In order to function effectively, the leadership would need to show expertise in and commitment to consumer protection. Crucial to the success of the agency would be to ensure that its funding is adequate, consistent and does not compromise this mission. Congress could also ensure that the method of agency funding that is used does not compromise the CFPA's mission by building accountability mechanisms into the authorizing statute and exercising effective oversight of the agency's operations. (See Section 4 below.) Recent history has demonstrated that even an agency with an undiluted mission to protect consumers can be undermined by hostile or negligent leadership or by Congressional meddling on behalf of special interests. However, unless the structure of financial services regulation is realigned to change not just the focus of regulation but its underlying philosophy, it is very unlikely that consumers will be adequately protected from unwise or unfair credit products in the future. The creation of a CFPA is necessary because it ensures that the paramount priority of Federal regulation is to protect consumers, that the agency decision making is truly independent, and that agencies do not have financial or regulatory incentives to keep standards weaker than necessary.SECTION 3: ERRORS OF OMISSION AND COMMISSION BY THE FEDERAL BANK CHRG-111hhrg56847--203 Mr. Bernanke," Okay. Ms. Kaptur. Thank you. Number three, how can you use your power--and this goes to the housing issue--how can you use your power as the Fed to get these megabanks and the servicers that they have hired to the table to do housing workouts to avoid the ghost towns and ghost neighborhoods that we are getting across this country? There is a real stop-up in the system, a real blockage. Even though, for example, home values have lost 30 percent of value, that isn't booked on the books of the banks. And you can't get a negotiation at the local level because there is nothing requiring the servicers to come to the stable. And there is a contractual relationship due to the subprime bonded nature of the instrument. We need the Fed to take a look at this since you deal in the bond markets, and you deal with these companies anyway. We need to get people to the table. And with the number of underwater loans, this isn't going to get any better. Across the country--I was talking to Dennis Cardoza yesterday, from California. He and I are in the same boat, and his boat is actually sinking faster than ours. And we really need somebody to hold these servicers accountable. Is there some way you can use your power to do that? That is question one. And then, question two, since the crisis began, the megabanks actually have a larger share of assets in the market than they did at the beginning, and the big investment banks that are very important to the Fed and the way you operate particularly up there in New York. And they had about a third of the assets of the country prior to the crisis. They now have nearly two-thirds. In the meanwhile, institutions in places like I represent are paying huge FDIC fees, up from maybe $20,000 5 years ago up to $70,000 last year, this year $700,000. The reason that lending is constricted at the local level is because these large institutions are really holding so much of the power, and we don't have a really balanced financial system. So they are not making the small business loans. So my question is, what role can you play as the Fed in restoring prudent lending and broad competition across our financial system? So question one relates to getting the servicers to the table, working with the megabanks. And number two, what can you do to help restore lending across this country through a competitive financial marketplace? " FOMC20070628meeting--29 27,CHAIRMAN BERNANKE.," There are a couple of themes. One is that the subprime problems are still being worked through the financial markets. The second is that subprime is an example of a broader class of structured products that are difficult to value, and that creates some uncertainty in the markets in periods of stress. President Lacker." CHRG-111hhrg54868--62 The Chairman," Well, it is an appropriate segue to the gentleman from North Carolina, who has been a leading activist here in the subprime crisis, and I am about to recognize him. I would just say to my friend, no one ever said this was the answer to the subprime crisis. The answer to the subprime crisis was the subprime bill that we passed. That is what we thought was the answer to that. This was never meant to be the answer to that. The gentleman may have forgotten that we did pass the subprime bill. The gentleman from North Carolina. Mr. Miller of North Carolina. Thank you, Mr. Chairman. There is a division in the existing law between safety and soundness regulation and consumer protection regulation. Chairwoman Bair said that you had testified or that you had commented as part of the public comment period when the Fed adopted rules that applied to institutions for which you all have principal safety and soundness responsibility--and actually, Comptroller Dugan, you did as well--you commented not for stronger rules, but for weaker rules. You opposed in the public comments many parts of the credit card regulation. Mr. Dugan, I understand that you don't have rulemaking authority. You didn't have rulemaking authority. You do have the authority to bring enforcement actions. The great, great bulk of credit card business was with national banks. It is now like the top 3 banks have 75 percent of the business. It was a little bit less sometime back, but it has always been dominated by national banks. And there were no enforcement actions. Now--yes, sir? Am I missing something? " CHRG-110shrg50415--50 Chairman Dodd," And a lot of these instruments, of course, we are talking about some of the subprime mortgages. " FinancialCrisisReport--64 As part of the 2005 presentation to the Board of Directors outlining the strategy, OTS recommended that WaMu define higher risk lending. 159 The January 2005 presentation contained a slide defining “Higher Risk Lending”: “For the purpose of establishing concentration limits, Higher Risk Lending strategies will be implemented in a ‘phased’ approach. Later in 2005 an expanded definition of Higher Risk Lending – encapsulating multiple risk layering and expanded underwriting criteria – and its corresponding concentration limit – will be presented for Board approval. “The initial definition is ‘ Consumer Loans to Higher Risk Borrowers’ , which at 11/30/04 totaled $32 Billion or 151% of total risk-based capital, comprised of: -Subprime loans, or all loans originated by Long Beach Mortgage or purchased through our Specialty Mortgage Finance program -SFR [Single Family Residential] and Consumer Loans to Borrowers with low credit scores at origination.” 160 A footnote on the slide defined “low credit scores” as less than a 620 FICO score for first lien single family residence mortgages, home equity loans, and home equity lines of credit. It defined low credit scores as less than 660 for second lien home equity loans (HEL) and home equity lines of credit (HELOC), and other consumer loans. 161 While the January 2005 presentation promised to present a fuller definition of higher risk loans for Board approval at some future date, a more complete definition had already been provided to the Board a few weeks earlier in a December 21, 2004 presentation entitled, “Asset Allocation Initiative: Higher Risk Lending Strategy and Increased Credit Risk Management.” 162 This presentation contained the same basic definition of higher risk borrowers, but also provided a definition of higher risk loans. Higher risk loans were defined as single family residence mortgages with a loan-to-value (LTV) ratio of equal to or greater than 90% if not credit enhanced, or a combined-loan-to-value (CLTV) ratio of 95%. These numbers are a notable departure from the 80% LTV ratio 159 6/30/2004 OTS Memo to Lawrence Carter from Zalka Ancely (“Joint Memo #8 - Loans to ‘Higher-Risk Borrowers’”), OTSWME04-0000005357 at 61. 160 1/2005 “Higher Risk Lending Strategy Presentation,” submitted to Washington Mutual Board of Directors, at JPM_WM00302979, Hearing Exhibit 4/13-2a. 161 Id. at JPM_WM00302979. 162 12/21/2004 “Asset Allocation Initiative: Higher Risk Lending Strategy and Increased Credit Risk Management,” Washington Mutual Board of Directors Presentation, at JPM_WM04107995-8008, Hearing Exhibit 4/13-2b. traditionally required for a prime loan. 163 For home equity loans and lines of credit, WaMu considered a first lien to be high risk if it had a greater than 90% LTV ratio, and considered a second lien to be high risk if had a greater than 80% CLTV ratio. 164 CHRG-111shrg57319--441 Mr. Beck," They did, but they did not know how bad it was ultimately going to get, and so at that point in time, they were demanding wider margins for the securities that they bought, but had not stopped buying them yet. Senator Kaufman. OK. Thank you. Senator Levin. You made reference to the subprime market going down. Option ARMs are prime. They are not subprime, right? They are supposed to be prime mortgages. Isn't that correct? " FOMC20070628meeting--74 72,MS. LIANG., The red lines are subprime. FinancialCrisisInquiry--816 ROSEN: Those numbers—I’ve seen the numbers, and the numbers on Fannie and Freddie are small relative to the size of the market what I’ve seen. And I—we certainly think we should—you should get the actual numbers and check as a commission. But Fannie and Freddie, they’ve documented exactly how many subprime and Alt-A they’ve got and, certainly, they’re bad. No question about it. But that is certainly not anywhere near the majority of the subprime mortgages and Alt-A mortgages. That, I am certain of. CHRG-110shrg50415--31 Mr. Stein," I think it is substantially overstated. I think Fannie and Freddie followed the market. They did not lead the market. They did purchase the senior tranches of AAA subprime securities, and that was a bad idea because they are supporting a bad market, and they end up not to be very good loans. But these were the marketable AAA tranches that others would have purchased, and as someone mentioned earlier, those percentages declined as the subprime market went way up. The problem is that people conflate the subprime securities with what caused Fannie and Freddie to have financial problems, but actually, those were the Alt-A mortgages talked about earlier that did not document income. Those are the higher-income borrowers. Those actually diluted their affordable housing goals. Ten percent of their mortgages are Alt-A mortgages; 50 percent of both Fannie's and Freddie's losses are Alt-A losses. The critique that if Fannie and Freddie had not purchased those securities that subprime abuses wouldn't have happened is ridiculous because they were originated by Wall Street, Wall Street packaged and promoted the products, the originators were making those loans, and often the people saying Fannie and Freddie are to blame do not want any sort of regulation on the people that actually made the mortgages and made them happen. So I think it is a pretty weak argument. " CHRG-110shrg50415--87 Mr. Stein," I agree. About half of all foreclosures now are due to subprime loans, which is about 11 percent of mortgages originated. And the problem with those loans is that people cannot afford them. Half of them were undocumented income. They had prepayment penalties that statistically increased foreclosure. So, I agree, had those rules been promulgated even 4 years ago, a lot of the subprime foreclosures that we have seen--I would say the significant majority--would not have happened. It would not have addressed the Alt-A loans, which is kind of the second wave. We have a chart in our testimony of the resets. The subprime resets come first, and the Alt-A resets come after. That is why it is important for them to extend it to Alt-A, the protections to Alt-A, and the protections would not have helped that unless it changed the culture of originations. " FinancialCrisisInquiry--835 GORDON: My only input is to agree that the regulators—all of them, not just the Fed—had ample information to know that there was a problem. When we did our report on subprime mortgages in 2006 and looked back at the longitudinal performance of loans by origination year, I mean, we could see that the subprime loans had very high failure rates from very early on—from 1998 through 2001. And the regulators, presumably, would have had the same ability to find this information as we did. You know, by 2005, quite a number of the subprime originators had already collapsed or been the targets of major law enforcement actions. There was, you know, Household and an associates and Ameriquest—there was a ton of stuff out there. You know, the OTS had examiners on site at WaMu. I don’t know what they were doing, but they weren’t noticing the risky loans that were going on. CHRG-111hhrg54868--201 Mr. Bowman," I think Chairman Bair referred to an instance at one of our institutions in Pennsylvania where she and others worked very hard to assist the minority institution in locating available capital. Ultimately, for a variety of reasons, it just was not there. The availability of capital today for all of our institutions, except some of the larger ones, is very, very difficult to come by regardless of who the investor might be or who the interested parties might be. The ability of any institution to raise capital continues to be a problem. Ms. Waters. Well, I guess, again, if I may, what the small and minority banks are saying is just as the bailout assisted the big banks, that are ``too-big-to-fail,'' why can't government come up with a program to assist small and minority-owned banks? And they remind us that they are not the ones that had the subprime meltdown, they weren't doing that kind of lending, yet they stand on the sidelines and they watch as the very people who caused the problem are assisted because they are ``too-big-to-fail.'' What can you think about, what possibly could happen for getting capital for these small and minority-owned banks? What kind of--would you, for example, be an advocate for assisting minority-owned banks with bailout money in different ways than is being done now? " CHRG-110shrg46629--46 Chairman Bernanke," Recently, I think they perhaps tightened a bit, actually, because of some concerns that were initially prompted by the subprime mortgage lending issues. Again from the Federal Reserve's perspectives, our principal concern is the safety and soundness of the banking system. What we have done recently is work with other regulators such as the SEC and the OCC and, in some cases also with foreign regulators, the FSA in the United Kingdom for example and German and Swiss regulators, to do what we call horizontal reviews which is that collectively we look at the practices of a large set of institutions, both commercial banks and investment banks, to see how they are managing certain types of activities. For example, the financing of leveraged buyouts, abridged equity and the like. And trying to make an evaluation of what are best practices, trying to give back information back to the companies and trying to use those reviews to inform our own supervision. And so we are very aware of these issues from the perspective of the risk-taking by large financial institutions and we are studying them, trying to provide information to the institutions themselves, and using them in our own supervisory guidance. Senator Reed. Are you confident that you can identify and monitor these risks posed by CLOs? And in a related point, do you anticipate seeing the same phenomena in the CLO market that we have seen in the CDO market, a bump? " CHRG-110hhrg46591--434 Mr. Bartlett," Congressman, to take one more minute. In fact, these executives have, and the executives I work with have a total commitment to get it right, to work with the Congress and with the regulatory agencies to get it right. It was a systemic failure. And I will use one example of one company in Indiana. American General had one of the lowest rates of delinquencies of the subprime market and one of the largest subprime lenders in the country, 2 percent rate of delinquency. And yet they are owned by AIG. The credit derivative swaps was the problem that brought the whole company down. But it wasn't the subprime loans that were being made in Evansville, or throughout the country, from Evansville, Indiana. So it is a systemic failure, not a failure of individual parts. It is the fact that the parts didn't have a mechanism to talk to one another. " fcic_final_report_full--127 Even as the Fed was doing little to protect consumers and our financial system from the effects of predatory lending, the OCC and OTS were actively engaged in a campaign to thwart state efforts to avert the com- ing crisis. . . . In the wake of the federal regulators’ push to curtail state authority, many of the largest mortgage-lenders shed their state licenses and sought shelter behind the shield of a national charter. And I think that it is no coincidence that the era of expanded federal preemption gave rise to the worst lending abuses in our nation’s history.  Comptroller Hawke offered the FCIC a different interpretation: “While some crit- ics have suggested that the OCC’s actions on preemption have been a grab for power, the fact is that the agency has simply responded to increasingly aggressive initiatives at the state level to control the banking activities of federally chartered institutions.”  MORTGAGE SECURITIES PLAYERS: “WALL STREET WAS VERY HUNGRY FOR OUR PRODUCT ” Subprime and Alt-A mortgage–backed securities depended on a complex supply chain, largely funded through short-term lending in the commercial paper and repo market—which would become critical as the financial crisis began to unfold in . These loans were increasingly collateralized not by Treasuries and GSE securities but by highly rated mortgage securities backed by increasingly risky loans. Independent mortgage originators such as Ameriquest and New Century—without access to de- posits—typically relied on financing to originate mortgages from warehouse lines of credit extended by banks, from their own commercial paper programs, or from money borrowed in the repo market. For commercial banks such as Citigroup, warehouse lending was a multibillion- dollar business. From  to , Citigroup made available at any one time as much as  billion in warehouse lines of credit to mortgage originators, including  mil- lion to New Century and more than . billion to Ameriquest.  Citigroup CEO Chuck Prince told the FCIC he would not have approved, had he known. “I found out at the end of my tenure, I did not know it before, that we had some warehouse lines out to some originators. And I think getting that close to the origination function— being that involved in the origination of some of these products—is something that I wasn’t comfortable with and that I did not view as consistent with the prescription I had laid down for the company not to be involved in originating these products.”  As early as , Moody’s called the new asset-backed commercial paper (ABCP) programs “a whole new ball game.”  As asset-backed commercial paper became a popular method to fund the mortgage business, it grew from about one-quarter to about one-half of commercial paper sold between  and . fcic_final_report_full--95 Of course, even as these initiatives went nowhere, the market did not stand still. Subprime mortgages were proliferating rapidly, becoming mainstream products. Originations were increasing, and products were changing. By , three of every four subprime mortgages was a first mortgage, and of those  were used for refi- nancing rather than a home purchase. Fifty-nine percent of those refinancings were cash-outs,  helping to fuel consumer spending while whittling away homeowners’ equity. CHRG-111shrg57321--242 Mr. McDaniel," No. Senator Levin. OK. Ms. Corbet, take a look at Exhibit 52c,\1\ if you would. This is an email dated March 20, 2007. This is an S&P employee who writes that, ``In a meeting with Kathleen Corbet today, she requested we put together a marketing campaign around the events in the subprime market''--now, this is March 2007--``the sooner, the better.'' Why would you want to put together a marketing campaign in March 2007?--------------------------------------------------------------------------- \1\ See Exhibit No. 52c, which appears in the Appendix on page 439.--------------------------------------------------------------------------- Ms. Corbet. I would not use the term marketing campaign. What I did ask was for a more responsive communications campaign around the subprime market, and again, this followed along with a teleconference, an investor teleconference that we put on just about this time, shortly thereafter. Senator Levin. So you didn't use the term that they said you used? Ms. Corbet. I don't think that I would have used that term. It was clearly a communications effort. Senator Levin. Going back to this question of what happened late in 2007, in the last 6 months of 2007, after the crunch came, one of the last subprime RMBS deals that was rated was called Citigroup Mortgage Loan Trust, and both S&P and Moody's rated this deal in December 2007. I don't have any exhibits for you to look at, so I will just have to read this more slowly. December 2007, that was months after both of your companies had downgraded thousands of subprime RMBSes. First of all, were you aware that your agency, each of you, gave a AAA rating to four tranches of a $386 million Citibank subprime deal in December 2007? Were you aware of that? " FOMC20070321meeting--87 85,MS. MINEHAN.," Thank you very much, Mr. Chairman. Perhaps unlike in the rest of the country, most of the recent cyclical data point to some reasons for optimism about near-term growth in New England, with the possible exception of the rate of foreclosure initiations related to subprime mortgages. The annual benchmark revisions by the BLS paint a happier picture of the current state of regional job growth, especially in Massachusetts and Connecticut. The overall message is that the region has been growing at a pace that is about at its long-term trend and has been adding jobs consistently in recent months. This picture is a bit different from the one we’ve been seeing for some time. The region’s unemployment rate remains about at the nation’s, and demand for skilled labor, as measured by both online and newspaper help-wanted ads and by anecdotal reports, is quite strong. Indeed, many continue to note that hiring the skilled workers they need has been difficult. Both temporary-help service firms and software and IT firms report strong demand for labor, particularly to meet finance and technical positions and to meet a growing backlog in activity in high-tech businesses. This aspect of the region’s labor market may be pulling some discouraged workers back into the labor force, as reflected in the perhaps temporary uptick in unemployment. Reflecting this better news on regional job growth, the Philadelphia Fed’s coincident economic indexes point to economic activity in the region’s two largest states that is on a par with national growth. When we surveyed a wide swath of retail contacts, we saw a bit of gloom on the retail side. But the fact that in New England you have an array of very small companies, sometimes in unique circumstances, may have given a little downbeat sense to the retail climate. The reports from larger retailers in the survey—and we have a couple of them— show solid year-over-year growth. Manufacturing employment continued to decline, but manufactured exports last quarter rose at a pace just a bit slower than the nation’s and were buoyed by airline-related products, fabricated metals, and general machinery. As I’ve noted before, downtown vacancy rates in most of the cities in New England are declining, as are suburban office vacancies; rents are rising; and one or two corridors fanning out from Boston are reportedly hot sites for new biotech firm locations. Business confidence, as measured by local surveys, is up, as is consumer confidence. So, overall, things are not too bad. A concern among this mostly brighter news is the rising rate of initiations of real estate foreclosures, especially those related to properties financed with subprime adjustable-rate mortgages. According to data from the Mortgage Bankers Association, whether one looks at the rate of total foreclosures or at the pace of foreclosures among just subprime mortgages, initiations have risen rapidly in New England from a very low base and now outstrip the nation’s. This is not a contest you want to win. Anecdotes abound about individual borrowers lured into what appear to be quite inappropriate mortgages, and the Federal Reserve Bank of Boston has been working with local bankers’ associations and the Massachusetts Banking Department and others on outreach and education. Why New England generally, and Massachusetts specifically, should be outstripping the nation in this area isn’t really clear. The local banking industry does not appear to have played much of a role in subprime lending, nor were we an area of bubble-like real estate growth, though clearly prices rose rapidly in the region over a fairly long time. The detrimental effects to local communities from the rise in foreclosures and the potential for negative political fallout—not unlike what President Lacker mentioned—seem obvious. On the national scene, the incoming data on the real economy, with the possible exception of job growth, have been slower than I expected. Inflation data, if anything, have been higher. The picture is not comforting, and it is complicated by questions related both to the housing market and the surprisingly slow pace of business spending. Many people around the table have mentioned both those things. The degree of national fallout from problems in subprime mortgage lending is a question right now, as it bears both on the pace of recovery in residential real estate investment and on the potential for wider spillovers from housing to consumption. At present, we in Boston, like the Greenbook authors, don’t expect that subprime mortgage problems will by themselves have much of an effect on overall growth. But we do have a concern if these problems lead to tighter lending standards, making mortgages and other borrowing more difficult to obtain and thereby exacerbate housing inventory overhangs, extend the current period of sluggish new home starts, and create further downward pressure on home prices. So far, we don’t see much of that happening. Trends in overall market and banking liquidity, mortgage interest rates, and new mortgage issuance are all positive. We think that those trends, combined with positive consumer home-buying attitudes, paint a reassuring picture that some of the downward trends will not be as severe as they otherwise might be. Indeed, I spoke to members of the advisory board of Harvard’s Joint Center for Housing Studies in late February. The group was composed of about fifty major homebuilders and major suppliers to the building industry. They were in a bit of collective shock regarding the rapid deterioration that they saw in their industry from late last year into the current quarter and seemed to be focused on inventory and cost control rather than on profits this year, which they didn’t expect. However, they saw continuing spending on home improvement, growth from commercial construction, and strength in non-U.S. markets as partial offsets. No one in the group mentioned the subprime issue or potential problems in mortgage financing, but that may have just been the fact of the moment. It was actually the day before the market break in late February, so it’s possible that they are not thinking along the same lines today. We have also been asking ourselves why business fixed investment has been so slow relative to fundamentals. We had been assuming that this inexplicable trend would right itself and that growth of producers’ durable equipment would show greater signs of health, but that hasn’t happened. We, like the Greenbook, have written down expectations regarding PDE. I’d really like to be wrong on the downside regarding this area, as it worries me a bit more than subprime mortgages or any of the recent financial market ups and downs. If businesses lack the confidence to invest in new equipment as much as they might be expected to given the fundamentals, how much longer will they continue to hire staff? If job growth slows, what will happen to consumption? To date, both hiring and consumption remain pretty solid. But while I saw some upside risks here at our last meeting, now I’m a little worried on the downside. In view of the incoming data, we have written down our forecast, much as the Greenbook has, and we have joined the Greenbook in a lower estimate of potential. We see growth a bit above 2 percent this year, rising to the mid 2s in ’08, with slightly rising unemployment and only slightly slowing core PCE inflation. However, as I probably implied before, I think the risks around this forecast on both sides seem to have risen. Will housing trends and the possible effects of diminished business spending affect the resilient consumer more than we now expect? Will the underlying pattern of core inflation continue to surprise on the upside, with the moderation we expect remaining mostly in the forecast? I don’t mean to overreact here. There are positives. External growth is strong. Fiscal spending at both the state and the national levels should be supportive. Financial markets, though certainly a bit more volatile and nervous, remain accommodative. Perhaps the downside risks to growth that I see are simply the ebb and flow of the U.S. economy continuing its transition from an above-trend rate of expansion just a year ago, not unlike the slow patch we saw in the late summer and early fall of last year. All in all, I remain somewhat more concerned about risks on the inflation side than about risks to growth. But it does seem to me as though the balancing act in meeting our two objectives has gotten a bit more difficult." CHRG-111shrg52619--199 RESPONSE TO WRITTEN QUESTIONS OF SENATOR KOHL FROM DANIEL K. TARULLOQ.1. Two approaches to systemic risk seem to be identified: (1) monitoring institutions and taking steps to reduce the size/activities of institutions that approach a ``too large to fail'' or ``too systemically important to fail'' or (2) impose an additional regulator and additional rules and market discipline on institutions that are considered systemically important. Which approach do you endorse? If you support approach one how you would limit institution size and how would you identify new areas creating systemic importance? If you support approach two how would you identify systemically important institutions and what new regulations and market discipline would you recommend?A.1. As we have seen in the current financial crisis, large, complex, interconnected financial firms pose significant challenges to supervisors. In the current environment, market participants recognize that policymakers have strong incentives to prevent the failure of such firms because of the risks such a failure would pose to the financial system and the broader economy. A number of undesirable consequences can ensue: a reduction in market discipline, the encouragement of excessive risk-taking by the firm, an artificial incentive for firms to grow in size and complexity in order to be perceived as too big to fail, and an unlevel playing field with smaller firms that are not regarded as having implicit government support. Moreover, of course, government rescues of such firms can be very costly to taxpayers. The nature and scope of this problem suggests that multiple policy instruments may be necessary to contain it. Firms whose failure would pose a systemic risk should be subject to especially close supervisory oversight of their risk-taking, risk management, and financial condition, and should be held to high capital and liquidity standards. As I emphasized in my testimony, the government must ensure a robust framework--both in law and practice--for consolidated supervision of all systemically important financial firms. In addition, it is important to provide a mechanism for resolving systemically important nonbank financial firm in an orderly manner. A systemic risk authority that would be charged with assessing and, if necessary, curtailing systemic risks across the entire U.S. financial system could complement firm-specific consolidated supervision. Such an authority would focus particularly on the systemic connections and potential risks of systemically important financial institutions. Whatever the nature of reforms that are eventually adopted, it may well be necessary at some point to identify those firms and other market participants whose failure would be likely to impose systemic effects. Identifying such firms is a very complex task that would inevitably depend on the specific circumstances of a given situation and requires substantial judgment by policymakers. That being said, several key principles should guide policymaking in this area. No firm should be considered too big to fail in the sense that existing stockholders cannot lose their entire investment, existing senior management and boards of directors cannot be replaced, and over time the organization cannot be wound down or sold in an orderly way either in whole or in part, which is why we have recommended that Congress create an orderly resolution procedure for systemically important financial firms. The core concern of policymakers should be whether the failure of the firm would be likely to have contagion, or knock-on, effects on other key financial institutions and markets and ultimately on the real economy. Of course, contagion effects are typically more likely in the case of a very large institution than with a smaller institution. However, size is not the only criterion for determining whether a firm is potentially systemic. A firm may have systemic importance if it is critical to the functioning of key markets or critical payment and settlement systems.Q.2. Please identify all regulatory or legal barriers to the comprehensive sharing of information among regulators including insurance regulators, banking regulators, and investment banking regulators. Please share the steps that you are taking to improve the flow of communication among regulators within the current legislative environment.A.2. In general, there are few formal regulatory or legal barriers to sharing bank supervisory information among regulators, and such sharing is done routinely. Like other federal banking regulators, the Board's regulations generally prohibit the disclosure of confidential supervisory information (such as examination reports and ratings, and other supervisory correspondence) and other confidential information relating to supervised financial institutions without the Board's consent. See 12 C.F.R. 261, Subpart C. These regulations, however, expressly permit designated Board and Reserve Bank staff to make this information available to other Federal banking supervisors on request. 12 C.F.R. 261.20(c).. As a practical matter, federal banking regulators have access to a database that contains examination reports for regulated institutions, including commercial banks, bank holding companies, branches of foreign banks, and other entities, and can view examination material relevant to their supervisory responsibility. State banking supervisors also have access to this database for entities they regulate. State banking supervisors may also obtain other information on request if they have direct supervisory authority over the institution or if they have entered into an information sharing agreement with their regional Federal Reserve Bank and the information concerns an institution that has acquired or applied to acquire a financial institution subject to the state regulator's jurisdiction. Id. at 261.20(d). The Board has entered into specific sharing agreements with a number of state and federal regulators, including most state insurance regulators, the Securities and Exchange Commission, the Commodity Futures Trading Commission, the Office of Foreign Asset Control (OFAC), and the Financial Crimes Enforcement Network (FinCEN), authorizing sharing of information of common regulatory and supervisory interest. We frequently review these agreements to see whether it would be appropriate to broaden the scope of these agreements to permit the release of additional information without compromising the examination process. Other supervisory or regulatory bodies may request access to the Board's confidential information about a financial institution by directing a request to the Board's general counsel. Financial supervisors also may use this process to request access to information that is not covered by one of the regulatory provisions or agreements discussed above. Normally such requests are granted subject to agreement on the part of the regulatory body to maintain the confidentiality of the information, so long as the requester bas identified a legitimate basis for its interest in the information. Because the Federal Reserve is responsible for the supervision of all bank holding companies and financial holding companies on a consolidated basis, it is critical that the Federal Reserve also have timely access to the confidential supervisory information of other bank supervisors or functional regulators relating to the bank, securities, or insurance subsidiaries of such holding companies. Indeed, the Gramm-Leach-Bliley Act (GLBA) provides that the Federal Reserve must rely to the fullest extent possible on the reports of examinations prepared by the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the SEC, and the state insurance authorities for the national bank, state nonmember bank, broker-dealer, and insurance company subsidiaries of a bank holding company. The GLBA also places certain limits on the Federal Reserve's ability to examine or obtain reports from functionally regulated subsidiaries of a bank holding company. Consistent with these provisions, the Federal Reserve has worked with other regulators to ensure the proper flow of information to the Federal Reserve through information sharing arrangements and other mechanisms similar to those described above. However, the restrictions in current law still can present challenges to timely and effective consolidated supervision in light of, among other things, differences in supervisory models--for example, between those favored by bank supervisors and those used by regulators of insurance and securities subsidiaries--and differences in supervisory timetables, resources, and priorities. In its review of the U.S. financial architecture, we hope that the Congress will consider revising the provisions of Gramm-Leach-Bliley Act to help ensure that consolidated supervisors have the necessary tools and authorities to monitor and address safety and soundness concerns in all parts of an organization.Q.3. What delayed the issuance of regulations under the Home Ownership Equity Protection Act for more than 10 years? Was the Federal Reserve receiving outside pressure not to write these rules? Is it necessary for Congress to implement target timelines for agencies to draft and implement rules and regulations as they pertain to consumer protections?A.3. In responding, I will briefly report the history of the Federal Reserve's rulemakings under the Home Ownership and Equity Protection Act (HOEPA). Although I did not join the Board until January 2009, I support the action taken by Chairman Bernanke and the Board in 2007 to propose stronger HOEPA rules to address practices in the subprime mortgage market. I should note, however, that in my private academic capacity I believed that the Board should have acted well before it did. HOEPA, which defines a class of high-cost mortgage loans that are subject to restrictions and special disclosures, was enacted in 1994 as an amendment to the Truth in Lending Act. In March 1995, the Federal Reserve published rules to implement HOEPA, which are contained in the Board's Regulation Z. HOEPA also gives the Board responsibility for prohibiting acts or practices in connection with mortgage loans that the Board finds to be unfair or deceptive. The statute further requires the Board to conduct public hearings periodically, to examine the home equity lending market and the adequacy of existing laws and regulations in protecting consumers, and low-income consumers in particular. Under this mandate, during the summer of 1997 the Board held a series of public hearings. In connection with the hearings, consumer representatives testified about abusive lending practices, while others testified that it was too soon after the statute's October 1995 implementation date to determine the effectiveness of the new law. The Board made no changes to the HOEPA rules resulting from the 1997 hearings. Over the next several years, the volume of home-equity lending increased significantly in the subprime mortgage market. With the increase in the number of subprime loans, there was increasing concern about a corresponding increase in the number of predatory loans. In response, during the summer of 2000 the Board held a series of public hearings focused on abusive lending practices and the need for additional rules. Those hearings were the basis for rulemaking under HOEPA that the Board initiated in December 2000 to expand HOEPA's protections. The Board issued final revisions to the HOEPA rules in December 2001. These amendments lowered HOEPA's rate trigger for first-lien mortgage loans to extend HOEPA's protections to a larger number of high-cost loans. The 2001 final rules also strengthened HOEPA's prohibition on unaffordable lending by requiring that creditors generally document and verify consumers' ability to repay a high-cost HOEPA loan. In addition, the amendments addressed concerns that high-cost HOEPA loans were ``packed'' with credit life insurance or other similar products that increased the loan's cost without commensurate benefit to consumers. The Board also used the rulemaking authority in HOEPA that authorizes the Board to prohibit practices that are unfair, deceptive, or associated with abusive lending. Specifically, to address concerns about ``loan flipping'' the Board prohibited a HOEPA lender from refinancing one of its own loans with another HOEPA loan within the first year unless the new loan is in the borrower's interest. The December 2001 final rule addressed other issues as well. As the subprime market continued to grow, concerns about ``predatory lending'' grew. During the summer of 2006, the Board conducted four public hearings throughout the country to gather information about the effectiveness of its HOEPA rules and the impact of the state predatory lending laws. By the end of 2006, it was apparent that the nation was experiencing an increase in delinquencies and defaults, particularly for subprime mortgages, in part as a result of lenders' relaxed underwriting practices, including qualifying borrowers based on discounted initial rates and the expanded use of ``stated income'' or ``no doc'' loans. In response, in March 2007, the Board and other federal financial regulatory agencies published proposed interagency guidance addressing certain risks and emerging issues relating to subprime mortgage lending practices, particularly adjustable-rate mortgages. The agencies finalized this guidance in June 2007. Also in June 2007, the Board held a fifth hearing to consider ways in which the Board might use its HOEPA rulemaking authority to further curb abuses in the home mortgage market, including the subprime sector. This became the basis for the new HOEPA rules that the Board proposed in December 2007 and finalized in July 2008. Among other things, the Board's 2008 final rules adopt the same standard for subprime mortgage loans that the statute previously required for high cost HOEPA loans--a prohibition on making loans without regard to borrowers' ability to repay the loan from income and assets other than the home's value. The July 2008 final rule also requires creditors to verify the income and assets they rely upon to determine borrowers' repayment ability for subprime loans. In addition, the final rules restrict creditors' use of prepayment penalties and require creditors to establish escrow accounts for property taxes and insurance. The rules also address deceptive mortgage advertisements, and unfair practices related to real estate appraisals and mortgage servicing. We can certainly understand the desire of Congress to provide timelines for regulation development and implementation. This could be especially important to address a crisis situation. However, in the case of statutory provisions that require consumer disclosure for implementation, we hope that any statutory timelines would account for robust consumer testing in order to make the disclosures useful and effective. Consumer testing is an iterative process, so it can take some additional time, but we have found that it results in much clearer disclosures. Additionally, interagency rulemakings are also more time consuming. While they have the potential benefit of bringing different perspectives to bear on an issue, arriving at consensus is always more time consuming than when regulations are assigned to a single rule writer. Moreover, assigning rulewriting responsibility, to multiple agencies can result in diffused accountability, with no one agency clearly responsible for outcomes. ------ fcic_final_report_full--539 APPENDIX 1 Hypothetical Losses in Two Scenarios (No feedback) Scenario 1 is what was known to market professional during the 2nd half of 2007; Scenario 2 is the actual condition of the mortgage market. Second mortgage/home equity loan losses are excluded. Assumptions used: Number of mortgages= 53 million; Total value of first mortgages=$9.155 trillion; Losses on Prime=1.2%% (assumes 3% foreclosure rate & 40% severity); Losses on Subprime/Alt-A=12% (assumes 30% foreclosure rate & 40% severity); Average size of mortgage: $173,000 Losses in Scenario 1 Number of mortgages: 53 million Prime=40 million Subprime/Alt-A = 13 million (7.7. PMBS million + FHA/VA=5.2 million) Aggregate Value: Prime =$6.9 trillion ($173,000 X 40 million); Subprime/Alt-A=$2.25 trillion ($173,000 X 13 million) Losses on foreclosures: $353 billion ($6.9 trillion prime X 1.2%=$83 billion + $2.25 trillion subprime/Alt-A X 12%=$270 billion Overall loss percentage: 3.5% Losses in Scenario 2 Number of mortgages: 53 million Prime: 27 million Subprime/Alt-A: Original subprime/Alt-A: 13 million Other subprime/Alt-A: 13 million (10.5 F&F (excludes 1.25 million already counted in PMBS) + 2.5 million other loans not securitized (mostly held by the large banks)) Aggregate Value: Prime= $4.7 trillion ($173,000 X 27 million); Subprime/Alt-A = $4.5 trillion ($173,000 X 26 million) Losses on foreclosures: $596 billion ($4.7 trillion X 1.2%=$56 billion + $4.5 trillion X 12%=$540 billion) Overall loss percentage: 6.5%, for an increase of 86% Note: No allowance for feedback effect—that is, fall in home prices as a result of larger number of foreclosures in Scenario 2. With feedback effect, losses would 535 be even larger in Scenario 2 because a larger number of foreclosures would drive down housing prices further and faster. This feedback effect will likely cause total first mortgage losses to approach $1 trillion or 10% of outstanding first mortgages. CHRG-110shrg50414--19 Chairman Dodd," Thank you, Senator, very much. I want to point out, I turn to Senator Bunning, it was 2 years ago that Senator Bunning and Senator Allard held a joint hearing on subprime mortgages, at the conclusion of which Senator Schumer, Senator Reed, Senator Sarbanes, and myself, joined them in a letter to the regulators asking what actions and steps they were going to take in the subprime mortgage problem. Senator Bunning. fcic_final_report_full--463 Figure 1 below, based on the data of Robert J. Shiller, shows the dramatic growth of the 1997-2007 housing bubble in the United States. By mid-2007, home prices in the U.S. had increased substantially for ten years. The growth in real dollar terms had been almost 90 percent, ten times greater than any other housing bubble in modern times. As discussed below, there is good reason to believe that the 1997- 2007 bubble grew larger and extended longer in time than previous bubbles because of the government’s housing policies, which artificially increased the demand for housing by funneling more money into the housing market than would have been available if traditional lending standards had been maintained and the government had not promoted the growth of subprime lending. Figure 1. The Bubble According to Shiller That the 1997-2007 bubble lasted about twice as long as the prior housing bubbles is significant in itself. Mortgage quality declines as a housing bubble grows and originators try to structure mortgages that will allow buyers to meet monthly payments for more expensive homes; the fact that the most recent bubble was so long-lived was an important element in its ultimate destructiveness when it deflated. Why did this bubble last so long? Housing bubbles deflate when delinquencies and defaults begin to appear in unusual numbers. Investors and creditors realize that the risks of a collapse are mounting. One by one, investors cash in and leave. Eventually, the bubble tops out, those who are still in the game run for the doors, and a deflation in prices sets in. Generally, in the past, this process took three or four years. In the case of the most recent bubble, it took ten. The reason for this longevity is that one major participant in the market was not in it for profit and was not worried about the risks to itself or to those it was controlling. It was the U.S. government, pursuing a social policy—increasing homeownership by making mortgage credit available to low and moderate income borrowers—and requiring the agencies and financial institutions it controlled or could influence through regulation to keep pumping money into housing long after the bubble, left to itself, would have deflated. Economists have been vigorously debating whether the Fed’s monetary policy in the early 2000s caused the bubble by keeping interest rates too low for too long. Naturally enough, Ben Bernanke and Alan Greenspan have argued that the Fed was not at fault. On the other hand, John Taylor, author of the Taylor rule, contends that the Fed’s violation of the Taylor rule was the principal cause of the bubble. Raghuram Rajan, a professor at the Chicago Booth School of Business, argues that the Fed’s low interest rates caused the bubble, but that the Fed actually followed this policy in order to combat unemployment rather than deflation. 19 Other theories blame huge inflows of funds from emerging markets or from countries that were recycling the dollars they received from trade surpluses with the U.S. These debates, however, may be missing the point. It doesn’t matter where the funds that built the bubble actually originated; the important question is why they were transformed into the NTMs that were prone to failure as soon as the great bubble deflated. Figure 2 illustrates clearly that the 1997-2007 bubble was built on a foundation of 27 million subprime and Alt-A mortgages and shows the relationship between the cumulative growth in the dollar amount of NTMs and the growth of the bubble over time. It includes both GSE and CRA contributions to the number of outstanding NTMs above the normal baseline of 30 percent, 20 and estimated CRA lending under the merger-related commitments of the four large banks—Bank of America, Wells Fargo, Citibank and JPMorgan Chase—that, with their predecessors, made most of the commitments. As noted above, these commitments were made in connection with applications to federal regulators for approvals of mergers or acquisitions. The dollar amounts involved were taken from a 2007 report by the NCRC, 21 and adjusted for announced loans and likely rates of lending. The cumulative estimated CRA 19 CHRG-110shrg50410--99 Chairman Dodd," Thank you, Mr. Chairman. Thank you very much, Senator. Senator Casey. Senator Casey. Mr. Chairman, thank you very much. I think I might be the last questioner. I know those that have been waiting a long time will be happy to hear that. I want to thank all three of you for your testimony today as witnesses. But my questions will be directed at Secretary Paulson. I had a chance earlier to ask some questions of Chairman Bernanke. And Chairman Cox, I hope I can get to you on another day, if not today. I wanted to pick up on something the Chairman said earlier, that all of this began with predatory lending. I think all of us would agree on some of the origins of our problems here. In the State that I represent, Pennsylvania, when you are just looking at it from the perspective of the subprime market in terms of our housing challenges, it is really remarkable. A report done in the early part of 2008, when you look at the rate of subprime mortgages, just the existence of those mortgages at a very high rate, it was not just a big city like Philadelphia. The other 8 counties cited in the top 9, really, were all rural or relatively rural counties. I mentioned this, I think, to Secretary Paulson before. In light of that, though, I just wanted to let the Secretary know, I have sent a letter today to HUD Chairman Preston and I have copied you on this letter. You can react to it or not, because you have not seen the letter. But I want to highlight what the letter is about. It is an attempt to provide some answer, some one solution to part of our subprime crisis. In Philadelphia, a new program called the Philadelphia Residential Mortgage Foreclosure Diversion Pilot Program--a long name for a program which does two or three things basically. No. 1, it requires face-to-face meetings between borrowers and lenders and no owner-occupied home can be sold at a sheriff's sale without the owner first getting an opportunity to take part in a ``conciliation session'' with lenders. That is part one. Part two is the homeowner must participate in a free counseling session to develop a proposed payment schedule to present to their mortgage company. And finally, the third point, the Philadelphia Inquirer reported that approximately 200 Philadelphia lawyers--you do not hear too much about lawyers in this context--200 Philadelphia lawyers have donated their time to the program. And out of 600 homeowners who are in danger of losing their homes, approximately 325 were able to avoid foreclosure and eviction. I say that really to all three of you, but in particular to Secretary Paulson because I know you have worked a lot of months now on this problem and you have been determined and dogged and creative and resolute about it. And I would ask you to take a look at that letter and see if there is anything Treasury could do to--if you can endorse it and highlight it. Basically, what we are asking is to take a share of the counseling money and use it for a program like that. I do not know if you have any reaction to that. " CHRG-110hhrg46591--140 Mr. Ackerman," What if there was no past? Ms. Rivlin. Well, no, there was a past. Subprime mortgages didn't start in 2006. There was a history. Ned Gramlich has set this out rather nicely in his book. But the problem was as long as prices were going up, housing prices, there were relatively small defaults on subprime. So using that history--and there was a history--was misleading. As soon as we got to the top of the housing market, all the rules changed. " fcic_final_report_full--541 Scenario 1 is what was known to market professional during the 2nd half of 2007; Scenario 2 is the actual condition of the mortgage market. Second mortgage/home equity loan losses are excluded. Assumptions used: Number of mortgages= 53 million; Total value of first mortgages=$9.155 trillion; Scenario 1: Losses on prime=1.2%% (assumes 3% foreclosure rate & 40% severity); Losses on self-denominated subprime & Alt-A=14% ((assumes 35% foreclosure rate & 40% severity); Losses on FHA/VA=5.25% (assumes 15% foreclosure rate and 35% severity) Scenario 2: Losses on prime=1.6%% (assumes 3.5% foreclosure rate and 45% severity); Losses on self-denominated subprime & Alt-A=25% (assumes 45% foreclosure rate & 55% severity); Losses on FHA/VA & unknown subprime/Alt-A=15% (assumes 30% foreclosure rate & 50% severity) Average size of mortgage: Prime: $173,000 ($6.75 trillion/39 million) Subprime/Alt-A/FHA/VA: $182,000 ($2.4 trillion/13 million Losses in Scenario 1 Number of mortgages: 53 million Prime=40 million Subprime/Alt-A=7.7 million PMBS FHA, and VA=5.2 million Aggregate Value: Prime =$6.9 trillion ($173,000 X 39 million); Subprime/Alt-A=$1.7 trillion ($220,000 X 7.7 million) FHA/VA= $700 billion ($130,000x5.2 million) Total expected foreclosures: 4.7 million (3% X 39 million + 35% X 7.7 million + 15% X 5.2 million) Losses on foreclosures: $360 billion ($6.9 trillion prime X 1.2%=$83 billion + 1.7 trillion subprime/Alt-A X 14%=$240 billion + $700 billion X 5.25%=37 billion) Overall loss percentage: 3.9% 537 CHRG-111shrg54675--77 PREPARED STATEMENT OF CHAIRMAN TIM JOHNSON It is no exaggeration to say that our economy is currently experiencing extraordinary stress and volatility. As Congress and the Administration look at corrective policy changes, I am pleased to hold this hearing today to take a closer look at the role smaller financial institutions, specifically community banks and credit unions, play in our economy, especially in many rural communities. Throughout our Nation's economic crisis there has often been too little distinction made between troubled banks and the many banks that have been responsible lenders. There are many community banks and credit unions that did not contribute to the current crisis--many rural housing markets that didn't experience the boom that other parts of the country did, and community lending institutions didn't sell as many exotic loan products as other lenders sold. Nonetheless, small lending institutions in rural communities and their customers are feeling the effects of the subprime mortgage crisis and the subsequent crisis in credit markets. Jobs are disappearing, ag loans are being called, small businesses can't get the lines of credit they need to continue operation, and homeowners are struggling to refinance. Smaller banks play a crucial role in our economy and in communities throughout our Nation; we need to be mindful that some institutions are now paying the price for the risky strategies employed by some larger financial institutions. In coming weeks, the Banking Committee will continue its review of the current structure of our financial system and develop legislation to create the kind of transparency, accountability, and consumer protection that is now lacking. As this process moves forward, it will be important to consider the unique needs of smaller financial institutions and to preserve their viability as we come up with good, effective regulations that balance consumer protection and allow for sustainable economic growth. I would like to welcome our panel of witnesses, and thank them for their time and for their thoughtful testimony on how small lending institutions in rural communities have been affected by our troubled economy. I would also like to thank Senator Kohl for his interest in today's hearing topic. I will now turn to Senator Crapo, the Subcommittee's Ranking Member, for his opening statement. ______ CHRG-110hhrg46591--450 The Chairman," That said that the Federal Reserve should regulate mortgages. And it was assumed at the time that the bank regulators were regulating the mortgages on the regulated institutions, but that the Fed should do across-the-board mortgage regulation, knocking out a lot of things that should happen. Well, this is an important point, and it is not what you said. Mr. Greenspan, under his philosophy of deregulation, refused to use it. Now it is true, as some of my colleagues over there said, the law was on the books. But Mr. Greenspan said, no, the market is smarter than I am, and explicitly refused to use it. Federal Reserve Governor Gramlich urged him to use it, and he refused on philosophical grounds. Finally, frustrated that that wasn't happening, in 2005, four members of this committee--Mr. Bachus, who was then the chairman of the Financial Institutions Subcommittee as a Republican, Mr. Watt of North Carolina, Mr. Miller of North Carolina, and myself--began conversations to adopt legislation. So it is simply not true that no one was looking at this. In 2005, we began negotiations among us to adopt a bill to do what Mr. Greenspan wouldn't do, to restrict subprime mortgages that shouldn't have been granted. Those negotiations went on for a while, and I was then told by the then-chairman of the committee--I think Mr. Bachus got the same message--the Republican House leadership did not want that to go forward. And the efforts ended. In 2007, when I became the chairman, we took that issue up, and we did pass a bill in 2007. And Mr. Bachus, who voted for the bill, indicated he thought some of the people testifying had been against it, but we did pass a bill that would restrict most of these things. But here is some good news, and we don't like to talk about the good news for some reason. Even though that bill didn't pass in the Senate, which is a phrase you hear quite a lot these days, or forever, Mr. Bernanke, after the House acted, and in conversation with the House, then used exactly the authority that Alan Greenspan refused to use, and has promulgated a set of restrictions on subprime mortgage origination which will stop this problem from happening again. So the problem was twofold. And this is what the acceleration question is, Mr. Ryan. The weapons that destroyed the financial system of the world were the subprime loans. They shouldn't have been granted. A lot of people, certainly myself included, but top-ranked officials, all thought that while this would be damaging, the damage would be confined to the mortgage market. What very few people understood was the extent to which subprime damages would rocket throughout the system. And yes, it was the super sophisticated, not very well-understood, and not very well-regulated financial instruments that took these subprime loans and spread them around. Now, we have solved part of that problem going forward because, thanks to Ben Bernanke, acting after the House moved, there will be no more of those subprime loans. Ben Bernanke's rules are pretty good ones, and everything I would like to do. And we want to go further on yield spread premiums and elsewhere. The problem is that while subprime loans won't be the weapon that is loaded into these super sophisticated instruments and shot around, there may be something else. So that is why the second part of the job, having seen that subprime loans don't go forth, the second part of the job is what we have been talking about today--and you have all been very helpful and we appreciate it--how do we put some constraints on excessive risk-taking in the financial system so the next time--and nobody can be sure it won't happen-- loans are made that shouldn't have been made, we don't have them multiplied in their effect. But I did want to say it is really not fair to say that no one was looking at subprime loans. Many of us were doing it in 2005, and even earlier, trying to get Mr. Greenspan to do it. Yes, Mr. Yingling. " fcic_final_report_full--29 Two former OCC comptrollers, John Hawke and John Dugan, told the Commis- sion that they were defending the agency’s constitutional obligation to block state ef- forts to impinge on federally created entities. Because state-chartered lenders had more lending problems, they said, the states should have been focusing there rather than looking to involve themselves in federally chartered institutions, an arena where they had no jurisdiction.  However, Madigan told the Commission that national banks funded  of the  largest subprime loan issuers operating with state charters, and that those banks were the end market for abusive loans originated by the state- chartered firms. She noted that the OCC was “particularly zealous in its efforts to thwart state authority over national lenders, and lax in its efforts to protect con- sumers from the coming crisis.”  Many states nevertheless pushed ahead in enforcing their own lending regula- tions, as did some cities. In , Charlotte, North Carolina–based Wachovia Bank told state regulators that it would not abide by state laws, because it was a national bank and fell under the supervision of the OCC. Michigan protested Wachovia’s an- nouncement, and Wachovia sued Michigan. The OCC, the American Bankers Asso- ciation, and the Mortgage Bankers Association entered the fray on Wachovia’s side; the other  states, Puerto Rico, and the District of Columbia aligned themselves with Michigan. The legal battle lasted four years. The Supreme Court ruled – in Wachovia’s favor on April , , leaving the OCC its sole regulator for mortgage lending. Cox criticized the federal government: “Not only were they negligent, they were aggressive players attempting to stop any enforcement action[s]. . . . Those guys should have been on our side.”  Nonprime lending surged to  billion in  and then . trillion in , and its impact began to be felt in more and more places.  Many of those loans were funneled into the pipeline by mortgage brokers—the link between borrowers and the lenders who financed the mortgages—who prepared the paperwork for loans and earned fees from lenders for doing it. More than , new mortgage brokers began their jobs during the boom, and some were less than honorable in their deal- ings with borrowers.  According to an investigative news report published in , between  and , at least , people with criminal records entered the field in Florida, for example, including , who had previously been convicted of such crimes as fraud, bank robbery, racketeering, and extortion.  J. Thomas Card- well, the commissioner of the Florida Office of Financial Regulation, told the Com- mission that “lax lending standards” and a “lack of accountability . . . created a condition in which fraud flourished.”  Marc S. Savitt, a past president of the Na- tional Association of Mortgage Brokers, told the Commission that while most mort- gage brokers looked out for borrowers’ best interests and steered them away from risky loans, about , of the newcomers to the field nationwide were willing to do whatever it took to maximize the number of loans they made. He added that some loan origination firms, such as Ameriquest, were “absolutely” corrupt.  FOMC20070321meeting--50 48,CHAIRMAN BERNANKE.," I had been puzzled about the quantitative relationship between the subprime problems and the stock market. I think that the actual money at risk is on the order of $50 billion from defaults on subprimes, which is very small compared with the capitalization of the stock market. It looks as though a lot of the problem is coming from bad underwriting as opposed to some fundamentals in the economy. So I guess I’m a bit puzzled about whether it’s a signal about fundamentals or how it’s linked to the stock market." CHRG-110hhrg46591--139 Mr. Ackerman," An independent sheet? Ms. Rivlin. Pardon? You would have the major investment funds pay a small fee to support rating agencies rather than the sellers of securities. But another point. You said earlier that there was no record on the mortgage-backed securities backed by subprime. Actually, there was, and the record was pretty good. As long as prices were going up, defaults on subprime were minimal. So the rating agencies weren't absolutely wrong in using the past. It just wasn't-- " CHRG-111hhrg54868--190 Mr. Smith," Whoever was providing the money--someone provided financing to these alleged unregulated subprime originators. " CHRG-110hhrg34673--45 Mr. Bernanke," You are correct, Congresswoman. There has been a surge in delinquencies and foreclosures, particularly--as I mentioned in my testimony--in subprime lending with variable rates, rates that adjust with short-term interest rates, and that is a concern to us. We certainly have been following it carefully. It is obviously very bad for those who borrow under those circumstances, and it is not good for the lenders either, who are taking losses. We have tried, together with the other banking agencies, to address some of these concerns. We recently issued a guidance on nontraditional mortgages, which had three major themes. The first was that lenders should underwrite properly, that is, they should make sure that borrowers had the financial capacity to pay even when rates go up, and not simply underwrite based on the initial rate but also deal with the possible payment shock. Secondly, that lenders should give full disclosure and make sure that people understand the terms of the mortgages they are getting into. And I would add that the Federal Reserve provides a number of documents, booklets, and descriptions that are required to be included along with mortgage applications for adjustable rate mortgages. And thirdly, and this is more on the issue of the lenders rather than the borrowers, that lenders should make sure they appropriately risk manage these exotic mortgages, which we don't have much experience with, so some caution is needed in managing them, as we are now seeing. So those, I think, are very good principles, and I think we would stand by those principles. Now the question has arisen whether the 2/28's, 3/27's are covered by this guidance, and I think the answer is yes and no. The guidance as written refers to specific types of mortgages, including those that have negative amortization, that is, the amount owed can actually go up for a period, which is not usually the case with 2/28's and 3/27's. So in that respect, those types of mortgages were not, you know, literally included in that initial guidance. We, the Federal Reserve, along with the other banking agencies, are currently preparing a clarification to the initial guidance which will say that these same principles apply also to mortgages of this type that have variable rates, and particularly those that are of a subprime nature. But I would just say now that I hope that in our guidance, in our supervision, that we have conveyed to lenders that those three principles, good underwriting, good disclosure, and good risk management, are broad, good business principles, and they should be applying those to all mortgages they make. " CHRG-111shrg57322--728 Mr. Viniar," The other thing to remember back to 2007, it is hard to remember back then, but there was a very strong point of view, which didn't turn out to be correct, but it was very strong, that the decline was isolated to the subprime mortgage market. Again, that turned out not to be correct and different people had different views, but that was a fairly commonly held view through much of 2007, that the decline was just subprime mortgages. The rest of the mortgage market actually had not declined very much. It did later in the year. And if you remember, the equity markets actually peaked in October 2007. Senator Kaufman. Yes. No, I agree with that. " FinancialCrisisInquiry--244 Please. ZANDI: I think two fundamentals—the question being where were the regulators. I think the first point is that the Federal Reserve is the key regulator, and it had a philosophical predisposition towards regulation during this period—had faith in the securitization process that failed us. But, secondly, the regulatory structure also failed us. The Federal Reserve, along with other regulators, would come together and issue interagency guidance with respect to all kinds of lending activity. And this is a very cumbersome process to get consensus among these groups of regulators is very difficult. And to get explicit guidance is nearly impossible. And you can see that, in—with respect to the guidance issued on Alt-A and ultimately subprime, it came well after the fact. So it was this philosophical predisposition but I think it was also the structure of our regulatory framework that doomed us to not having this regulatory oversight. GORDON: I mean, we—you know, our view is that, as long as consumer protection remains, kind of, the— the stepchild at agencies, we’re not likely to get better results through the same incentive structure for the regulators, which is why we do support an independent regulator of products—financial products aimed at consumers. CLOUTIER: And I would—I would add, I’ve testified many times—I think, most probably, 13 times, here— but I remember one that sticks in my mind. Congressman Richard Baker was having a hearing. This was about 2001. CHRG-111shrg57322--811 Mr. Broderick," It does not specify, but it was one of the desks within the mortgage---- Senator Coburn. One of the desks that would buy subprime mortgages, correct? " CHRG-111shrg51303--169 PREPARED STATEMENT OF SENATOR RICHARD C. SHELBY Thank you, Mr. Chairman. The collapse of the American International Group is the greatest corporate failure in American history. Once a premiere global insurance and financial services company with more than one trillion dollars in assets, AIG lost nearly $100 billion last year. Over the past 5 months it has been the recipient of four bailouts. To date, the Federal Government has committed to provide approximately $170 billion in loans and equity to AIG. Given the taxpayer dollars at stake and impact on our financial system, this Committee has an obligation to throughly examine the reasons for AIG's collapse and how Federal regulators have responded. I also hope that today's hearing will shed new light on the origins of our financial crisis, as well as inform our upcoming discussions on financial regulatory reform. In reviewing our witnesses' testimony and AIG's public filings, it appears that the origins of AIG's demise were two-fold. First, as has been widely reported, AIG suffered huge losses on credit default swaps written by its Financial Products subsidiary on collateralized debt obligations. AIG's problems, however, were not isolated to its credit default swap business. Significant losses at AIG's State-regulated life insurance companies also contributed to the company's collapse. Approximately a dozen of AIG's life insurance subsidiaries operated a securities lending program, whereby they loaned out securities in exchange for cash collateral. Typically, an insurance company or bank will lend securities and reinvest the cash collateral in very safe, short-term instruments. AIG's insurance companies, however, invested their collateral in riskier long-term mortgage-backed securities. Although they were highly rated securities, approximately half of them were backed by subprime and alt-a mortgage loans. When the prices for mortgage-backed securities declined sharply last year, the value of AIG's collateral plummeted. The company was rapidly becoming unable to meet the demands of borrowers returning securities to AIG. By September, it became clear that AIG's life insurance companies would not be able to repay collateral to their borrowers. Market participants quickly discovered these problems and rushed to return borrowed securities and get back their collateral. Because AIG was unable to cover its obligations to both its securities lending and derivatives operations, it ultimately had to seek Federal assistance. In total, AIG's life insurance companies suffered approximately $21 billion in losses related to securities lending in 2008. More than $20 billion dollars in Federal assistance has been used to recapitalize the State-regulated insurance companies to ensure that they are able to pay their policyholders' claims. In addition, the Federal Reserve had to establish a special facility to help unwind AIG's securities lending program. I am submitting for the record a document from AIG that shows the losses from securities lending suffered by each AIG subsidiary that participated in AIG's securities lending program and the impact those losses had on its statutory capital. (See Exhibit A, below.) The causes of AIG's collapse raise profound questions about the adequacy of our existing State and Federal financial regulatory regimes. With respect to AIG's derivatives operations, the Office of Thrift Supervision was AIG's holding company regulator. It appears, however, that the OTS was not adequately aware of the risks presented by the company's credit default swap positions. Since AIG's Financial Products subsidiary had operations in London and Hong Kong, as well as in the U.S., it is unclear whether the OTS even had the authority to oversee all of AIG's operations. It is also unclear whether OTS had the expertise necessary to properly supervise what was primarily an insurance company. According to the National Association of Insurance Commissioners, a life insurance company may participate in securities lending only after it obtains the approval of its State insurance regulator. If so, why did State insurance regulators allow AIG to invest such a high percentage of the collateral from its securities lending program in longer-term mortgage-backed securities? Also, how did insurance regulators coordinate their oversight of AIG's securities lending since it involved life insurers regulated by at least five different States? While I hope we can get answers to these and many other questions today, I believe we are just beginning to scratch the surface of what is an incredibly complex and, on many levels, a very disturbing story of malfeasance, incompetence, and greed. Thank you, Mr. Chairman. CHRG-111shrg56376--79 Mr. Bowman," Correct. Senator Reed. And the company that did the bulk of the subprime was a California-regulated mortgage entity. " CHRG-111shrg57322--816 Mr. Broderick," These would have been clients from whom we buy mortgage product, subprime---- Senator Coburn. And then packaged and--OK. " FOMC20070628meeting--73 71,VICE CHAIRMAN GEITHNER.," But to make sure that is right, the red lines are subprime?" CHRG-111shrg54675--28 Chairman Johnson," Thank you. A question for Mr. Hopkins, Mr. Michael, Mr. Johnson, and Mr. Templeton. Mr. Skillern's testimony said that in North Carolina there is a higher percentage of subprime mortgages in rural areas than urban areas although the actual volume is lower. Do you find that this is true in the areas your institutions serve? Are you finding that those homeowners with subprime mortgages in your areas are underwater? Are existing loan modification programs useful to you in helping these homeowners? Mr. Hopkins. " CHRG-111shrg57319--13 Mr. Vanasek," Yes, I agree. Senator Levin. Now, take a look, if you all would, at Exhibit 1c.\1\ This is based on WaMu data, and it shows the Long Beach and WaMu securitizations of subprime loans. In 6 years, starting from 2000 all the way through 2006, the securitization of subprime home loans went from $2.5 billion all the way up to $29 billion. And then in 2007, the number dropped dramatically, not because Long Beach decided to stop securitizing loans, but because by September of that year, investors had stopped buying subprime mortgage-backed securities. The credit rating agencies had started to downgrade those securities in July, and the market froze at that point.--------------------------------------------------------------------------- \1\ See Exhibit No. 1c, which appears in the Appendix on page 214.--------------------------------------------------------------------------- Mr. Vanasek and Mr. Cathcart, did either of you become involved with managing the risks associated with securitization at Long Beach? " FinancialCrisisReport--161 IV. REGULATORY FAILURE: CASE STUDY OF THE OFFICE OF THRIFT SUPERVISION Washington Mutual Bank (WaMu), with more than $300 billion in assets, $188 billion in deposits, over 2,300 branches in 15 states, and 43,000 employees, was by late 2008 the largest thrift under the supervision of the Office of Thrift Supervision (OTS) and among the eight largest financial institutions insured by the Federal Deposit Insurance Corporation (FDIC). The bank’s collapse in September 2008 came on the heels of the Lehman Brothers bankruptcy filing, accelerating the unraveling of the financial markets. WaMu’s collapse marked one of the most spectacular failures of federal bank regulators in recent history. In 2007, many of WaMu’s home loans, especially those with the highest risk profile, began experiencing increased rates of delinquency, default, and loss. After the subprime mortgage backed securities market collapsed in September 2007, Washington Mutual was unable to sell or securitize subprime loans and its loan portfolio began falling in value. By the fourth quarter of 2007, the bank recorded a loss of $1 billion, and then in the first half of 2008, WaMu lost $4.2 billion more. WaMu’s stock price plummeted against the backdrop of these losses and a worsening financial crisis elsewhere on Wall Street, which was witnessing the forced sales of Countrywide Financial Corporation and Bear Stearns, the government takeover of IndyMac, Fannie Mae and Freddie Mac, the bankruptcy of Lehman Brothers, the taxpayer bailout of AIG, and the conversion of Goldman Sachs and Morgan Stanley into bank holding companies. From 2007 to 2008, WaMu’s depositors withdrew a total of over $26 billion in deposits from the bank, triggering a liquidity crisis. On September 25, 2008, OTS placed Washington Mutual Bank into receivership, and the FDIC, as receiver, immediately sold it to JPMorgan Chase for $1.9 billion. Had the sale not gone through, Washington Mutual’s failure could have exhausted the FDIC’s entire $45 billion Deposit Insurance Fund. OTS records show that, during the five years prior to its collapse, OTS examiners repeatedly identified significant problems with Washington Mutual’s lending practices, risk management, and asset quality, and requested corrective action. Year after year, WaMu promised to correct the identified problems, but failed to do so. OTS, in turn, failed to respond with meaningful enforcement action, choosing instead to continue giving the bank inflated ratings for safety and soundness. Until shortly before the thrift’s failure in 2008, OTS regularly gave WaMu a CAMELS rating of “2” out of “5,” which signaled to the bank and other regulators that WaMu was fundamentally sound. Federal bank regulators are charged with ensuring that U.S. financial institutions operate in a safe and sound manner. However, in the years leading up to the financial crisis, OTS failed to prevent Washington Mutual’s increasing use of high risk lending practices and its origination and sale of tens of billions of dollars in poor quality home loans. The agency’s failure to adequately monitor and regulate WaMu’s high risk lending stemmed in part from an OTS regulatory culture that viewed its thrifts as “constituents,” relied on them to correct the problems identified by OTS 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. 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 were corrected, with little need for tough enforcement actions. It was a regulatory approach with disastrous results. CHRG-110hhrg38392--169 Mr. Bernanke," Well, on the first part of your comments, there are many issues that affect a consumer's budget: energy; health care; a whole variety of items. Each one of these things is a big and complex problem. There is not a single solution. We are just going to have to address them piece by piece. So we talked about energy, we talked about health care, we talked about other aspects of the cost of living. Let me turn, though, to your very good question about subprime. First, there always have been some concerns about these practices; you are correct about that. But there was a period that lasted perhaps less than a year--late 2005, early 2006--when there was just a tremendous sea change, a deterioration in underwriting and its standards. That came about because of the confluence of a number of different events, including this huge demand for high-yield mortgage securities from Wall Street, the expansion of lenders outside the banking system where they are closely regulated, financial innovation, new kinds of products. An important factor was the fact that with high house prices, people were stretching for affordability. All those things came together at the same time and underwriting standards really deteriorated pretty quickly. And we have seen that of mortgages written in 2006, with many of them the first payment doesn't get made; they get returned within a few months. So, something seems to have changed in late 2005 and early 2006. We were very active early on in providing guidance on best practices, on doing disclosure work, on doing fair lending reviews and so on. But it is clear, having seen some of these recent developments and asking my staff to do a top-to-bottom review, it does seem clear we need to take additional steps, which I have talked about today, and they include not just disclosure, but the rules. And among the rules we are considering are addressing low doc loans, escrow, some of these other prepayment penalties, and some of these other things you have mentioned. Some of these things have already appeared in our subprime mortgage guidance, which a lot of the States have adopted for their own, so a lot of these things are going to be put in place more quickly. But in terms of the rulemaking process, there are obviously some procedural steps that we have to take. We have to go through a full process of getting commentary and the like, and we can't go faster than that. Ms. Waters. Do you have any suggestions for legislation for us? We would move it a little bit faster if we understood it a little bit better and knew what to do. " FinancialCrisisInquiry--303 WALLISON: Back to you, Mr. Blankfein. When was Goldman, in your knowledge, first alerted to the fact that there was serious problems with subprime mortgages? CHRG-110shrg46629--88 Chairman Bernanke," It is a consideration. As you pointed out initially, I am not taking a position on this. Senator Schumer. I understand. I am just asking your economic views of these things and I appreciate it. Next, I would like to go to subprimes. Basically, you mentioned today that direct Federal legislation would help speed up the Fed's efforts to fix the problems in the subprime industry. As you know, Senators Brown, Casey, and I have introduced proposed legislation that would specifically regulate the mortgage broker industry. Our bill would establish a fiduciary duty and good faith stands for mortgage brokers and other nonbank originators and require originators to underwrite loans at the fully indexed rate, prohibit steering, among other things. First, could you give us your thoughts--I am not asking you to endorse the specific bill--but on those concepts and whether it makes sense? And are these types of proposals some that would help the Fed's efforts to regulate the subprime mortgage broker industry? " FinancialCrisisReport--409 At the end of February, Goldman’s controllers prepared a summary of the changes in Goldman’s RMBS and whole loan inventory since December 2006, and reported: “Residential Credit Loans: The overall loans inventory decreased from $11bn to $7bn. ... subprime loans decreased from $6.3bn to $1.5bn, Second Liens decreased from $1.5bn to $0.7bn and S&D [scratch and dent] Loans remained unchanged at $0.8bn.” 1655 This analysis indicates that, in less than three months, Goldman had reduced its subprime loan inventory by over two-thirds, and its second lien inventory by half. The Mortgage Department reduced its inventory, not only by selling assets outright, but also by reducing its purchase of whole loans and securitization efforts. In March 2007, Goldman informed its Board of Directors and the SEC that it had stopped purchasing subprime loans and RMBS securities through, in its words, the use of “conservative bids.” 1656 While those presentations did not explain the phrase “conservative bids,” an email to Goldman’s Chief Credit Officer, Craig Broderick, discussing a March 2007 presentation to Goldman’s Audit Committee about the subprime mortgage business, was much more explicit: “Just fyi not for the memo, my understanding is that the desk is no longer buying subprime. (We are low balling on bids).” 1657 Still another method to reduce its loan inventory was an ongoing effort by the Mortgage Department to return defaulted or fraudulent loans to the lenders from which it had purchased them. On April 23, 2007, Mr. Gasvoda reported to Messrs. Montag and Sparks a dramatic reduction in Goldman’s inventory of subprime loans and RMBS securities: “[W]e have $180mm in loans (unsecuritized) and $255mm of residuals off old deals. The $180mm of loans is the smallest we’ve been since we started the business in 2002. We had been running at an average loan position balance in subprime of around $4B . ... The $255mm we have retained is from deals dating back to 2002 and while we’ve developed some buying partners, it is not a deep market. These have been intentional principal retained positions.” 1658 1655 2/23/2007 “Significant Cash Inventory Change (Q1 ’07 vs. Q4 ’06),” prepared by Goldman, GS MBS-E- 010037310, Hearing Exhibit 4/27-12. “Scratch and dent” loans are loans that are not performing. 1656 3/26/2007 Goldman presentation to Board of Directors, “Subprime Mortgage Business,” GS MBS-E- 005565527, Hearing Exhibit 4/27-22 ; 3/14/2007 Goldman Presentation to SEC, “Subprime Mortgage Business 14- Mar-2007,” at 7, GS MBS-E-010022328. 1657 3/2/2007 email from Patrick W elch to Craig Broderick, “Audit Committee Package_Feb 21_Draft_M ortgage_Page.ppt, ” GS MBS-E-009986805, Hearing Exhibit 4/27-63. In the context of assets offered by a customer to the Correlation Desk, it appears that Mr. Egol also may have returned an unappealing bid: “Many of these assets are garbage. I told her should would not like the level [the price bid by Goldman] .... ” 2/26/2007 email from Jon Egol, “Portfolio for Proposed Transaction 070226 (2).xls, ” GS MBS-E-002631719. 1658 4/22/2007 email from Kevin Gasvoda, “Resi credit QTD/YTD P&L and positions,” GS MBS-E-010474983. CHRG-111hhrg74090--46 CONGRESS FROM THE STATE OF FLORIDA Ms. Castor. Thank you, Chairman Rush, for calling this critically important hearing on the Obama Administration's proposal for a Consumer Financial Protection Agency. Last Congress, in the wake of widespread concerns about toxic lead in paint on children's toys and other toxic consumer products, this subcommittee originated legislation to reorganize and strength the Consumer Product Safety Commission, and last year as the economy plunged, there were some analogous terms being used to describe some of the mortgage and investment products. We heard about toxic assets, poisoning banks balance sheets and toxic mortgage products, leaving millions of our neighbors facing foreclosure. Predatory lenders wreaked havoc on my community and the subsequent significant decline in property values has affected millions of folks in my home State, and unfortunately consumers could not count on State oversight of these mortgage brokers. In my home State, they just turned a blind eye and I recommend the Miami Herald expose that documented how many convicted felons entered into the subprime mortgage loan marketing business. So this financial crisis has taught us that in order to maintain a healthy economy, effective regulation must focus on protecting consumers from abusive, deceptive and unfair lending practices. The FTC has the enforcement authority to go after only non-depository lending institutions that deal unfairly with their borrowers but the abuses that led to the financial crisis spread deep into the banking system. So in light of the need for more-effective regulation of all lending institutions, depository and non-depository, the Obama Administration has rightly proposed a reorganization, and I think all of us can agree that regulation of financial institutions must be improved to better protect consumers. However, we must be aware not only of the impact of granting authority to a new Consumer Financial Protection Agency but also the consequences to consumers of the changes that have been proposed to the FTC. The Administration's proposal would reshape the FTC by shifting authority over consumer credit but also by streamlining its rulemaking process and allowing it to assess civil penalties on bad actors. So I look forward to your testimony on what this new FTC might look like and how its ability to achieve its mandate of consumer protection will be affected. I yield back. " FinancialCrisisReport--59 In 2006, WaMu took several major actions that reduced the size of its Home Loans Group. It sold $140 billion in mortgage servicing rights to Wells Fargo; sold a $22 billion portfolio of home loans and other securities; and reduced its workforce significantly. 129 In July 2007, after the Bear Stearns hedge funds collapsed and the credit rating agencies downgraded the ratings of hundreds of mortgaged backed securities, including over 40 Long Beach securities, the secondary market for subprime loans dried up. In September 2007, due to the difficulty of finding investors willing to purchase subprime loans or mortgage backed securities, Washington Mutual discontinued its subprime lending. It also became increasingly difficult for Washington Mutual to sell other types of high risk loans and related mortgage backed securities, including its Option ARMs and home equity products. Instead, WaMu retained these loans in its portfolios. By the end of the year, as the value of its loans and mortgage backed securities continued to drop, Washington Mutual began to incur significant losses, reporting a $1 billion loss in the fourth quarter of 2007, and another $1 billion loss in the first quarter of 2008. In February 2008, based upon increasing deterioration in the bank’s asset quality, earnings, and liquidity, OTS and the FDIC lowered the bank’s safety and soundness rating to a 3 on a scale of 1 to 5, signaling it was a troubled institution. 130 In March 2008, at the request of OTS and the FDIC, Washington Mutual allowed several potential buyers of the bank to review its financial information. 131 JPMorgan Chase followed with a purchase offer that WaMu declined. 132 Instead, in April 2008, Washington Mutual’s parent holding company raised $7 billion in new capital and provided $3 billion of those funds to the bank. 133 By June, the bank had shut down its wholesale lending channel. 134 It also closed over 180 loan centers and terminated 3,000 employees. 135 In addition, WaMu reduced its dividend to shareholders. 136 In July 2008, a $30 billion subprime mortgage lender, IndyMac, failed and was placed into receivership by the government. In response, depositors became concerned about Washington Mutual and withdrew over $10 billion in deposits, putting pressure on the bank’s liquidity. After the bank disclosed a $3.2 billion loss for the second quarter, its stock price continued to drop, and more deposits left. 129 Subcommittee interview of Steve Rotella (2/24/2010). See also 3/1/2007 Washington Mutual Inc. 10-K filing with the SEC, at 1 (Washington Mutual reduced its workforce from 60,789 to 49,824 from December 31, 2005 to December 31, 2006.); “Washington Mutual to cut 2,500 jobs,” MarketWatch (2/15/2006), available at http://www.marketwatch.com/story/washington-mutual-cutting-2500-mortgage-jobs. 130 See 2/27/2008 letter from Kerry Killinger to Washington Mutual Board of Directors, Hearing Exhibit 4/16-41. 131 Subcommittee interviews of WaMu Chief Financial Officer Tom Casey (2/20/2010); and OTS West Region Office Director Darrel Dochow (3/3/2010); 4/2010 “Washington Mutual Regulators Timeline,” prepared by the Subcommittee, Hearing Exhibit 4/16-1j. 132 Subcommittee interview of Tom Casey (2/20/2010). 133 4/2010 “Washington Mutual Regulators Timeline,” prepared by the Subcommittee, Hearing Exhibit 4/16-1j. 134 See 2/27/2008 letter from Kerry Killinger to Washington Mutual Board of Directors, Hearing Exhibit 4/16-41. 135 “Washington Mutual to Take Writedown, Slash Dividend,” Bloomberg (12/10/2007), available at http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aNUz6NmbYZCQ. 136 Id. CHRG-111hhrg52406--181 Mr. Yingling," I don't know about the word profitability, particularly with respect to banks. I think that there were severe, terrible problems in the subprime lending market. In the President's proposal, it points out that 94 percent of that took place outside the traditional regulated banking market. There were terrible problems with mortgage brokers who were giving loans to people that never should have been made. There were problems with the fact that those loans went over the banking system to Wall Street where they were given AAA. Mr. Miller of North Carolina. My time is about to expire, and I haven't really gotten much on that. But the second question, there have been several mentions of protecting consumer choice. And I am very perplexed at what consumers appeared to have chosen in financial products in the last few years. Can you get me the names of some consumers that I can talk to who would explain why they chose a double cycle billing for credit card transactions, or consumers who qualified for a prime mortgage but instead asked for a mortgage that had an initial rate that started at about prime; after 2 or 3 years, the rate adjusted, their monthly payment went up 30 to 50 percent, and they had a prepayment penalty? Could you give me the names of consumers who went into one of your member institutions and asked for those products, so I could somehow fathom how they made those choices? " fcic_final_report_full--474 Of course, in the early 2000s there was no generally understood definition of the term “subprime,” so Fannie and Freddie could define it as they liked, and the assumption that the GSEs only made prime loans continued to be supported by their public disclosures. So when Fannie and Freddie reported their loan acquisitions to various mortgage information aggregators they did not report those mortgages as subprime or Alt-A, and the aggregators continued to follow industry practice by placing virtually all the GSEs’ loans in the “prime” category. Without understanding Fannie and Freddie’s peculiar and self-serving loan classification methods, the recipients of information about the GSEs’ mortgage positions simply seemed to assume that all these mortgages were prime loans, as they had always been in the past, and added them to the number of prime loans outstanding. Accordingly, by 2008 there were approximately 12 million more NTMs in the financial system—and 12 million fewer prime loans—than most market participants realized. Appendix 1 shows that the levels of delinquency and default would be 86 percent higher than expected if there were 12 million NTMs in the financial system instead of 12 million prime loans. Appendix 2 shows that the levels of delinquency would be 150 percent higher than expected if the feedback effect of mortgage delinquencies—causing lower housing prices, in a downward spiral—were taken into account. These differences in projected losses could have misled the rating agencies into believing that, even if the bubble were to deflate, the losses on mortgage failures would not be so substantial as to have a more than local effect and would not adversely affect the AAA tranches in MBS securitizations. The Commission never looked into this issue, or attempted to determine what market participants believed to be the number of subprime and other NTMs outstanding in the system immediately before the financial crisis. Whenever possible in the Commission’s public hearings, I asked analysts and other market participants how many NTMs they believed were outstanding before the financial crisis occurred. It was clear from the responses that none of the witnesses had ever considered that question, and it appeared that none suspected that the number was large enough to substantially affect losses after the collapse of the bubble. It was only on November 10, 2008, after Fannie had been taken over by the federal government, that the company admitted in its 10-Q report for the third quarter of 2008 that it had classified as subprime or Alt-A loans only those loans that it purchased from self-denominated subprime or Alt-A originators, and not loans that were subprime or Alt-A because of their risk characteristics. Even then Fannie wasn’t fully candid. After describing its classification criteria, Fannie stated, “[H]owever, we have other loans with some features that are similar to Alt-A and subprime loans that we have not classified as Alt-A or subprime because they do not meet our classification criteria.” 43 This hardly described the true nature of Fannie’s obligations. On the issue of the number of NTMs outstanding before the crisis the Commission studiously averted its eyes, and the Commission majority’s report 43 Fannie Mae, 2008 3rd quarter 10-Q. p.115, http://www.fanniemae.com/ir/pdf/earnings/2008/q32008. pdf. 469 never addresses the question. HUD’s role in pressing for a reduction in mortgage underwriting standards escaped the FCIC’s attention entirely, the GSEs’ AH goals are mentioned only in passing, CRA is defended, and neither HUD’s Best Practices Initiative nor FHA’s activities are mentioned at all. No reason is advanced for the accumulation of subprime loans in the bubble other than the idea—implicit in the majority’s report—that it was profitable. In sum, the majority’s report is Hamlet without the prince of Denmark. fcic_final_report_full--137 As the scandals unfolded, subprime private label mortgage–backed securities (PLS) issued by Wall Street increased from  billion in  to  billion in  (shown in figure .); the value of Alt-A mortgage–backed securities increased from  billion to  billion. Starting in  for Freddie and  for Fannie, the GSEs—particularly Freddie—became buyers in this market. While private investors always bought the most, the GSEs purchased . of the private-issued subprime mortgage–backed securities in . The share peaked at  in  and then fell back to  in . The share for Alt-A mortgage–backed securities was always lower.  The GSEs almost always bought the safest, triple-A-rated tranches. From  through , the GSEs’ purchases declined, both in dollar amount and as a percentage. These investments were profitable at first, but as delinquencies increased in  and , both GSEs began to take significant losses on their private-label mortgage– backed securities—disproportionately from their purchases of Alt-A securities. By the third quarter of , total impairments on securities totaled  billion at the two companies—enough to wipe out nearly  of their pre-crisis capital.  OFHEO knew about the GSEs’ purchases of subprime and Alt-A mortgage– backed securities. In its  examination, the regulator noted Freddie’s purchases of these securities. It also noted that Freddie was purchasing whole mortgages with “higher risk attributes which exceeded the Enterprise’s modeling and costing capabil- ities,” including “No Income/No Asset loans” that introduced “considerable risk.” OFHEO reported that mortgage insurers were already seeing abuses with these loans.  But the regulator concluded that the purchases of mortgage-backed securi- ties and riskier mortgages were not a “significant supervisory concern,” and the ex- amination focused more on Freddie’s efforts to address accounting and internal deficiencies.  OFHEO included nothing in Fannie’s report about its purchases of subprime and Alt-A mortgage–backed securities, and its credit risk management was deemed satisfactory.  The reasons for the GSEs’ purchases of subprime and Alt-A mortgage–backed se- curities have been debated. Some observers, including Alan Greenspan, have linked the GSEs’ purchases of private mortgage–backed securities to their push to fulfill their higher goals for affordable housing. The former Fed chairman wrote in a working pa- per submitted as part of his testimony to the FCIC that when the GSEs were pressed to “expand ‘affordable housing commitments,’ they chose to meet them by investing heavily in subprime securities.”  Using data provided by Fannie Mae and Freddie Mac, the FCIC examined how single-family, multifamily, and securities purchases contributed to meeting the affordable housing goals. In  and , Fannie Mae’s single- and multifamily purchases alone met each of the goals; in other words, the en- terprise would have met its obligations without buying subprime or Alt-A mortgage– backed securities. In fact, none of Fannie Mae’s  purchases of subprime or Alt-A securities were ever submitted to HUD to be counted toward the goals. Before ,  or less of the GSEs’ loan purchases had to satisfy the affordable housing goals. In  the goals were increased above ; but even then, single- and multifamily purchases alone met the overall goals.  Securities purchases did, in CHRG-111shrg52966--64 Mr. Sirri," I am not sure I can cite a public action, something that has happened and been closed. I will cite something that is public. I do not know the current list, but a number of months ago we stated how many cases we had in progress on matters related to subprime mortgages. Now subprime mortgages run the gamut, the cases from issues about origination through issues related to other things within large firms. It would not surprise me, and it may be possible, I honestly do not know, that there might be something related in there. But I truly do not know. And even if I did, I should not comment. Senator Reed. Mr. Polakoff? " fcic_final_report_full--461 Bankers Association eventually adhered. As shown later, this program was explicitly intended to encourage a reduction in underwriting standards so as to increase access by low income borrowers to mortgage credit. Countrywide was by far the largest member of this group and by the early 2000s was also competing, along with others, for the same NTMs sought by Fannie and Freddie, FHA, and the banks under the CRA . With all these entities seeking the same loans, it was not likely that all of them would find enough borrowers who could meet the traditional mortgage lending standards that Fannie and Freddie had established. It also created ideal conditions for a decline in underwriting standards, since every one of these competing entities was seeking NTMs not for purposes of profit but in order to meet an obligation imposed by the government. The obvious way to meet this obligation was simply to reduce the underwriting standards that impeded compliance with the government’s requirements. Indeed, by the early 1990s, traditional underwriting standards had come to be seen as an obstacle to home ownership by LMI families. In a 1991 Senate Banking Committee hearing, Gail Cincotta, a highly respected supporter of low-income lending, observed that “Lenders will respond to the most conservative standards unless [Fannie Mae and Freddie Mac] are aggressive and convincing in their efforts to expand historically narrow underwriting.” 13 In this light, it appears that Congress set out deliberately in the GSE Act not only to change the culture of the GSEs, but also to set up a mechanism that would reduce traditional underwriting standards over time, so that home ownership would be more accessible to LMI borrowers. For example, the legislation directed the GSEs to study “The implications of implementing underwriting standards that—(A) establish a downpayment requirement for mortgagors of 5 percent or less; 14 (B) allow the use of cash on hand as a source of downpayments; and (C) approve borrowers who have a credit history of delinquencies if the borrower can demonstrate a satisfactory credit history for at least the 12-month period ending on the date of the application for the mortgage.” 15 None of these elements was part of traditional mortgage underwriting standards as understood at the time. I have been unable to find any studies by Fannie or Freddie in response to this congressional direction, but HUD treated these cues as a mandate to use the AH goals as a mechanism for eroding the traditional standards. HUD was very explicit about this, as shown in Part II. In the end, the goal was accomplished by gradually expanding the requirements and enlarging the AH goals over succeeding years, so that the only way Fannie and Freddie could meet the AH goals was by purchasing increasing numbers of subprime and Alt-A mortgages, and particularly mortgages with low or no downpayments. Because the GSEs were the dominant players in the mortgage market, their purchases also put competitive pressure on the other entities that were subject to government control—FHA and the banks 13 Allen Fishbein, “Filling the Half-Empty Glass: The Role of Community Advocacy in Redefining the Public Responsibilities of Government-Sponsored Housing Enterprises”, Chapter 7 of Organizing Access to Capital: Advocacy and the Democratization of Financial Institutions , 2003, Gregory Squires, editor. 14 At that time the GSEs’ minimum downpayment was 5 percent, and was accompanied by conservative underwriting. The congressional request was to break through that limitation. 15 GSE Act, Section 1354(a). under CRA—to reach deeper into subprime lending in order to find the mortgages they needed to comply with their own government requirements. This was also true of the mortgage banks—the largest of which was Countrywide—that were bound to promote affordable housing through HUD’s Best Practices Initiative. FinancialCrisisInquiry--817 WALLISON: Have you seen the disclosure of Fannie and Freddie in their 10-Q for 2008 where they said how they had defined subprime loans? FinancialCrisisInquiry--204 Yes, yes, we’ll do that. But let me—let me add on, too, that you need to be well aware that the subprime crisis was brought – the products were brought to Citicorp when it was acquired by Sandy Weil, who was a -- who had become very big in commercial credit. And so they developed it. And a lot of the people that were unregulated were mules for the larger Wall Street firms that were pushing these products. But we will get you some data. We appreciate it. CHAIRMAN ANGELIDES: All right. Thank you very much. Ms. Murren? Oh, Mr. Vice Chair—oh, gosh, I’m in trouble now. VICE CHAIRMAN THOMAS: Ms. Gordon, in terms of your Center for Responsible Lending, do you deal with folks with credit cards as well? GORDON: We do work on credit—credit card issues. VICE CHAIRMAN THOMAS: Have you run any comparisons in terms of those who got upside down on their homes versus also in significant debt with a credit cards? Is there a correlation there? GORDON: We haven’t run any data like that. One of the things that’s most difficult about the mortgage work that we do is that data is so hard to come by. There’s some data that we get through the Home Mortgage Disclosure Act on the higher- cost loans, and then we do purchase some proprietary databases to work with. But for the most part, it’s very hard to get loan level data that could then be matched with, you know, consumer-to-consumer or bucket-to-bucket. fcic_final_report_full--478 When the housing bubble began to deflate in mid-2007, delinquency rates among NTMs began to increase substantially. Previously, although these mortgages were weak and high risk, their delinquency rates were relatively low. This was a consequence of the bubble itself, which inflated housing prices so that homes could be sold with no loss in cases where borrowers could not meet their mortgage obligations. Alternatively, rising housing prices—coupled with liberal appraisal rules—created a form of free equity in a home, allowing the home to be refinanced easily, perhaps even at a lower interest rate. However, rising housing prices eventually reached the point where even easy credit terms could no longer keep the good times rolling, and at that point the bubble flattened and weak mortgages became exposed for what they were. As Warren Buffett has said, when the tide goes out, you can see who’s swimming naked. The role of the government’s housing policy is crucial at this point. As discussed earlier, if the government had not been directing money into the mortgage markets in order to foster growth in home ownership, NTMs in the bubble would have begun to default relatively soon after they were originated. The continuous inflow of government or government-backed funds, however, kept the bubble growing—not only in size but over time—and this tended to suppress the significant delinquencies and defaults that had brought previous bubbles to an end in only three or four years. That explains why PMBS based on NTMs could become so numerous and so risky without triggering the delinquencies and defaults that caused earlier bubbles to deflate within a shorter period. With losses few and time to continue originations, Countrywide and others were able to securitize subprime PMBS in increasingly large amounts from 2002 ($134 billion) to 2006 ($483 billion) without engendering the substantial increase in delinquencies that would ordinarily have alarmed investors and brought the bubble to a halt. 46 Indeed, the absence of delinquencies had the opposite effect. As investors around the world saw housing prices rise in the U.S. without any significant losses even among subprime and other high-yielding loans, they were encouraged to buy PMBS that—although rated AAA—still offered attractive yields. In other words, as shown in Figure 2, government housing policies—AH goals imposed on the GSEs, the decline in FHA lending standards, HUD’s pressure for reduced underwriting standards among mortgage bankers, and CRA requirements for insured banks— by encouraging the growth of the bubble, increased the worldwide demand for subprime PMBS. Then, in mid-2007, the bubble began to deflate, with catastrophic consequences. 46 Inside Mortgage Finance, The 2009 Mortgage Market Statistical Annual—Volume II , MBS database. 473 2. The Defaults Begin CHRG-111hhrg52406--10 Mr. Royce," Thank you, Mr. Chairman. Well, beyond the problems with bifurcating consumer protection and solvency protection, a fundamental question remains. And that is, would a consumer financial products agency have stopped the issuance of subprime mortgages to consumers or Alt-A mortgages to consumers? I think it is fair to say the regulators we had in place, many of whom were responsible for consumer protection, were assisting in rather than hindering the proliferation of these subprime products, the proliferation of what are now called ``liar loans.'' In fact, it was because of regulators in Congress that these various products came into existence and thrived in the manner that they did. Subprime mortgages came out of CRA regulations, according to a former Fed official. And Fannie Mae and Freddie Mac purchased subprime and Alt-A loans to meet their affordable housing goals set by their regulators and by Congress. They lost $1 trillion doing that. The consumers frequently lost their homes as a result of the collapse of the boom and bust that was thus created. Instead of adding another government agency, and unwisely separating solvency protection from consumer protection, we should take a step back and look at the artificial mandates we place on financial institutions that inevitably distort the market which ends up in the long-term walloping the consumer and creating the kind of housing problem that we have today. Thank you, and I yield back, Mr. Chairman. " CHRG-110hhrg46593--195 Mr. Yingling," Thank you, sir. I appreciate the opportunity to testify on the current status of the Troubled Asset Relief Program. The TARP program has served to calm financial markets and does have promise to promote renewed economic growth. However, it is also a source of great frustration and uncertainty to banks. Much of the frustration and uncertainty is because of the numerous significant changes to the program and the misperceptions that have resulted on the part of the press and the public. Hopefully, this hearing will help clarify the situation. ABA greatly appreciates the consistent statements by members of this committee, and particularly its leadership, that regulated banks were not the cause of the problem and have generally performed well. Not only did regulated banks not cause the problem, they are the primary solution to the problem, as both regulation and markets move toward the bank model. Thousands of banks across the country did not make toxic subprime loans, are strongly capitalized, and are lending. As you know, TARP started out focused on asset purchases. But then after European countries announced they were putting capital in undercapitalized banks, everything changed. Overnight, nine banks were called to Washington and requested to take capital injections. As this program was extended beyond the first nine to other banks, it was not initially clear that the program was to focus on healthy banks and its purpose was to promote lending. ABA was extremely frustrated with the lack of clarity, and we wrote to Secretary Paulson asking for clarification. The press, the public, Members of Congress, and banks themselves were initially confused. Many people understandably did not differentiate between this voluntary program for a solid institution and bailouts. Bankers, for a few days, were not sure of the purpose, although they were sure their regulators were making it clear it was a good idea to take the capital. Put yourself in the place of a community banker. You are strongly capitalized and profitable. Your regulator is calling you to suggest taking TARP capital is a good idea. You, the banker, can see that it might be put to good purposes in terms of increasing lending, but you have many questions about what will be a decision that will dramatically affect the future of your bank, questions like, what will my customers think? What will the markets think? What restrictions might be added ? Despite the uncertainty, banks are signing up. In my written testimony, I have provided examples of how different banks can use the capital in ways to promote lending. One aspect of the program that needs to be addressed further is the fact that it is still unavailable to many banks. Last night, the Treasury did offer a term sheet for private corporations, and we greatly appreciated that. However, term sheets for many banks, including S corporations and mutual institutions, have not been issued. This is unfair to these banks, and it undermines the effectiveness of the program. In my written testimony, I have discussed the fact that while TARP is designed to increase bank capital and lending, other programs are actually in conflict and are actually reducing capital and lending. In that regard, I once again call to the attention of the committee the dramatic effect of current accounting policies which continue unnecessarily to eat up billions of dollars in capital by not understanding the impact of mark-to-market and dysfunctional markets. Finally, in our written testimony, ABA also supports efforts to address foreclosures and housing. We have proposed a four-point plan: First, greater efforts to address foreclosures; second, efforts to address the problems caused by securitization of mortgages that you have championed, Mr. Kanjorski; third, the need to lower mortgage interest rates, which are not following normal patterns; and fourth, tax incentives for purchasing homes. Thank you. [The prepared statement of Mr. Yingling can be found on page 194 of the appendix.] " CHRG-110shrg46629--27 Chairman Dodd," That is right. Senator Shelby. So, I will move on to some other things. Subprime problems. The subprime problems are real, not just in New Jersey and Ohio but in Alabama and everywhere else. There has been a huge expansion, Mr. Chairman, as you know, of structured financial products. We call what, collateralized debt obligations backed by subprime debt. In concept these projects involve converting highly risky loans, as I understand it, into a collection of securities that have a range of risk from AAA to junk. The rating agencies provide the AAA ratings based on the idea that the structure of the products satisfactorily dissipates or spreads the risks associated with the underlying prime loan. That is the basis of that. But it appears that is not always working. It appears that many of the assumptions here regarding these structured products, collateralized, have significantly underestimated the true risk. We have seen what the rating agencies, it has been talked about, at least Senator Menendez and also Senator Brown brought it up. We have seen S&P--and I believe Senator Reed. We have seen S&P and Moody's already downgrading the debt that they invited as AAA. How did they get to the point to rate a lot of these collateralized obligations AAA grade with so much underlying junk you might say? You cannot make gold out of lead. We know that. That has been tried. Does all of this deeply concern you, how this came about to begin with? Because I think the subprime not only has deep repercussions when a lot of people, our constituents that have been victimized I think to some extent by this. But a lot of it has been brought about by very ingenious financial people. And then looks like the rating agencies fell right in line with them, knowing that this is not really AAA stuff. This is questionable stuff. Now it is coming home to roost. And, as someone else said earlier here, a lot of those loans are going to be reset not downward but upward. Senator Dodd is very much out front on this, and should be as the Chairman of this Committee. And we are deeply concerned that the subprime problem is not going to just be contained so easily but could deeply spread and have some repercussions out there. What do you think? " CHRG-110shrg50409--24 Mr. Bernanke," Well, first, of course, I would like to revise and extend my remarks from March of 2007. The issue was that the subprime crisis triggered a much broader retreat from credit and risk taking, which has affected not just subprime lending but a wide variety of credit instruments. And that is why it has become a much bigger element in the situation than, frankly, I anticipated at that time. The housing market is still under considerable stress and construction is still declining. I do believe that we will start to see stabilization in the construction of new homes sometime later this year or the beginning of next year, and that will be a benefit because the slowing construction pattern has been subtracting about 1 percentage point from the growth of the GDP going back now for some time. So that will be a benefit. House prices may continue to fall longer than that because of the large inventories of unsold homes that we still face. And then I would have to say that there is uncertainty about exactly what the equilibrium level that house prices will reach is. Unfortunately, it is that uncertainty, which is generating a lot of the stress and risk aversion we are seeing in financial markets. It is for that reason--the need to find a footing, to find stability in the housing market--that I do think that action by this Congress to support the housing market through strengthening the GSEs and FHA and so on is of vital importance. Senator Menendez. Let me talk about the other major driver, then, of what is happening to our economy, and that is the whole question of energy prices and oil. You know, I appreciate in your answer to the Chairman and in your testimony, because we have had testimony before the Congress by all executives who say that the difference between supply and demand over the last 2 years would largely lead us to a concern that, in fact, speculation may have driven the price of oil up an additional $50 a barrel. You have the view that that may not be the most significant thing in prices, but you do take the view that useful steps can be taken to improve the transparency and functioning of future markets. Are you ready to say to the Committee today what some of those useful steps are? Or are you still depending upon that Committee that you are meeting with to look at that? Because we do not have a lot of time here. " CHRG-111shrg54789--177 FINANCIAL PROTECTION AGENCY It has become clear that a major cause of the most calamitous worldwide recession since the Great Depression was the simple failure of Federal regulators to stop abusive lending, particularly unsustainable home mortgage lending. Such action would not only have protected many families from serious financial harm but would likely have stopped or slowed the chain of events that has led to the current economic crisis. The idea of a Federal consumer protection agency focused on credit and payment products has gained broad and high-profile support because it targets the most significant underlying causes of the massive regulatory failures that occurred. First, Federal agencies did not make protecting consumers their top priority and, in fact, seemed to compete against each other to keep standards low, ignoring many festering problems that grew worse over time. If agencies did act to protect consumers (and they often did not), the process was cumbersome and time-consuming. As a result, agencies did not act to stop some abusive lending practices until it was too late. Finally, regulators were not truly independent of the influence of the financial institutions they regulated. Meanwhile, despite an unprecedented Government intervention in the financial sector, the passage of mortgage reform legislation in the House of Representatives and the enactment of a landmark law to prevent abusive credit card lending, problems with the sustainability of home mortgage and consumer loans keep getting worse. With an estimated 2 million households having already lost their homes to foreclosure because of the inability to repay unsound loans, Credit Suisse now predicts that foreclosures will exceed 8 million through 2012. \27\ The amount of revolving debt, most of which is credit card debt, is approaching $1 trillion. \28\ Based on the losses that credit card issuers are now reporting, delinquencies and defaults are expected to peak at their highest levels ever within the next year. \29\ One in two consumers who get payday loans default within the first year, and consumers who receive these loans are twice as likely to enter bankruptcy within 2 years as those who seek and are denied them. \30\ Overall, personal bankruptcies have increased sharply, up by one-third in the last year. \31\--------------------------------------------------------------------------- \27\ ``Foreclosures Could Top 8 million: Credit Suisse,'' 9 December 2008, MarketWatch, available at http://www.marketwatch.com/story/more-than-8-million-homes-face-foreclosure-in-next-4-years (last visited 21 June 2009). \28\ See the Federal Reserve statistical release G19, Consumer Credit, available at http://www.federalreserve.gov/releases/g19/ \29\ ``Fitch Inc. said it continues to see signs that the credit crunch will escalate into next year, and it said card chargeoffs may approach 10 percent by this time next year.'' ``Fitch Sees Chargeoffs Nearing 10 percent,'' Dow Jones, May 5, 2009. \30\ Paige Marta Skiba and Jeremy Tobacman, ``Payday Loans, Uncertainty, and Discounting: Explaining Patterns of Borrowing, Repayment, and Default,'' August 21, 2008. http://www.law.vanderbilt.edu/faculty/faculty-personal-sites/paige-skiba/publication/download.aspx?id=1636 and Paige Marta Skiba and Jeremy Tobacman, ``Do Payday Loans Cause Bankruptcy?'' October 10, 2008 http://www.law.vanderbilt.edu/faculty/faculty-personal-sites/paige-skiba/publication/download.aspx?id=2221 (last visited 21 June 2009). \31\ ``Bankruptcy Filings Continue to Rise'' Administrative Office of the U.S. Courts, news release, 8 June 2009, available at http://www.uscourts.gov/Press_Releases/2009/BankruptcyFilingsMar2009.cfm (last visited 21 June 2009).--------------------------------------------------------------------------- The failure of Federal banking agencies to stem subprime mortgage lending abuses is fairly well known. They did not use the regulatory authority granted to them to stop unfair and deceptive lending practices before the mortgage foreclosure crisis spun out of control. In fact, it wasn't until July of 2008 that these rules were finalized, close to a decade after analysts and experts started warning that predatory subprime mortgage lending would lead to a foreclosure epidemic. Less well known are Federal regulatory failures that have contributed to the extension of unsustainable consumer loans, such as credit card, overdraft and payday loans, which are now imposing a crushing financial burden on many families. As with problems in the mortgage lending market, failures to rein in abusive types of consumer loans were in areas where Federal regulators had existing authority to act, and either chose not to do so or acted too late to stem serious problems in the credit markets. Combining safety and soundness supervision--with its focus on bank profitability--in the same institution as consumer protection magnified an ideological predisposition or antiregulatory bias by Federal officials that led to unwillingness to rein in abusive lending before it triggered the housing and economic crises. Though we now know that consumer protection leads to effective safety and soundness, structural flaws in the Federal regulatory system compromised the independence of banking regulators, encouraged them to overlook, ignore, and minimize their mission to protect consumers. This created a dynamic in which regulatory agencies competed against each other to weaken standards and ultimately led to an oversight process that was cumbersome and ineffectual. These structural weaknesses threatened to undermine even the most diligent policies and intentions. They complicated enforcement and vitiated regulatory responsibility to the ultimate detriment of consumers. These structural flaws include: a narrow focus on ``safety and soundness'' regulation to the exclusion of consumer protection; the huge conflict-of-interest that some agencies have because they rely heavily on financial assessments on regulated institutions that can choose to pay another agency to regulate them; the balkanization of regulatory authority between agencies that often results in either very weak or extraordinarily sluggish regulation (or both); and a regulatory process that lacks transparency and accountability. Taken together, these flaws severely compromised the regulatory process and made it far less likely that agency leaders would either act to protect consumers or succeed in doing so.SECTION 2. CORRECTING REGULATORY SHORTCOMINGS BY CREATING A CONSUMER CHRG-111shrg57322--620 Mr. Viniar," I am just reading it---- Senator Levin [continuing]. Subprime notional history. Do you see that? " CHRG-111hhrg52406--211 Mr. Bachus," On the subprime, where do we stand on that after this legislation? Ms. Keest. Well, first off, number one, we have to make sure that it gets through the Senate and does something. " CHRG-111shrg56262--91 Outside of the mortgage sector, auto loan, credit card, and student loan securitizations have fallen by over half since 2007. All three sectors became paralyzed in mid-2008, prompting the Federal Reserve to revive these markets with the Term Asset-Backed Securities Lending Facility (TALF). Spreads soared in 2008 and have since fallen, although have not completely recovered. This suggests that investor concerns about the general integrity of the securitization process spilled over to other sectors.[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] Although TALF has helped to revive these markets, particularly in the auto and credit card areas, delinquencies and charge-offs continue to climb.V. Needed Reforms Private-label mortgage securitization will undoubtedly return in one form or another. And just as certainly, investors will eventually forget the lessons from this crisis. To avoid repeating the mistakes of the past, it is essential to put private-label mortgage securitization on sound footing going forward.A. Proposals To Realign Incentives Discussions about reforming private-label securitization often revolve around proposals to realign the incentives of originators and investment banks. The idea is to give them sufficient ``skin in the game'' to care about soundly underwritten loans. Thus, the Obama Administration has proposed \9\ requiring securitizers to retain at least 5 percent of the credit risk on each asset in the asset-backed securities that they issue. \10\ Securitizers would also be barred from resecuritizing or hedging that retained risk. Section 213 of the Mortgage Reform and Anti-Predatory Lending Act, H.R. 1728, passed by the House of Representatives on May 7, 2009, contains a similar proposal.--------------------------------------------------------------------------- \9\ Financial Regulatory Reform Proposal, Title IX, 951, www.treas.gov/initiatives/regulatoryreform/. \10\ The implementing agencies would also have to adopt provisions allocating the risk retention obligation between the securitizer and the originator.--------------------------------------------------------------------------- There are other incentive-based proposals to improve loan underwriting. One involves increased capital: in other words, requiring commercial and investment banks --especially too-big-to-fail banks--to hold more capital, both against the tranches they retain and against other aspects of securitization that could come back to haunt them, such as recourse clauses and structured investment vehicles. Another proposal is to realign originators' compensation with loan performance. Accounting standards could be changed to eliminate immediate recognition of gain on sale by originators at the time of securitization. And there are two promising proposals to curb reckless originations by independent mortgage brokers. One would prohibit pay incentives such as yield spread premiums for steering customers to costlier or riskier loans. H.R. 1728, 103. Another proposal would make full payout of compensation to mortgage brokers contingent on good performance of the loan. A final idea along these lines is to require lenders and securitizers to make stronger representations and warranties to investors, accompanied by stiffer recourse provisions for loans that violate those reps and warranties. The American Securitization Forum has advanced this reform. All of these proposals are good ideas. However, they are not enough, together or alone, to ensure sound underwriting. Take the risk retention requirement, for example. It is doubtful whether the ban on hedging is even enforceable, since ``sometimes firms pool their risk and set hedges against several positions at once.'' \11\ More importantly, requiring risk retention does not solve the fact that banks, once they got loans off of their books through securitization, assumed that risk again by investing in toxic subprime RMBS and CDOs.--------------------------------------------------------------------------- \11\ Fender and Mitchell, supra note 4, at 41.--------------------------------------------------------------------------- As for capital requirements, more capital is essential for depository institutions and investment banks. But capital is no panacea. Banks have proven adept at evading minimum capital requirements. Furthermore, the credit crisis raised serious concerns about the newly adopted Basel II capital standards, which were designed to lower capital and allow large internationally active banks--i.e., too-big-to-fail banks--to set their own minimum capital. Stronger reps and warranties, backed by stiffer recourse, are likewise advisable. But the crisis has shown that recourse provisions are only as good as a lender's solvency. Since the credit crisis began, most nonbank subprime lenders have gone out of business. In addition, 126 banks and thrifts have failed since 2007. Some institutions failed precisely due to their inability to meet investor demands for recourse. \12\--------------------------------------------------------------------------- \12\ See, e.g., Office of Inspector General, Department of the Treasury, ``Safety and Soundness: Material Loss Review of NetBank, FSB'' (OIG-08-032, April 23, 2008), www.ustreas.gov/inspector-general/audit-reports/2008/OIG08032.pdf.--------------------------------------------------------------------------- Even when recourse can be had, negotiations can be long and drawn-out. Moreover, if a recourse provision is not ironclad, a solvent lender may be able to escape it. For example, any provisions that would condition recourse on the lender's knowledge that the reps and warranties were violated--creating a Sergeant Schultz ``I know nothing'' defense--usually would be meaningless if the misconduct in question was committed by an independent mortgage broker. That would include situations where the lender failed to adequately supervise the broker, which often was the case. For all of these reasons, having ``skin in the game'' is not enough to ensure sound loan underwriting. As discussed below, more is needed in the form of minimum underwriting standards.B. Improved Due Diligence by Investors Meanwhile, investors need the ability to do better due diligence. Three major reforms are needed to provide investors with the information that they need to make sound investment decisions about private-label mortgage-related bonds. First is improved transparency, second is product simplification and standardization, and third is rating agency reform. Transparency--The SEC should require securitizers to provide investors with all of the loan-level data they need to assess the risks involved. See Obama Administration Proposal, Title IX, 952. In addition, the SEC should require securitizers and servicers to provide loan-level information on a monthly basis on the performance of each loan and the incidence of loan modifications and recourse. These disclosures should be made in public offerings and private placements alike. In addition, TBA offerings should be prohibited because it is impossible for investors to do due diligence on those loan pools. Product Simplification and Standardization--The Government should encourage simpler, standardized securitization products, whether through the REMIC tax rules or rules governing permissible investments by insured banks and thrifts. Similarly, the Government should explore ways to build a liquid secondary trading market in private-label RMBS and other bonds. Rating Agency Reform--The most critical rating agency reform is banning the ``issuer pays'' system, in which issuers pay for ratings. That would help ensure that rating agencies serve the interests of investors, not issuers. In addition, it is necessary to require the rating agencies to create a new, different ratings scale for mortgage structured finance to distinguish it from the ratings for corporate bonds. Finally, NRSRO designations need to be abolished. The Obama Administration's proposal takes a different approach. The proposal would subject NRSROs to enhanced SEC oversight, including expanded public disclosures. In addition, the Administration would require rating agencies to have systems to ``manage, and disclose'' their conflicts of interest. Title IX, subtitle C. While better investor due diligence is necessary to improve private-label mortgage securitization, it is not enough. At the height of every business cycle, memories grow dim and euphoria takes hold. During bubbles, when default rates are low, investors are apt to cast aside basic due diligence precautions to grab the chance of a high-yield investment. This temptation is particularly great for institutional money managers, who have cash they need to put to work and face pressure to report the same high returns as their competitors. For all of these reasons, minimum Federal underwriting standards are a needed supplement to investor due diligence.C. Protecting Borrowers and the Financial System We cannot assume that investors will monitor adequately or that standardization will be achieved. Furthermore, none of the measures outlined above addresses the obstacles to loan modifications. Two additional measures are needed to protect borrowers and the larger economic system from reckless loans and unnecessary foreclosures. 1. Uniform Minimum Underwriting Standards Enforceable by Borrowers--The downward spiral in underwriting standards drove home the need for uniform consumer protection standards that apply to all financial services providers. In fact, a new study by the Center for Community Capital at the University of North Carolina (Chapel Hill) finds that States that mandated strong loan underwriting standards had lower foreclosure rates than States without those laws. \13\--------------------------------------------------------------------------- \13\ Center for Community Capital, State Anti-Predatory Lending Laws (October 5, 2009), http://www.ccc.unc.edu/news/AG_study_release_5[2].10.2009.pdf.--------------------------------------------------------------------------- The Federal Reserve's 2008 rule for higher-cost loans accomplished part of this goal, \14\ but all loans need protection, not just subprime loans. The Obama Administration proposal, H.R. 1728, and H.R. 3126 would solve this problem by creating one set of uniform Federal laws that apply to all financial services providers across the country, regardless of entity, charter, or geographic location. To prevent a race to the bottom in which regulators compete to relax lending standards, the Administration proposal and H.R. 3126 would consolidate the authority to administer those laws in a new Consumer Financial Protection Agency. Under both, the standards would constitute a floor, in which weaker State laws are federally preempted. States would remain free to enact stricter consumer protections so long as those protections were consistent with Federal law.--------------------------------------------------------------------------- \14\ Federal Reserve System, Truth in Lending: Final rule; official staff commentary, 73 FED. REG. 44522, 44536 (July 30, 2008). The Board intended to cover the subprime market, but not the prime market. See, id. at 44536-37.--------------------------------------------------------------------------- These Federal standards do three things. First, the standards would ensure proper loan underwriting based on the consumer's ability to repay. Second, the standards would prohibit unfair or deceptive practices in consumer credit products and transactions. Finally, the standards would promote transparency through improved consumer disclosures. Bottom-line, the proposed standards would help make it possible for consumers to engage in meaningful comparison shopping, with no hidden surprises. In the event these standards are violated, injured borrowers need an affirmative claim for relief as well as a defense to foreclosure. Both the claim and the defense should be available against loan originators. Limiting relief to loan originators does not help borrowers with securitized loans, however, if their loans later go into foreclosure or their originators become judgment-proof. When a securitized loan is foreclosed on, for example, the lender is not the plaintiff; rather, foreclosure is instituted by the servicer, the owner of the loan, or its designee (generally the Mortgage Electronic Registration Systems or MERS). Consequently, fairness requires allowing injured borrowers to raise violations as a defense to foreclosure against those entities. Similarly, giving borrowers an affirmative claim against assignees for violations of Federal lending standards by originators will spur investors and investment banks to insist on proper underwriting of loans and afford injured borrowers relief when their originators are judgment-proof or a securitized trust sues for foreclosure. The Administration's proposal and H.R. 1728, 204, both contain assignee liability provisions designed to accomplish these objectives. Some fear that a borrower right of action against securitized trusts and investment banks would reduce access to credit. A 2008 study by Dr. Raphael Bostic et al. examined that question by looking at the effect of assignee liability provisions in nine State antipredatory lending laws on the availability of subprime credit. The study found ``no definitive effect of assignee liability on the likelihood of subprime originations, even when the [assignee] liability provisions are in their strongest form.'' Subprime originations rose in six of the nine States studied that had assignee liability, relative to the control State. Results were mixed in the other three States, depending on how subprime lending was defined. No State reported a consistent drop in subprime originations. \15\--------------------------------------------------------------------------- \15\ Raphael Bostic, Kathleen C. Engel, Patricia A. McCoy, Anthony Pennington-Cross, and Susan Wachter, ``The Impact of Predatory Lending Laws: Policy Implications and Insights'', In Borrowing To Live: Consumer and Mortgage Credit Revisited 138 (Nicolas P. Retsinas and Eric S. Belsky eds., Joint Center for Housing Studies of Harvard University and Brookings Institution Press, 2008), working paper version at http://www.jchs.harvard.edu/publications/finance/understanding_consumer_credit/papers/ucc08-9_bostic_et_al.pdf.--------------------------------------------------------------------------- In short, assignee liability is not likely to impede access to credit. To the contrary, borrower relief will provide needed incentives for originators, Wall Street, and investors to only securitize loans that borrowers can repay. Providing that relief would go a long way toward avoiding the biggest threat to access to credit, which is a repeat collapse of private-label securitization. 2. Remove Artificial Barriers to Cost-Effective Loan Modifications--Right now, too many distressed loans are needlessly going to foreclosure despite the availability of cost-effective loan modifications. Not only do these foreclosures oust homeowners from their homes, they needlessly depress home values for everyone else. It is time to cut this Gordian knot. Most securitized loan pools are created as ``Real Estate Mortgage Investment Conduits,'' or REMICs, under the Federal tax code. Any securitization vehicle that qualifies for REMIC treatment is exempt from Federal income taxes. Congress or the Internal Revenue Service should amend the REMIC rules to disqualify future mortgage pools from favored REMIC tax treatment unless pooling and servicing agreements and related deal documents are drafted to give servicers ironclad incentives to participate in large-scale loan modifications when specific triggers are hit. \16\--------------------------------------------------------------------------- \16\ See, Michael S. Barr and James A. Feldman, Issue Brief: Overcoming Legal Barriers to the Bulk Sale of At-Risk Mortgages (Center for American Progress April 2008).--------------------------------------------------------------------------- ______ fcic_final_report_full--91 Despite this diffusion of authority, one entity was unquestionably authorized by Congress to write strong and consistent rules regulating mortgages for all types of lenders: the Federal Reserve, through the Truth in Lending Act of . In , the Fed adopted Regulation Z for the purpose of implementing the act. But while Regu- lation Z applied to all lenders, its enforcement was divided among America’s many fi- nancial regulators. One sticking point was the supervision of nonbank subsidiaries such as subprime lenders. The Fed had the legal mandate to supervise bank holding companies, in- cluding the authority to supervise their nonbank subsidiaries. The Federal Trade Commission was given explicit authority by Congress to enforce the consumer pro- tections embodied in the Truth in Lending Act with respect to these nonbank lenders. Although the FTC brought some enforcement actions against mortgage companies, Henry Cisneros, a former secretary of the Department of Housing and Urban Development (HUD), worried that its budget and staff were not commensu- rate with its mandate to supervise these lenders. “We could have had the FTC oversee mortgage contracts,” Cisneros told the Commission. “But the FTC is up to their neck in work today with what they’ve got. They don’t have the staff to go out and search out mortgage problems.”  Glenn Loney, deputy director of the Fed’s Consumer and Community Affairs Division from  to , told the FCIC that ever since he joined the agency in , Fed officials had been debating whether they—in addition to the FTC—should enforce rules for nonbank lenders. But they worried about whether the Fed would be stepping on congressional prerogatives by assuming enforcement responsibilities that legislation had delegated to the FTC. “A number of governors came in and said, ‘You mean to say we don’t look at these?’” Loney said. “And then we tried to explain it to them, and they’d say, ‘Oh, I see.’”  The Federal Reserve would not exert its authority in this area, nor others that came under its purview in , with any real force until after the housing bubble burst. The  legislation that gave the Fed new responsibilities was the Home Owner- ship and Equity Protection Act (HOEPA), passed by Congress and signed by Presi- dent Clinton to address growing concerns about abusive and predatory mortgage lending practices that especially affected low-income borrowers. HOEPA specifically noted that certain communities were “being victimized . . . by second mortgage lenders, home improvement contractors, and finance companies who peddle high- rate, high-fee home equity loans to cash-poor homeowners.”  For example, a Senate report highlighted the case of a -year-old homeowner, who testified at a hearing that she paid more than , in upfront finance charges on a , second mortgage. In addition, the monthly payments on the mortgage exceeded her income.  HOEPA prohibited abusive practices relating to certain high-cost refinance mort- gage loans, including prepayment penalties, negative amortization, and balloon pay- ments with a term of less than five years. The legislation also prohibited lenders from making high-cost refinance loans based on the collateral value of the property alone and “without regard to the consumers’ repayment ability, including the consumers’ current and expected income, current obligations, and employment.”  However, only a small percentage of mortgages were initially subject to the HOEPA restrictions, be- cause the interest rate and fee levels for triggering HOEPA’s coverage were set too high to catch most subprime loans.  Even so, HOEPA specifically directed the Fed to act more broadly to “prohibit acts or practices in connection with [mortgage loans] that [the Board] finds to be unfair, deceptive or designed to evade the provisions of this [act].”  CHRG-111shrg57321--76 Mr. Raiter," No, sir, I do not. Senator Levin. Now, there are also some things that should not happen regardless of the complexity of how you design a better system. There are some things, it seems to me, that are clearly wrong that happened and should not happen. In the subprime loan deals, a number of loans in which borrowers paid a low initial rate, sometimes interest-only payments, and then after a specified number of months or years, switched to a higher floating rate that was often linked to an index. Did you have any data at the time as to how those subprime loans would perform? Mr. Raiter, did you have data? " CHRG-111shrg51303--5 STATEMENT OF SENATOR RICHARD C. SHELBY Senator Shelby. Thank you, Mr. Chairman. The collapse of the American International Group is the largest corporate failure in American history. Once a premier global insurance and financial services company, with more than $1 trillion in assets, AIG lost nearly $100 billion last year. Over the past 5 months, it has been the recipient of four bailouts. To date, the Federal Government has committed to provide approximately $170 billion in loans and equity. Given the taxpayers' dollars at stake and the impact on our financial system, this Committee has an obligation to thoroughly examine the reasons for AIG's collapse and how Federal regulators have responded. I also hope that today's hearing will shed new light on the origins of our financial crisis as well as inform our upcoming discussions on financial regulatory reform. In reviewing our witnesses' testimony here today and AIG's public filings, it appears that the origins of AIG's demise were twofold: First, as has been widely reported, AIG suffered huge losses on credit default swaps written by its Financial Products subsidiary on collateralized debt obligations. AIG's problems, however, were not isolated to its credit default swap business. Significant losses in AIG's State-regulated life insurance companies also contributed to the company's collapse. Approximately a dozen of AIG's life insurance subsidiaries operated a securities lending program whereby they loaned out securities for short periods in exchange for cash collateral. Typically, an insurance company or bank will lend securities and reinvest the cash collateral in very safe short-term instruments. AIG's insurance companies, however, invested their collateral in riskier long-term mortgage-backed securities. And although they were highly rated at the time, approximately half of them were backed by subprime and Alternate-A mortgage loans. When the prices for mortgage-backed securities declined sharply last year, the value of AIG's collateral plummeted. The company was rapidly becoming unable to meet the demands of borrowers returning securities to AIG. By September, it became clear that AIG's life insurance companies would not be able to repay collateral to their borrowers. Market participants quickly discovered these problems and rushed to return borrowed securities and get back their collateral. Because AIG was unable to cover its obligations to both its securities lending and derivatives operations, it ultimately had to seek Federal assistance. In total, AIG's life insurance companies suffered approximately $21 billion in losses related to securities lending in 2008. More than $17 billion in Federal assistance has been used to recapitalize the State-regulated insurance companies to ensure that they are able to pay their policy holders' claims. In addition, the Federal Reserve had to establish a special facility to help unwind AIG's securities lending program. The causes of AIG's collapse raise profound questions about the adequacy of our existing State and Federal financial regulatory regimes. With respect to AIG's derivatives operations, the Office of Thrift Supervision was AIG's holding company regulator. It appears, however, that the OTS was not adequately aware of the risks presented by the companies credit default swap positions. Since AIG's Financial Products subsidiary had operations in London and Hong Kong, as well as in the U.S., it is unclear whether the OTS even had the authority to oversee all of AIG's operations. It is also unclear whether OTS had the expertise necessary to properly supervise what was primarily an insurance company. Additionally, did AIG life insurance companies obtain the approval of their State regulators before they participated in securities lending? If so, why did the State insurance regulators allow AIG to invest such a high percentage of the collateral from its securities lending program in longer-term mortgage-backed securities? Also, did the insurance regulators coordinate their oversight of AIG's securities lending since it involved life insurance regulated by at least five different States? While I hope we can get some answers to these and many other questions today, I believe we are just beginning to scratch the surface of what is an incredibly complex and, on many levels, a very disturbing story of malfeasance, incompetence, and greed. Thank you, Mr. Chairman. " CHRG-111hhrg53240--78 Mr. Bachus," Will that be just on subprime loans or-- Ms. Duke. It will be on every kind of loan. " FOMC20070628meeting--87 85,MS. LIANG., We think there is probably $900 billion to $1 trillion in adjustable- rate subprime mortgages outstanding. fcic_final_report_full--106 In , the four bank regulators issued new guidance to strengthen appraisals. They recommended that an originator’s loan production staff not select appraisers. That led Washington Mutual to use an “appraisal management company,” First American Corporation, to choose appraisers. Nevertheless, in  the New York State attorney general sued First American: relying on internal company documents, the complaint alleged the corporation improperly let Washington Mutual’s loan pro- duction staff “hand-pick appraisers who bring in appraisal values high enough to permit WaMu’s loans to close, and improperly permit[ted] WaMu to pressure . . . appraisers to change appraisal values that are too low to permit loans to close.”  CITIGROUP:  “INVITED REGULATORY SCRUTINY ” As subprime originations grew, Citigroup decided to expand, with troubling conse- quences. Barely a year after the Gramm-Leach-Bliley Act validated its  merger with Travelers, Citigroup made its next big move. In September , it paid  bil- lion for Associates First, then the second-largest subprime lender in the country (af- ter Household Finance.). Such a merger would usually have required approval from the Federal Reserve and the other bank regulators, because Associates First owned three small banks (in Utah, Delaware, and South Dakota). But because these banks were specialized, a provision tucked away in Gramm-Leach-Bliley kept the Fed out of the mix. The OCC, FDIC, and New York State banking regulators reviewed the deal. Consumer groups fought it, citing a long record of alleged lending abuses by Associ- ates First, including high prepayment penalties, excessive fees, and other opaque charges in loan documents—all targeting unsophisticated borrowers who typically could not evaluate the forms. “It’s simply unacceptable to have the largest bank in America take over the icon of predatory lending,” said Martin Eakes, founder of a nonprofit community lender in North Carolina.  Advocates for the merger argued that a large bank under a rigorous regulator could reform the company, and Citigroup promised to take strong actions. Regula- tors approved the merger in November , and by the next summer Citigroup had started suspending mortgage purchases from close to two-thirds of the brokers and half the banks that had sold loans to Associates First. “We were aware that brokers were at the heart of that public discussion and were at the heart of a lot of the [con- troversial] cases,” said Pam Flaherty, a Citigroup senior vice president for community relations and outreach.  The merger exposed Citigroup to enhanced regulatory scrutiny. In , the Fed- eral Trade Commission, which regulates independent mortgage companies’ compli- ance with consumer protection laws, launched an investigation into Associates First’s premerger business and found that the company had pressured borrowers to refi- nance into expensive mortgages and to buy expensive mortgage insurance. In , Citigroup reached a record  million civil settlement with the FTC over Associ- ates’ “systematic and widespread deceptive and abusive lending practices.”  In , the New York Fed used the occasion of Citigroup’s next proposed acqui- sition—European American Bank on Long Island, New York—to launch its own in- vestigation of CitiFinancial, which now contained Associates First. “The manner in which [Citigroup] approached that transaction invited regulatory scrutiny,” former Fed Governor Mark Olson told the FCIC. “They bought a passel of problems for themselves and it was at least a two-year [issue].”  The Fed eventually accused Citi- Financial of converting unsecured personal loans (usually for borrowers in financial trouble) into home equity loans without properly assessing the borrower’s ability to repay. Reviewing lending practices from  and , the Fed also accused the unit of selling credit insurance to borrowers without checking if they would qualify for a mortgage without it. For these violations and for impeding its investigation, the Fed in  assessed  million in penalties. The company said it expected to pay an- other  million in restitution to borrowers.  CHRG-111shrg52966--27 Mr. Cole," Well, that is---- Senator Bunning. That is about 5 years after the subprime and the mortgage mess hit the fan. Two-thousand-and-two and 2003 is when it hit. " fcic_final_report_full--468 Table 3. 28 Delinquency rates on nontraditional mortgages Loan Type Estimated # of Loans Total Delinquency Rate (30+ Days and in Foreclosure) 1. High Rate Subprime (including Fannie/ 6.7 million 45.0% Freddie private MBS holdings) 2. Option Arm 1.1 million 30.5% 3. Alt-A (inc. Fannie/Freddie/FHLBs 2.4 million† 23.0% private MBS holdings) 4. Fannie Subprime/Atl-A/Nonprime 6.6 million 17.3% 5. Freddie Subprime/Alt-A/Nonprime 4.1 million 13.8% 6. Government 4.8 million 13.5% Subtotal # of Loans 25.7 million 7. Non-Agency Jumbo Prime 9.4 million ‡ 6.8% 8. Non-Agency Conforming Prime * 5.6% 9. Fannie Prime ** 11.2 million 2.6% 10. Freddie Prime *** 8.7 million 2.0% Total # of Loans 55 million * Includes an estimated 1 million subprime (FICO<660) that were (i) not high rate and (ii) non-prime CRA and HUD Best Practices Initiative loans. These are included in the “CRA and HUD Programs” line in Table 1. ** Excludes Fannie subprime/Alt-A/nonprime. *** Excludes Freddie subprime/Alt-A/nonprime. † Excludes loans owned or securitized by Fannie and Freddie. ‡ Non-agency jumbo prime and conforming prime counted together. Total delinquency data sources: 1, 2, 3, 6, 7 & 8: Lender Processing Services, LPS Mortgage Monitor, June 2009. 4 & 9: Based on Fannie Mae 2009 2Q Credit Supplement. Converted from a serious delinquency rate (90+ days & in foreclosure) to an estimated Total Delinquency Rate (30+ days and in foreclosure). 5 & 10: Based on Freddie Mac 2009 2Q Financial Results Supplement. Converted from a serious delinquency rate (90+ days & in foreclosure) to an estimated Total Delinquency Rate (30+ days and in foreclosure). 4. The Origin and Growth of Subprime PMBS It was only in 2002 that the market for subprime PMBS—that is private mortgage-backed securities backed by subprime loans or other NTMs—reached $100 billion. In that year, the top five issuers were GMAC-RFC ($11.5 billion), Lehman ($10.6 billion), CS First Boston ($10.5 billion), Bank of America ($10.4 billion) and Ameriquest ($9 billion). 29 The issuances of PMBS that year totaled $134 billion, of which $43 billion in PMBS were issued by Wall Street financial institutions. In subsequent years, as the market grew, Wall Street institutions fell behind the major subprime issuers, so that by 2005—the biggest year for subprime PMBS issuance—only Lehman was among the top five issuers and Wall Street issuers as a group were only 27 percent of the $507 billion in total PMBS issuance in that year. 30 28 29 30 Id., Figure 53. Inside Mortgage Finance, The 2009 Mortgage Market Statistical Annual—Vol. II , p143. Id., p.140. 463 FOMC20070321meeting--117 115,MR. KROSZNER.," Thank you very much. I very much agree with President Stern’s characterization that, although some of the incoming data are a bit weaker than we had been seeing, we certainly shouldn’t overreact. Optimally, we should react to what the data tell us about the future, and I’m not sure we’ve learned an enormous amount about the future over the past few months. Actually Dave has kept a very steady hand on the forecast throttle because we have seen a lot of data come in over the past six months, but they haven’t led to much change in the Greenbook forecast, and I think that’s quite reasonable. Given that some of the numbers have come in slightly weaker and given some of the market volatility, I think that uncertainty is a bit up; so the tails are somewhat fatter, and I agree with the number of people who had said that. Quickly looking at GDP from the C + I + G + net exports context, I think net exports will be reasonably robust as world growth, at least over the next few quarters, is going to be fairly strong. We also heard a lot of anecdotal support for that. On both the state and federal levels, government spending is likely to continue at a pace that will certainly not reduce demand and may have the potential to add to demand. But when it comes to consumption and investment, that’s where the uncertainties are. I won’t restate the concerns that several of you have raised about the deepening puzzle in investment. I mentioned this at the last meeting—that for many months we’ve been seeing very good balance sheets, good employment numbers, good sentiment, good returns, and so on and so forth, but no pickup in investment. Given that we’ve now gone at least six months without seeing that pickup, I am concerned that, with the greater uncertainty that seems to be in the markets, we may not see that pickup and that somehow our models may be missing something that should be in there but that has not been there in the past. The other area of the greatest uncertainty is related to the subprime market. As you know now, we and the other federal regulators put out for comment—actually right at the end of the week of the increased concern about volatility in the subprime market—guidance with respect to subprime mortgages, the so-called 2/28s and 3/27s. That is still out for comment. We’re very mindful of some of the comments that have been raised here about whether that could inappropriately reduce the supply of credit in this market, and in the notice of proposed rulemaking, we have really emphasized questions about what the unintended consequences are. So we want to make sure that we get information in on that. Some loans that were made may have been inappropriate, but there may have been some that were completely appropriate. We want to make sure that, when we put out the guidance, we don’t choke off the appropriate loans. The supervision and regulation staff has surveyed five active lenders in the subprime market that represent about 30 percent of that market. We’ve gotten data so far from three of the five. From some of them it’s a bit difficult to get the data quickly because of a fair amount of management turnover, but we are still working on it. But I think it’s a healthy thing that there are some delays. What’s interesting is that one of the main concerns is refinancing: What will happen to these guys because this market seems to be drying up. As we discussed at the beginning, it’s really the variable-rate subprime market. The subprime market is roughly 13 percent of the total mortgages outstanding. The variable-rate subprime is about 7.4 percent of total mortgages outstanding, nearly two-thirds of the subprime market. The fixed-rate part has not had any uptick in delinquencies. Because of the inversion of the yield curve, the people who may be facing increases in their variable rates may be able to refinance into fixed-rate subprimes. Over ’06, the average introductory adjustable-rate subprime mortgages were in the 7 percent to 9 percent area—depending on the loan-to-value ratio, debt-to-income ratio, and so forth—if income was stated. Right now, to refinance into fixed rate, the range is about 7½ percent to 9½ percent. It’s fairly similar, so many of these people may be able to move into this area. One thing that we want to know is what happens after people get these loans. What do they do with them next? In the survey, about 25 percent of the loans were retained by the individual banks, and so we could follow through what happened to the borrowers when they refinanced; but we see only 25 percent. Obviously this share could be heavily selective, but it still may be somewhat interesting to know that about 40 percent of those on whom we have some information actually moved into a prime product. About 34 percent went into a fixed subprime; and the rest, about 25 percent, refinanced to another type of variable subprime. So a fair number of these are able to move either into prime or into fixed subprime. Although this sample is obviously selective, it says something about the likely effects going forward. The benefits, at least in the short run, of the inverted yield curve are that many of these individuals will have a lot of opportunities to refinance into a fixed product that will have payments similar to the ones that they’re paying now rather than ones that would be much higher. That said, the situation suggests that the concerns about what will happen to the market may not be as strong as some people have said. We still don’t know, as President Fisher said, a lot about the alt-A market. That market almost by definition is low documentation or no documentation. The FICO scores tend to be higher. From the survey, a lot of these people appear to be self-employed, so it becomes more difficult to independently verify the income that they have. That’s a large part of the market, but obviously potentially a very risky part of the market. Fortunately, it’s not an enormous part of the market, and so it doesn’t seem to be a major challenge going forward. Certainly there are some potential challenges, but I think some of the data from the survey are interesting. With respect to inflation pressures, I think very much like Dave (now that he’s a much more balanced person than he was earlier in 2006), that we see neither intensifying nor abating inflationary pressures. You know, some of the numbers more recently have not been as favorable as they could be, but they are certainly by no means out of control. Expectations continue to appear well anchored and well contained. We don’t know a lot about what’s driving short-term to intermediate-term inflation dynamics. It’s hard to see lots of correlations with unemployment rates, economic activity, resource utilization, energy prices, and other things. I have been hoping to see and we have been seeing a gradual downtrend that seems to be flattening out to neither intensifying nor abating, which leaves us with some concerns going forward about the upside potential to inflation." FOMC20070131meeting--44 42,MR. REINHART., We reported in yesterday’s briefing that subprime borrowers constituted only about 13 percent of all mortgages outstanding. FinancialCrisisInquiry--604 CLOUTIER: Thank you very much. Chairman Angelides, Vice Chairman Thomas and members of the commission, my name is Rusty Cloutier, and I am pleased to testify today on the current state of the financial crisis and in particular the effect it has had on the small- business lending community. I am president and chief executive officer of MidSouth Bank, a $980 million community bank headquartered in Lafayette, Louisiana, with locations throughout south Louisiana and southeast Texas. I am also the author of the book “Big Bad Banks,” which details how a few megabanks and powerful individuals fueled the current financial and economic crisis. I’m proud to testify today on behalf of the Independent Community Bankers of America and its 5,000 community bank members nationwide. Mr. Chairman, it is difficult to talk about the effects of the financial crisis without speaking to the root cause. Too-big-to-fail institutions and the systemic risks that they pose were the heart of our financial and economic meltdown. Equally responsible were those institutions making up the unregulated shadow banking industry operating just not outside of legal parameters, of the regulatory framework, which made most of the subprime exotic loans and brought the housing markets to its knees. For far too long, these institutions have enjoyed privileges of favorable government treatment, easier access to cheaper funding sources, lower or no compliance cost, and little if any oversight. A little more than a few years ago, a key element of the financial system nearly collapsed due to the failure of these institutions to manage their highly risky activities. January 13, 2010 These reckless and irresponsible actions by a handful of managers with too much power nearly destroyed our equity, real estate, consumer loan and global financial markets and cost the American people some $12 trillion in net worth. This crisis also has pushed our nation to the brink of insolvency by forcing the federal government to intervene with trillions in capital and loans and commitments to large, complex financial institutions whose balance sheets were overlevereged, lacked adequate liquidity to offset the risks that they had recklessly taken. We’re at the point where some of the world markets are even questioning if the United States dollar should be retained as the world’s reserve currency. All of this was driven by the ill-conceived logic that some institutions should be allowed to exist even if they were too big to manage, too big to regulate, too big to fail, and above the law of the United States of America. By contrast, community banks like mine, highly regulated, stuck to their knitting and had no role in the economic crisis. Even though community banks did not cause the economic crisis, we have been affected by it through a shrinking of our asset base, heavier FDIC assessments, and suffocating examination environments. The work of this commission is important if Congress is already actively advancing dramatic financial sector reforms. The ICBA wants Congress to pass meaningful financial reforms to rein in the financial behemoths and the shadow financial industry to ensure that this crisis like this never happen again to the American people. We need a financial reform that will restore reasonable balance between Wall Street and Main Street. So where are we today? While the financial meltdown and deep global recession may be over, economic growth remains too weak to quickly reverse the massive job losses and asset price damage that is resulting. After more than a year and a half of economic decline, the United States economy grew by a modest 2.2 percent in the third quarter January 13, 2010 of 2009, unemployment is still at a 26-year high and new hiring remains elusive at this modest growth level. The long, deep recession has dramatically increased the lending risk for all banks, as individuals’ and business credit risk have increased with the declining balance sheets and reduced sales in most cases. Today bank regulators are far more sensitive to lending risk and force banks to be much more conservative in underwriting on all types of loans. While this is to be expected after a deep recession, the regulatory pendulum has swung too far in the direction of overkill and choking off credit at the community bank level. Indeed, the mixed signals that appear to be coming out of Washington have dampened the lending environment in many communities. On one hand, the administration and lawmakers are saying lend, lend, lend, and on the other, that message seems to be lost on the examiners, particularly in the parts of the nation most severely affected by the recession. Bankers continue to comment that they are being treated like they have portfolio full of subprime mortgages and even though they had no subprime on their books. Under the climate community bankers may avoid making good loans for the fear of an examination criticism, write-down and resulting loss of income and capital. Community banks are willing to lend. That’s how banks generate a return and survive. However, quality loan demand is down. It is a fact that demand for credit overall is down as business suffered lower sales, reducing their inventory, cut capital spending, shed workers and cut debt. In a recent National Federation of Independent Business survey, respondents identified weak sales as the biggest problem they face, with only 5 percent of the respondents saying that access to credit is a hurdle. I can tell you from my own bank’s experience customers are scared about the economic climate and are not borrowing. They are basically panicked. Credit is available, but businesses are not demanding it. The good news is that my bank did make $233 million in new loans this past year. MidSouth is extremely well capitalized and would do even more if quality loans were available. January 13, 2010 For example, my bank’s lines of credit usage is down to the lowest utilization in 25 years. I am pressing my loan officers daily to find more loans, but demand is not there. All community banks want to lend. Less lending hurts profits and income. For the first time in my 44 years in banking I have witnessed a decline in assets in my banks due to lower loan demand. In total, my loans were down from $600 million to $585 million this past year. Most businesses I work with are using cash flow only and are not interested in taking on new debt. The key reason they cite for not seeking credit is their uncertainty of the economic climate and the cost of doing business going forward. Until their confidence in the economic outlook improves, businesses will be unlikely to borrow from any bank. The financial meltdown should be a lesson learned in supporting diversity in the banking and in community banks. Community banks represent the other side of the financial story in credit markets. Community banks serve a vital role in small-business lending and local community activity not supported by Wall Street, who has only an international view. For their size, community banks are enormous small-business lenders. Community banks represent only about 12 percent of all bank assets, they currently make up 31 percent of the dollar amount of all small business loans less than a million dollars. Notably, more than half of all small business loans under $100,000 are made by community banks. In contrast, banks with more than $100 billion in assets, the nation’s largest financial firms, make only 22 percent of small business loans. Community banks in general rely more on local deposits to fund local lending. So they don’t rely on the Wall Street capital markets for funding. In fact, small banks of $1 billion in asset size or less were the only segment to show any increase in net loans and leases year over year in the latest third quarter 2009 quarterly FDIC data. However, small business loan demand is down in general, because businesses and individuals are deleveraging and reducing their reliance on debt after the current meltdown. The FDIC quarterly banking profile for the third quarter of 2009 showed a January 13, 2010 record $210 billion quarterly decline in outstanding loan balances. Net loans and leases declined across all asset size groups on—in a quarterly basis in the third quarter of 2009. Despite a quarterly decline of net loans and leases, at 2.6 percent annual, community banks with less than a billion dollars in assets were the only group to show a year over year increase in net loans and leases of 0.5 percent. While modest, these gains were the best in the financial sector. Our nation’s biggest banks, who were here earlier today, cut back on lending the most. The institutions with more than $100 billion in assets showed a quarterly decline of 10.9 percent annual rate and a 10.5 percent decrease, year over year. Banks $10 billion to $100 billion asset banks, had net loans and leases decline at an astounding 17.8 percent annual rate over the previous quarter. In conclusion, highly regulated community bank sector did not trigger the financial crisis. We must end too big to fail, reduce systemic risk and focus regulation on the unregulated financial entities that caused this economic meltdown on Wall Street. The best financial reform will protect small business from being crushed by the devastating effects of one giant financial institution stumbling. A diverse, competitive financial system will best serve the needs of small business in America. Thank you, and I’m prepared to answer any questions. fcic_final_report_full--258 SUMMER 2007: DISRUPTIONS IN FUNDING CONTENTS IKB of Germany: “Real money investors” .........................................................  Countrywide: “That’s our /” ........................................................................  BNP Paribas: “The ringing of the bell” ..............................................................  SIVs: “An oasis of calm” .....................................................................................  Money funds and other investors: “Drink[ing] from a fire hose ........................  In the summer of , as the prices of some highly rated mortgage securities crashed and Bear’s hedge funds imploded, broader repercussions from the declining housing market were still not clear. “I don’t think [the subprime mess] poses any threat to the overall economy,” Treasury Secretary Henry Paulson told Bloomberg on July .  Mean- while, nervous market participants were looking under every rock for any sign of hidden or latent subprime exposure. In late July, they found it in the market for asset-backed commercial paper (ABCP), a crucial, usually boring backwater of the financial sector. This kind of financing allowed companies to raise money by borrowing against high-quality, short-term assets. By mid-, hundreds of billions out of the . trillion U.S. ABCP market were backed by mortgage-related assets, including some with subprime exposure.  As noted, the rating agencies had given all of these ABCP programs their top in- vestment-grade ratings, often because of liquidity puts from commercial banks. When the mortgage securities market dried up and money market mutual funds be- came skittish about broad categories of ABCP, the banks would be required under these liquidity puts to stand behind the paper and bring the assets onto their balance sheets, transferring losses back into the commercial banking system. In some cases, to protect relationships with investors, banks would support programs they had sponsored even when they had made no prior commitment to do so. IKB OF GERMANY: “REAL MONEY INVESTORS” The first big casualty of the run on asset-backed commercial paper was a German  bank, IKB Deutsche Industriebank AG. Since its foundation in , IKB had fo- cused on lending to midsize German businesses, but in the past decade, management diversified. In , IKB created an off-balance-sheet commercial paper program, called Rhineland, to purchase a portfolio of structured finance securities backed by credit card receivables, business loans, auto loans, and mortgages. It made money by using less expensive short-term commercial paper to purchase higher-yielding long- term securities, a strategy known as “securities arbitrage.” By the end of June, Rhineland owned  billion (. billion) of assets,  of which were CDOs and CLOs (collateralized loan obligations—that is, securitized leveraged loans). And at least  billion (. billion) of that was protected by IKB through liquidity puts.  Importantly, German regulators at the time did not require IKB to hold any capital to offset potential Rhineland losses.  CHRG-111shrg57322--629 Mr. Viniar," I do. Senator Levin. OK. Take a look at the ``Time Line of Major Events.'' If you look at the subprime sector---- " CHRG-110hhrg46591--30 The Chairman," I will now recognize myself for our remaining time. The purpose of this hearing was to be forward-looking, and that is why the panel of witnesses, proposed by both sides, are people who, in their testimony--and I was pleased to see it--talked about going forward. The next panel is a panel of people from the financial industry, and I had hoped we could focus on that, but after the gentleman from New Jersey's comments in having decried partisanship, he then practiced it. It does seem to me to be important to set the record clearly before us. He alluded to a markup in 2005 in which the Democrats refused to support his amendments. The Democrats were, of course, in the Minority on the committee at that time. Had a Republican Majority been in favor of passing that bill, they would have done it. The facts are--and, again, the gentleman from New Jersey continues to return to this, so we have to lay the record out here--that from 1995 to 2006, the Republicans controlled the Congress, particularly the House. Now, he has claimed that it was we Democrats--myself included--who blocked things. The number of occasions on which either Newt Gingrich or Tom DeLay consulted me about the specifics of legislation are far fewer than the gentleman from New Jersey seems to think. In fact, the Republican Party was in control from 1997 to 2005, and it did not do anything. I now quote from the article that came out from the lead representative for FM Watch, which is the organization formed solely to restrain Fannie Mae and Freddie Mac and which is an organization, by the way, after the Congress finally passed the bill that came out of this committee in March of 2007, when Congress finally overcame some Republican filibusters that passed in 2008, that disbanded, saying that our bill had accomplished everything they had wanted. He says he was asked if any Democrats had been helpful. Well, Barney Frank of Massachusetts: ``The Senate Banking Committee produced a very good bill in 2004. It was S.190, and it never got to the Senate floor.'' The Senate was then, of course, controlled by the Republicans. ``Then the House introduced a bill which passed,'' the one the gentleman from New Jersey alluded to, ``but we could not get a bill to the floor of the Senate.'' So here you have the documentation of the Republicans' failure to pass the bill. He goes on to say, ``After the 2006 election, when everyone thought FM policy focus issues would be tough sledding in their restrictions with Democrats in the majority, Barney Frank, as the new chairman, stepped up and said, `I am convinced we need to do something.' He sat down with Treasury Secretary Paulson, and upset people in the Senate and Republicans in the House, but they came up with a bill that was excellent, and it was a bill that largely became law.'' So there is the history. I will acknowledge that, during the 12 years of Republican rule, I was unable to get that bill passed. I was unable to stop them from impeaching Bill Clinton. I was unable to stop them from interfering in Terri Schiavo's husband's affairs. I was unable to stop their irresponsible tax cuts with the war in Iraq and in the PATRIOT Act that did not include civil liberties. Along with the chairman of the committee, Mike Oxley, I was for a reasonable bill in 2005. Mr. Oxley told the Financial Times, of course, that he was pushing for that bill, the bill that's mentioned favorably by the advocate for FM Watch but that, unfortunately, all he could get from the Bush Administration was a ``one-finger salute,'' and that killed the bill. Now, I regret that we have to get into this. I do hope we will look forward. One other factor: There is a book out by Mark Zandi called, ``Financial Shock.'' Mr. Zandi is an adviser to John McCain. Here's what he says on page 151: ``President Bush readily took up the homeownership at the time of the start of his administration. To reinforce this effort, the Bush administration put substantial pressure on Fannie Mae and Freddie Mac to increase their funding of mortgage loans to lower income groups. They had been shown to have problems during the corporate accountingscandals and were willing to go along with any request from the administration.'' This is Mr. Zandi, John McCain's economic adviser. ``OHFEO, the Bush-controlled operation, set aggressive goals for the two giant institutions, which they met, in part, by purchasing subprime mortgage securities. By the time of the subprime financial shock, both had become sizable buyers.'' That is John McCain's economic adviser. That is the advocate for FM Watch. I will throw in one other factor, which notes, ``The Congress in 1994,'' the last year of Democratic control, ``passed the Homeowners' Equity Protection Act, giving the Federal Reserve the authority to regulate subprime mortgage. Mr. Greenspan refused to use it.'' As Mr. Zandi--again, John McCain's economic adviser--notes: ``Democrats in Congress were worried about increasing evidence of predatory lending, pushed for legislation, pushed the Fed. We were rejected.'' I hope we can now go forward and try to deal with this situation. Yes, it is too bad that we did not do anything about subprime lending. I wish the bill that the Congress passed on Fannie and Freddie in 2007 and in this committee in 2008 had been passed earlier, and I wish I could eat more and not gain weight. Now let us get constructive about what we need to do in the future. The gentleman from Alabama is recognized for the final 3 minutes. " CHRG-111hhrg53246--43 Mr. Garrett," Wasn't most of the problem with the AIG situation with their credit default swaps which were based upon the subprime problem and the mortgage problem? They would not be standardized product. " CHRG-111hhrg48867--71 Mr. Bartlett," Congressman, I don't see it that way. I think lending is up. I think that the lending from all sizes of banks, both largest and smallest, is actually up. Regions in Birmingham and Compass Bank in Birmingham have, in fact, increased their lending. Whitney has increased their lending. So it is not size that either causes more commercial lending or less. It is the capital underneath at the bank. So I don't see it as a size issue. " CHRG-110shrg50415--52 Chairman Dodd," That is my point. So that is the point. These were these things moving through with the subprime. That is the piece that I think is missing in this. Yes, Gene, do you want to comment? " fcic_final_report_full--542 Losses in Scenario 2 Number of mortgages: 53 million Prime: 27 million Original subprime/Alt-A: 7.7 million FHA/VA: 5.2 million Other subprime/Alt-A: 13 million (10.5 F&F (excludes 1.25 million already counted in PMBS), 2.5 million other loans not securitized (mostly held by the large banks)) Aggregate Value: Prime= $4.7 trillion ($173,000 X 27 million); Original Subprime/Alt-A = $1.7 trillion ($220,000 X 7.7 million) FHA/VA= $700 billion ($130,000x5.2 million) Other subprime/Alt-A: $2 trillion ($154,000X13 million Total expected foreclosures: 8.4 million (3.5% X 27 million=0.95 million, 45% X 7.7 million=3.5 million, 30% X 13 million=3.9 million) Losses on foreclosures: $890 billion ($4.7 trillion X 1.6%=$60 billion + $1.7 trillion X 25%=$425 billion + $700 billion X 15% = $105 billion + $2 trillion X 15% = $300 billion) Overall loss percentage: 9.8%, for an increase of 150% FOMC20080130meeting--338 336,MR. GIBSON.," As noted in the top left panel of exhibit 5, we would like to stress two key points on the rating agency and investor issues. First, credit rating agencies are one of the weak links that helped a relatively small shock in the subprime mortgage market spread so widely, though certainly not the only one. This is not just our staff working group's view--most market participants have also expressed the opinion that rating agencies deserve some of the blame. Second, the way that some investors use ratings for their own risk management has not kept up with financial innovations, such as the growth of structured finance. These financial innovations have made a credit rating less reliable as a sufficient statistic for risk. The top right panel provides a roadmap to our presentation. To start, I'll expand on some of the points that Pat made on the role of rating agencies in the financial crisis. My aim is to show why credit rating agencies were a weak link, which will lead naturally to our recommendations on rating agency practices. As we go, I'll point out several places where the rating agency issues link up with the investor practices issues that you'll hear about next from Bev. We feel strongly that the ratings and investor issues are really just two angles on the same underlying issue. The crisis began in the subprime market, the subject of the next panel. The subprime mess happened--and keeps getting worse--in part because of the issues associated with rating agencies (though as I said earlier, there is plenty of blame to go around). Our staff working group was asked whether the rating agencies got it wrong when they rated subprime RMBS. The answer is ""yes""--they got it wrong. Rating agencies badly underestimated the risk of subprime RMBS. Last year, Moody's downgraded 35 percent of the first-lien subprime RMBS issued in 2006. The average size of these subprime RMBS downgrades was two broad rating categories--for example, a downgrade from A to BB--compared with the historical average downgrade of 1 broad rating categories. As indicated in the exhibit, the rating methodologies for subprime were flawed because the rating agencies relied too much on historical data at several points in their analysis. First, the rating agencies underestimated how severe a housing downturn could become. Second, rating agencies underestimated how poorly subprime loans would perform when house prices fell because they relied on historical data that did not contain any periods of falling house prices. Third, the subprime market had changed over time, making the originator matter more for the performance of subprime loans, but rating agencies did not factor the identity of the originator into their ratings. Fourth, the rating agencies did not consider the risk that refinancing opportunities would probably dry up in whatever stress event seriously threatened the subprime market. Of course, the rating agencies were not alone in this. Many others misjudged these risks as well. Some have suggested that conflicts of interest were a factor in the poor performance of rating agencies. While conflicts of interest at rating agencies certainly do exist, because the rating is paid for by the issuer, we didn't see evidence that conflicts affected ratings. That said, we also cannot say that conflicts were not a factor. The SEC currently has examinations under way at the rating agencies to gather the detailed information that is needed to check whether conflicts had a significant effect. In the next panel, I turn to the ABS CDOs that had invested heavily in subprime. Rating agencies got it wrong for ABS CDOs. The downgrade rate of ABS CDOs in 2007 was worse than the previous historical worst case, just as it was for subprime. AAA tranches of ABS CDOs turned out to be remarkably vulnerable: Last year, twenty-seven AAA tranches were downgraded all the way from AAA to below investment grade. As indicated in the exhibit, the main reason that rating agencies got it wrong for ABS CDOs was that their rating models were very crude. Rating agencies used corporate CDO models to rate ABS CDOs. They had no data to estimate the correlation of defaults across asset-backed securities. Despite the many flaws of credit ratings as a sufficient statistic for credit risk, the rating agencies used ratings as the main measure of the quality of the subprime RMBS that the ABS CDOs invested in. And the rating agencies did only limited, ad hoc analysis of how the timing of cash flows affects the risk of ABS CDO tranches. As a result, the ratings of ABS CDOs should have been viewed as highly uncertain. As one risk manager put it, ABS CDOs were ""model risk squared."" A final point on ABS CDOs is that the market's reaction to the poor performance of ABS CDOs makes it clear that some investors did not understand the differences between corporate and structured-finance ratings. Because structured-finance securities are built on diversified portfolios, they have more systematic risk and less idiosyncratic risk than corporate securities. They will naturally be more sensitive to macroeconomic risk factors like house prices, and by design, downgrades of structured-finance securities will be more correlated and larger than downgrades of corporate bonds. Turning to the bottom panel, as Pat noted, in August of last year the subprime shock hit the ABCP markets, especially markets for ABCP issued by SIVs. Rating agencies also got it wrong for the SIVs. More than two-thirds of the SIVs' commercial paper has been downgraded or has defaulted. The problem with the ratings was that the rating agencies' models for SIVs relied on a rapid liquidation of the SIVs' assets to shield the SIVs' senior debt from losses. While this might have worked if a single SIV got into trouble, the market would not have been able to absorb a rapid liquidation by all SIVs at the same time. Once investors began to understand the rating model for SIVs, even SIVs with no subprime exposure could not roll over their commercial paper. Investors who thought they were taking on credit risk became uncomfortable with the market risk and liquidity risk that are inherent in a SIV's business model. The next exhibit presents the staff subgroup's recommendations for addressing the weaknesses in credit ratings for structured-credit products. A common theme of our recommendations is drawing sharper distinctions between corporate ratings and structured-finance ratings. First, we recommend that rating agencies should differentiate structured-finance ratings from corporate ratings by providing additional measures of the risk or leverage of structured-finance securities to the market along with the rating. We don't make a specific recommendation on exactly what measures of risk or leverage because we believe rating agencies and investors should work out the details together (on this and the recommendations to follow). Second, rating agencies should convey a rating's uncertainty in an understandable way. The ratings of ABS CDOs were highly uncertain because the models were so crude. This is what I call the Barry Bonds solution--put an asterisk on the rating if you have doubts about the quality. [Laughter] Third, we recommend more transparency from rating agencies for structured-finance ratings. What we need is not just a tweak to the existing transparency, but a whole new paradigm that actually helps investors get the information they want and need. For example, why can't the rating agency pass on to investors, along with its rating, all the information it got from the issuer that it used to assign the rating? Fourth, we recommend that rating agencies be conservative when they rate new or evolving asset classes. Fifth, the rating agencies should enhance their rating frameworks for structured products. For example, when they rate RMBS, they should consider the originator as well as the servicer as an important risk factor. Our last recommendation is addressed to regulators, including the Federal Reserve. When we reference a rating, we should differentiate better between corporate and structured-finance ratings. Sometimes we do that already, but we could provide some leadership to the market by doing more. Now Bev will discuss the work on investor practices. " fcic_final_report_full--452 In this environment, the government’s rescue of Bear Stearns in March of 2008 temporarily calmed investor fears but created a significant moral hazard; investors and other market participants reasonably believed after the rescue of Bear that all large financial institutions would also be rescued if they encountered financial diffi culties. However, when Lehman Brothers—an investment bank even larger than Bear—was allowed to fail, market participants were shocked; suddenly, they were forced to consider the financial health of their counterparties, many of which appeared weakened by losses and the capital writedowns required by mark- to-market accounting. This caused a halt to lending and a hoarding of cash—a virtually unprecedented period of market paralysis and panic that we know as the financial crisis of 2008. Weren’t There Other Causes of the Financial Crisis? Many other causes of the financial crisis have been cited, including some in the report of the Commission’s majority, but for the reasons outlined below none of them alone—or all in combination—provides a plausible explanation of the crisis. Low interest rates and a flow of funds from abroad . Claims that various policies or phenomena—such as low interest rates in the early 2000s or financial flows from abroad—were responsible for the growth of the housing bubble, do not adequately explain either the bubble or the destruction that occurred when the bubble deflated. The U.S. has had housing bubbles in the past—most recently in the late 1970s and late 1980s—but when these bubbles deflated they did not cause a financial crisis. Similarly, other developed countries experienced housing bubbles in the 2000s, some even larger than the U.S. bubble, but when their bubbles deflated the housing losses were small. Only in the U.S. did the deflation of the most recent housing bubble cause a financial meltdown and a serious financial crisis. The reason for this is that only in the U.S. did subprime and other risky loans constitute half of all outstanding mortgages when the bubble deflated. It wasn’t the size of the bubble that was the key; it was its content. The 1997-2007 U.S. housing bubble was in a class by itself. Nevertheless, demand by investors for the high yields offered by subprime loans stimulated the growth of a market for securities backed by these loans. This was an important element in the financial crisis, although the number of mortgages in this market was considerably smaller than the number fostered directly by government policy. Without the huge number of defaults that arose out of U.S. housing policy, defaults among the mortgages in the private market would not have caused a financial crisis. Deregulation or lax regulation . Explanations that rely on lack of regulation or deregulation as a cause of the financial crisis are also deficient. First, no significant deregulation of financial institutions occurred in the last 30 years. The repeal of a portion of the Glass-Steagall Act, frequently cited as an example of deregulation, had no role in the financial crisis. 1 The repeal was accomplished through the Gramm-Leach-Bliley Act of 1999, which allowed banks to affi liate for the first time since the New Deal with firms engaged in underwriting or dealing in securities. There is no evidence, however, that any bank got into trouble because of a securities affi liate. The banks that suffered losses because they held low quality mortgages or MBS were engaged in activities—mortgage lending—always permitted by Glass- Steagall; the investment banks that got into trouble—Bear Stearns, Lehman and Merrill Lynch—were not affi liated with large banks, although they had small bank affi liates that do not appear to have played any role in mortgage lending or securities trading. Moreover, the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) substantially increased the regulation of banks and savings and loan institutions (S&Ls) after the S&L debacle in the late 1980s and early 1990s, and it is noteworthy that FDICIA—the most stringent bank regulation since the adoption of deposit insurance—failed to prevent the financial crisis. CHRG-111shrg57319--201 Mr. Vanasek," Yes, they did, and again, that was a sort of thing you wish to limit highly. The only reason to do that would be to meet a CRA requirement. There was a debate in the industry, Senator, about what constituted subprime. It used to be that anything below 660 was considered--a FICO score of 660 was considered subprime, and the industry seemed to adopt the 660 limit. So it was, again, evidence of the overall deterioration going on. Senator Levin. Now, we have put in these exhibits, Exhibit 1i.\1\ This is based on data on loan originations from WaMu's Securities and Exchange filings from 2004 to 2008. What these numbers show is that in 2003, fixed mortgages, the traditional mortgages, make up about two-thirds of WaMu's loan originations, and that percentage shrank every year until 2007, when they accounted for only one-quarter of the loans that WaMu originated. Meanwhile, higher-risk mortgages, including Option ARMs, home equity, and subprime loans, increased from one-third of the mortgages in 2003 to three-quarters of the mortgages by 2007.--------------------------------------------------------------------------- \1\ See Exhibit No. 1i, which appears in the Appendix on page 223.--------------------------------------------------------------------------- Do those figures reflect the implementation of the strategy of moving to higher-risk loans, would you say? " CHRG-110shrg46629--138 PREPARED STATEMENT OF SENATOR RICHARD C. SHELBY Chairman Bernanke, we are very pleased to have you before the Committee this morning to deliver the Federal Reserve's Semi-Annual Monetary Policy Report. This hearing provides the Congress a very important opportunity to have an open and detailed discussion about the Fed's monetary policy goals and their implementation. I also expect that Members of the Committee, including myself, will take advantage of your appearance to raise some other issues that fall under the jurisdiction of the Federal Reserve. I also would like to welcome our colleagues from the European Union Parliament. I trust that their visit today will be enlightening and provide them with much to discuss with the European Central Bank. Chairman Bernanke, your testimony and report this morning note the continued healthy performance of the economy in the first half of 2007. Although real gross domestic product (GDP) increased 0.7 percent in the first quarter of 2007, the consensus view among economists is that growth for the second quarter will show a rebound in the neighborhood of 2.5 percent. Along with continued GDP growth, we have seen positive news on the job front. Gains in payroll employment averaged 145,000 jobs per month in the first half of 2007. We continue to enjoy a low unemployment rate, both historically and relative to other industrialized nations. The global economy also continues to be strong, with Canada, Europe, Japan, and the United Kingdom experiencing above-trend growth rates in the first quarter. This is good news for American businesses seeking to expand their exports around the world. In its statement following the June 28, 2007, meeting, the FOMC suggested that while core inflation readings had moderated, ``sustained moderation in inflation pressures has yet to be convincingly demonstrated.'' Inflation risk, not slow growth, remains the predominant concern as we continue to see a rise in energy and food prices. I also share your view on the importance of low inflation in promoting growth, efficiency, and stability which in turn equal maximum sustainable employment. Chairman Bernanke, your statement also includes an extended discussion of the Federal Reserve's recent activities relating to subprime mortgage lending. The recent sharp increases in subprime mortgage loan delinquencies are troubling. The initiatives that you highlight in your testimony are welcome. However, I am concerned that the weaknesses in the subprime market may have broader systemic consequences. We have been told that the problem is largely isolated and contained, but I am concerned that it may not be. I will be particularly interested in hearing your views on the scope of the problem and how the Federal Reserve will monitor and manage the situation going forward. Chairman Bernanke, we are pleased to have you with us this morning. We look forward to discussing in greater detail the Federal Reserve's performance and its views on the future direction of our Nation's economy. Thank you, Mr. Chairman. ______ FinancialCrisisReport--183 At another point, the ROE warned: “Ensure cost-cutting measures are not impacting critical risk management areas.” 668 Another OTS examination that focused on WaMu’s holding company identified multiple risks associated with Long Beach: “[P]rimary risks associated with Long Beach Mortgage Company remain regulatory risk, reputation risk, and liquidity of the secondary market in subprime loans.” 669 Its concern about WaMu’s risk management practices prompted, in part, OTS’ requirement that WaMu commit its high risk lending strategy to paper and gain explicit approval from the Board of Directors. 2005 Risk Management Deficiencies. In 2005, after adoption of the High Risk Lending Strategy, OTS again highlighted risk management issues in its examination reports and again brought the matter to the attention of WaMu’s Board of Directors. In March 2005, OTS observed that WaMu’s five-year strategy, which increased credit risk for the bank, did not “clearly articulate the need to first focus on addressing the various operational challenges before embarking on new and potentially more risky growth initiatives.” 670 OTS also wrote: “We discussed the lack of a clear focus in the plan on resolving operational challenges with CEO Killinger and the Board.” 671 OTS continued to express concerns about the bank’s weak risk management practices for the rest of the year, yet took no concrete enforcement action to compel the bank to address the issue. In June 2005, OTS described risk management weaknesses within WaMu’s Corporate Risk Oversight group, a sub- group within the ERM Department responsible for evaluating credit and compliance risk. OTS wrote that it had deemed its comments as “criticisms” of the bank, because of the significance of the risk management function in addressing ongoing problems with the bank’s lending standards and loan error rates: “Most of the findings are considered ‘criticisms’ due to the overall significance of CRO [Corporate Risk Oversight] activities and the fact that we have had concerns with quality assurance and underwriting processes within home lending for several years.” 672 In August 2005, in its annual Report on Examination, OTS urged the WaMu Board to obtain progress reports from the ERM Department and ensure it had sufficient resources to 667 9/13/2004 OTS Report of Examination, at OTSWMS04-0000001504, Hearing Exhibit 4/16-94 [Sealed Exhibit]. 668 Id. at OTSWMS04-000001488. 669 4/5/2004 OTS Report of Examination, at OTSWMEF-0000047477, Hearing Exhibit 4/16-94 [Sealed Exhibit]. 670 3/15/2004 OTS Report of Examination, at OTSWMS04-0000001509, Hearing Exhibit 4/16-94 [Sealed Exhibit]. 671 Id. 672 6/1/2005 OTS Findings Memorandum, “Corporate Risk Oversight,” OTSWMS05-005 0002046, Hearing Exhibit 4/16-23. become an effective counterweight to the increased risk-taking entailed in the High Risk Lending Strategy: “Monitor and obtain reports from management on status of [Enterprise Risk FOMC20070628meeting--69 67,MS. LIANG.," The serious delinquency rate is for the pool of adjustable-rate subprime loans, and they represent about 9 percent of the outstanding mortgages." CHRG-111hhrg56241--184 Mr. Bachus," And I do think one answer is to look at whether they are lending, and if they are not lending, the government, if they are going to make money available it ought to be to those institutions that are lending and lending on Main Street, and put some competition out there . " FinancialCrisisReport--385 Hudson Mezzanine 2006-1, which included over $1.2 billion of long positions on CDS contracts to offset risk associated with ABX assets in Goldman’s own inventory and another $800 million in single name CDS contracts referencing subprime RMBS securities that Goldman wanted to short; the Mortgage Department then sold the Hudson securities to its clients. 1554 While this CDO transferred $1.2 billion of subprime risk from Goldman’s inventory to its clients and gave Goldman an opportunity to short another $800 million in RMBS securities it thought would perform poorly, the Mortgage Department still held billions of dollars of long positions in subprime mortgage related assets, primarily in ABX index assets. 1555 On December 14, 2006, as Goldman’s mortgage related assets continued to lose value, Goldman’s Chief Financial Officer, David Viniar, held a meeting with key Mortgage Department personnel and issued instructions for the Department to “get closer to home.” 1556 By “closer to home,” Mr. Viniar meant for the Mortgage Department to assume a more neutral risk position, one that was neither substantially long nor short, but actions taken by the Mortgage Department in response to his instructions quickly shot past “home,” resulting in Goldman’s first large net short position in February 2007. 1557 The actions taken by the Mortgage Department included selling outright from its inventory large numbers of subprime RMBS, CDO, and ABX assets, even at a loss, while simultaneously buying CDS contracts to hedge the long assets remaining in its inventory. The Mortgage Department also halted new RMBS securitizations, began emptying its RMBS warehouse accounts, and generally stopped purchasing new assets for its CDO warehouse accounts. It also purchased the short side of CDS contracts referencing the ABX index for a basket of AAA rated subprime residential loans, as a kind of “disaster insurance” in the event that even AAA rated mortgages started defaulting. Within about a month of the “closer to home” meeting, in January 2007, the Mortgage Department had largely eliminated or offset Goldman’s long positions on subprime mortgage related assets. The Mortgage Department then started to build a multi-billion-dollar short position to enable the firm to profit from the subprime RMBS and CDO securities starting to lose value. By the end of the first quarter of 2007, the Mortgage Department had swung from a $6 billion net long position in December 2006, to a $10 billion net short position in late February vultures wouldn ’t be circling. You also know that we probably would have gotten the position correct had I been involved a year ago – I probably would have gotten short to protect our warehouse and general hedge against the business given our outlook in the space. ” 2/5/2007 email from Richard Ruzika to Gary Cohn, “Are you living Morgatages? [sic], ” GS MBS-E-016165784. 1554 1555 For more information about the Hudson CDO, see below. See, e.g., 12/7/2006 email from Tom Montag, GS M BS-E-009756572 ( “I don ’t think we should panic regarding ABX holdings ”). 1556 12/14/2006 email from Daniel Sparks, “Subprime risk meeting with Viniar/McMahon Summary,” GS MBS-E- 009726498, Hearing Exhibit 4/27-3. 1557 Subcommittee interview of David Viniar (4/13/2010). 2007, a $16 billion reversal. 1558 A senior Goldman executive later described a net short position of $3 billion in subprime mortgage backed securities as “huge and outsized.” 1559 But Goldman’s net short position in February 2007 was $10 billion – more than triple that size. FinancialCrisisReport--358 The Offering Circular did, however, describe in detail a number of significant risks associated with RMBS securities. For example, it stated: • “The risk of losses on residential mortgage loans is particularly relevant now. While there is always a risk of defaults or delinquencies in payment, recently losses on residential mortgage loans have been increasing and may continue to increase in the future. The losses have been most significant in respect of subprime mortgage loans but all are affected. • A number of factors are contributing to the increase in losses. Residential property values that increased for many years are now declining. … Declining property values also exacerbate the losses due to a failure to apply adequate standards to potential borrowers. Failures to properly screen borrowers may include failures to do adequate due diligence on a borrower (including employment and income history) or the relevant property (including valuation) or failures to follow predatory lending and the other borrower-protection statutes. Increases in interest rates may also contribute to higher rates of loss. ... • The increase in delinquencies and defaults has contributed to a declining market for mortgage loans. The declining market has, in turn, seriously impacted mortgage originators and servicers. … The financial difficulties of servicers in particular are likely to result in losses in respect of securities backed by residential mortgage loans. … At any one time, the portfolio of Residential ABS Securities may be backed by residential loans with disproportionately large aggregate principal amounts secured by properties in only a few states or regions.” 1393 These disclosures demonstrate that both HBK and Deutsche Bank were well aware of the deteriorating mortgage market and increased risks associated with RMBS and CDO securities, even as they were marketing the Gemstone 7 securities and claiming HBK had applied careful analysis in the asset selection process to ensure good quality CDO securities. Long Beach-Fremont-New Century Bonds. A substantial portion of the cash and synthetic assets included in Gemstone 7, 30% in all, involved subprime residential mortgages issued by three subprime lenders, Long Beach, Fremont, and New Century, all known for issuing poor quality loans and securities. 1394 Loans by these lenders were among the first to collapse. According to Moody’s, these three originators, plus WMC Corporation, accounted for 31% of 1393 3/15/2007 Offering Circular for Gemstone CDO VII, Ltd., GEM7-00000427-816 at 483-84. While an earlier offering circular for Gemstone 7, dated February 14, 2007, identifies some risks associated with the CDO, the March offering circular contains additional language, quoted above, on the risks associated with the deteriorating mortgage market. 2/14/2007 Offering Circular for Gemstone CDO VII, Ltd., PSI-M&T_Bank-02-0001-370. 1394 For more information on these three lenders, see sections D(3)(d) and E(2)(c)-(d) of Chapter IV. Mr. Jenks of HBK told the Subcommittee that he saw data showing that Long Beach and Fremont were poor performers, but he thought the performance varied depending upon the tranche, and he believed he could pick the better tranches. He thought he could buy low, structure the deal well, and make money. Subcommittee interview of Kevin Jenks (10/13/2010). the subprime RMBS securities issued in 2006, but 63% of the rating downgrades issued in the second week of July 2007, when the mass rating downgrades began. 1395 CHRG-110shrg50369--119 Mr. Bernanke," Well, I think the subprime crisis sort of triggered these events. But it is true that investors have lost confidence in a lot of different assets at this point, including, it was mentioned, some student loans and other things as well. And part of the problem--not all of the problem, but part of the problem--is that in these complex structured credit products, it is very difficult for the investor to know exactly what is in there and what derivative support or credit liquidity support is involved. Senator Corker. So, in essence, the subprime issue that has occurred has caused us to look at those in a more healthy way, and hopefully the market will create some mechanisms for us to actually value those in real time and create a way for us to have some transparency there. Is that correct? " CHRG-111shrg52966--25 Mr. Cole," And we initiated major analysis of subprime mortgage markets in March and published an interim report in June of that year. Senator Bunning. Two-thousand-and-seven? " CHRG-111shrg57321--236 Mr. McDaniel," We were observing deterioration in performance of mortgages. That is what had the impact on the market, I believe---- Senator Levin. Yes. The subprime market just collapsed, right. " FinancialCrisisInquiry--239 ROSEN: Before that, the books... WALLISON: 2005 and 2004 are also bad. 2003 are much better. But my point is it’s important to understand what their portfolios consist of if we are to understand where these bad loans came from. And if the bad loans actually came from Fannie and Freddie wanting those loans and FHA wanting those loans, and those loans are a majority of the loans that are outstanding in our economy, that is a majority of the total bad loans that are outstanding in our economy, then that says something about why these loans were created. And it wasn’t just, I think, the desire for profit on the part of unregulated mortgage brokers. So I’m trying to—trying to understand whether you would agree with that if, in fact, the numbers are correct. ROSEN: Those numbers—I’ve seen the numbers, and the numbers on Fannie and Freddie are small relative to the size of the market what I’ve seen. And I—we certainly think we should—you should get the actual numbers and check as a commission. But Fannie and Freddie, they’ve documented exactly how many subprime and Alt-A they’ve got and, certainly, they’re bad. No question about it. But that is certainly not anywhere near the majority of the subprime mortgages and Alt-A mortgages. That, I am certain of. WALLISON: Have you seen the disclosure of Fannie and Freddie in their 10-Q for 2008 where they said how they had defined subprime loans? ROSEN: I have not looked at it in detail. CHRG-111hhrg48868--152 Mr. Clark," The moneys relating to those credit default swaps on the assets that covered subprime mortgages were used essentially to fund this ``Maiden Lane III'' vehicle. " fcic_final_report_full--557 Unless otherwise specified, data come from the sources listed below. Board of Governors of the Federal Reserve System, Flow of Funds Reports: Debt, international capital flows, and the size and activity of various financial sectors Bureau of Economic Analysis: Economic output (GDP), spending, wages, and sector profit Bureau of Labor Statistics: Labor market statistics BlackBox Logic and Standard & Poor’s: Data on loans underlying CMLTI 2006-NC2 CoreLogic: Home prices Inside Mortgage Finance, 2009 Mortgage Market Statistical Annual: Data on origination of mortgages, issuance of mortgage-backed securities and values outstanding Markit Group: ABX-HE index Mortgage Bankers Association National Delinquency Survey: Mortgage delinquency and fore- closure rates 10-Ks, 10-Qs, and proxy statements filed with the Securities and Exchange Commission: Com- pany-specific information Many of the documents cited on the following pages, along with other materials, are available on www.fcic.gov. Chapter 1 1. Charles Prince, testimony before the FCIC, Hearing on Subprime Lending and Securitization and Government-Sponsored Enterprises (GSEs), day 2, session 1: Citigroup Senior Management, April 8, 2010, transcript, p. 10. 2. Warren Buffett, testimony before the FCIC, Hearing on the Credibility of Credit Ratings, the In- vestment Decisions Made Based on Those Ratings, and the Financial Crisis, session 2: Credit Ratings and the Financial Crisis, June 2, 2010, transcript, p. 208; Warren Buffett, interview by FCIC, May 26, 2010. 3. Lloyd Blankfein, testimony before the First Public Hearing of the FCIC, day 1, panel 1: Financial Institution Representatives, January 13, 2010, transcript, p. 36. 4. Ben S. Bernanke, closed-door session with FCIC, November 17, 2009; Ben S. Bernanke, testimony before the FCIC, Hearing on Too Big to Fail: Expectations and Impact of Extraordinary Government In- tervention and the Role of Systemic Risk in the Financial Crisis, day 2, session 1: The Federal Reserve, September 2, 2010, transcript, p. 27. 5. Alan Greenspan, written testimony for the FCIC, Subprime Lending and Securitization and Gov- ernment-Sponsored Enterprises (GSEs), day 1, session 1: The Federal Reserve, April 7, 2010, p. 9. 553 6. Richard C. Breeden, interview by FCIC, October 14, 2010. 7. Paul A. McCulley, testimony before the FCIC, Hearing on the Shadow Banking System, day 2, ses- sion 3: Institutions Participating in the Shadow Banking System, May 6, 2010, transcript, p. 249. 8. Arnold Cattani, testimony before the FCIC, Hearing on the Impact of the Financial Crisis—Greater FinancialCrisisInquiry--619 ROSEN: They were, and many of these practices have been around for a long time, very successfully done, not the risk element—we heard that earlier—but narrowly based. It’s when they became—layered the risk. So if you underwrote a subprime mortgage but underwrote the person’s income, gave them counseling, did all the right things, you didn’t have this issue. Defaults were always higher, but not dramatically higher. Same thing with option ARMs. What happened is we layered the risk. We decided to give a person a subprime mortgage, not verify their income, give them no down payment. And I have charts in the paper which I sent to you guys that—it was hard to believe they were doing it; it’s layering all the risks. And it is because the owner of these mortgages was distant from the origination process. I think that’s why it happened. So the proliferation of products that were sound for certain categories of people with the right underwriting, became—underwriting just disappeared, and it proliferated throughout the system, so we ended up writing, instead of January 13, 2010 5 percent subprime mortgages, all of a sudden, it was 20 percent. Also, we had, I think, some of the predatory things that we heard from another witness that I think we did have people focusing and steering people. You’ve seen—I don’t have evidence of that, but we’ve seen lots of anecdotal evidence of that, and that certainly was a problem. FinancialCrisisInquiry--237 HENNESSEY: OK. How big of an impact do you think that ideal policy can have on that? I mean, a lot of mortgages are—it’s not preventing a lot of foreclosures. Again, sort of your magic wand works as well as you could expect, how much better do you think—how much bigger of an impact do you think you can have on foreclosures? ZANDI: Well, I think if we implemented a program that had principal reduction—and I can describe that in gory detail, if you’d like, exactly how that would work. Use the money that we’ve allocated in the TARP for housing policy that will not be used because HAMP and HARP are not working. Just use that money towards principle reduction, I think that would make a very meaningful difference to 2010. HENNESSEY: Thank you. CHAIRMAN ANGELIDES: Thank you. Mr. Wallison? WALLISON: Thanks very much. Mr. Rosen, Fannie Mae and Freddie Mac have become insolvent. The reason, I think, is that they have large numbers of subprime and Alt-A loans that are failing at very high rates. The numbers that I have seen indicate that they have about 10.7 million subprime loans and Alt-A loans. And that is in addition to about four and a half million FHA, VA loans which are also subprime and Alt-A. FinancialCrisisReport--398 Each of the four CDOs examined by the Subcommittee presents conflict of interest concerns and elements of deception related to how information about the CDO was presented to investors, including disclosures related to the relevant CDO’s asset selection process, the quality and value of the CDO’s assets and securities, and the nature and size of Goldman’s proprietary financial interests. The Subcommittee’s investigation raises questions regarding whether Goldman complied with its obligations to disclose material information to investors, including its material adverse interests, and to refrain from making investment recommendations that are unsuitable for any investor by recommending financial instruments designed to lose value and perform poorly. A key issue underlying much of this analysis is the structuring of and disclosures related to financial instruments that enable an investment bank to bet against the very financial products it is selling to clients. (4) How Goldman Shorted the Subprime Mortgage Market Having provided an overview of Goldman’s shorting activities and CDO activities in the years leading up to the financial crisis, this next section of the Report provides detailed information about how Goldman shorted the subprime mortgage market. (a) Starting $6 Billion Net Long By mid-2006, Goldman’s Mortgage Department had a predominantly pessimistic view of the U.S. subprime mortgage market. According to Michael Swenson, head of the Mortgage Department’s Structured Products Group: “[D]uring the early summer of 2006 it was clear that the market fundamentals in subprime and the highly levered nature of CDOs [were] going to have a very unhappy ending.” 1608 $6 Billion Long. In mid-2006, Goldman held billions of dollars in long subprime mortgage related securities, in particular the long side of CDS contracts referencing the ABX Index. In September 2006, Mortgage Department head Daniel Sparks and his superior, Jonathan Sobel, initiated a series of meetings with Mr. Swenson, head of the Structured Products Group (SPG), and Mr. Birnbaum, the Mortgage Department’s top trader in ABX assets, to discuss the Department’s long holdings. 1609 In those meetings, they discussed whether the Asset Backed Security (ABS) Trading Desk within SPG should get out of its existing positions or “double- down.” After the first meeting, Mr. Birnbaum emailed Mr. Swenson: 1608 9/26/2007 Michael J. Swenson Self-Review, GS-PSI-02396-401 at 398, Hearing Exhibit 4/27-55b. See also 12/14/2006 email from Daniel Sparks to Messrs. Montag and Ruzika, “Subprime risk meeting with Viniar/McMahon Summary,” GS M BS-E-009726498, Hearing Exhibit 4/27-3 ( “there will be very good opportunities as the market[] goes into what is likely to be even greater distress ”); 7/13/2006 email from Stuart Bernstein copied to Mr. Cohn, GS MBS-E-016209254 ( “he believes the REIT market is dead. We agreed . . . that as the market got worse, his ‘distressed ’ expertise would be more (not less) interesting to investors ”). See also Section 5(a)(iii) below regarding Goldman executives’ negative views of the market for subprime mortgages and subprime mortgage backed securities. 1609 9/19/2006 email chain between Joshua Birnbaum and Daniel Sparks, “ABX,” GS MBS-E-012683946. “Sobel and Sparks want to know if we should exit or double down. We double down if we have a structured place to go with the risk. ... [W]e are going to sit down with the CDO guys and talk about a deal.” 1610 CHRG-111shrg56376--119 PREPARED STATEMENT OF SENATOR JACK REED Today's hearing addresses a critical part of this Committee's work to modernize the financial regulatory system--strengthening regulatory oversight of the safety and soundness of banks, thrifts, and holding companies. These institutions are the engine of our economy, providing loans to small businesses and helping families buy homes and cars, and save for retirement. But in recent years, an outdated regulatory structure, poor supervision, and misaligned incentives have caused great turmoil and uncertainty in our financial markets. Bank regulators failed to use the authority they had to mitigate the financial crisis. In particular, they failed to appreciate and take action to address risks in the subprime mortgage market, and they failed to implement robust capital requirements that would have helped soften the impact of the recession on millions of Americans. Regulators such as the Federal Reserve also failed to use their rulemaking authority to ban abusive lending practices until it was much too late. I will work with my colleagues to ensure that any changes to the financial system are focused on these failings in order to prevent them from reoccurring (including by enhancing capital, liquidity, and risk management requirements). Just as importantly, however, we have to reform a fragmented and inefficient regulatory structure for prudential oversight. Today we have an inefficient system of five Federal regulators and State regulators that share prudential oversight of banks, thrifts, and holding companies. This oversight has fallen short in many significant ways. We can no longer ignore the overwhelming evidence that our system has led to problematic charter shopping among institutions looking to find the most lenient regulator, and has allowed critical market activities to go virtually unregulated. Regulators under the existing system acted too slowly to stem the risks in the subprime mortgage market, in large part because of the need to coordinate a response among so many supervisors. The Federal Reserve itself has acknowledged that the different regulatory and supervisory regimes for lending institutions and mortgage brokers made monitoring such institutions difficult for both regulators and investors. It is time to reduce the number of agencies that share responsibility for bank oversight. I support the Administration's plan to merge the Office of the Comptroller of the Currency and the Office of Thrift Supervision, but I think we should also seriously consider consolidating all Federal prudential bank and holding company oversight. Right now, a typical large holding company is overseen by the Federal Reserve or the Office of Thrift Supervision at the holding company level, and then the banks and thrifts within the company can be overseen by the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, and often many others. Creating a new consolidated prudential regulator would bring all such oversight under one agency, streamlining regulation and reducing duplication and gaps between regulators. It would also bring all large complex holding companies and other systemically significant firms under one regulator, allowing supervisors to finally oversee institutions at the same level as the companies do to manage their own risks. I appreciate the testimony of the witnesses today and I look forward to discussing these important issues. ______ FinancialCrisisInquiry--820 ROSEN: It is true. But, again, the vast majority of origination of the subprime mortgages came from unregulated lenders, most of who are gone now. Again, there are numbers that you should, as a commission, get those numbers, of course. FinancialCrisisInquiry--230 GEORGIOU: Some certain institutions. Right. CHAIRMAN ANGELIDES: Mr. Thomas, you want to take... VICE CHAIRMAN THOMAS: Mr. Chairman, I’ll take a—a minute, and then ask the question in terms of the distribution of the commercial loans vis-à-vis subprime and the rest. We had big banks in. Is there a greater strain on community banks in terms of the commercial loans versus the subprime being consolidated, and taken to a higher level? And that I think is something that should cause a lot of concern. Because if you get a collapse at that level, and we haven’t seen the response to recover or protect at that level, you’re going to have a far more fundamental erosion of locales than you would based upon what happened in the subprime. GEORGIOU: Do you agree with that? ROSEN: I’d say there’s—what you’re really talking about is the construction and development loans. There’s $550 billion of that outstanding, and that is at the smaller bank level. ROSEN: And—and we’ve already seen 170 banks—I guess there’s five or 600 more. VICE CHAIRMAN THOMAS: Oh, yes. ROSEN: And it’s a big number. And there really isn’t the policy response to this other than close them. CHRG-111hhrg48875--260 Mr. Manzullo," Okay. Thank you. They do have those powers. They did that by regulation, and the reason I bring that up is that here we have a very powerful Federal agency that could have curbed a lot of the subprime abuse by eliminating the 3/27 and the 3/28 teaser mortgages and by eliminating the so-called ``cheater'' mortgages by requiring proof that a person has the income that he states on his mortgage application, yet they did not act. And the reason I bring that up is you are wanting to start yet another large powerful Federal agency and give it additional powers and yet I just gave an example of a situation where a Federal agency with the powers to have stopped a lot of the subprime bleeding had the power but simply did not act. " FinancialCrisisReport--238 As a California based industrial loan company, Fremont Investment & Loan was overseen by the California Department of Financial Institutions, a state bank regulator. Since it had deposits that were federally insured, Fremont was also regulated by the FDIC. 937 The March 2007 FDIC cease and desist order required the bank to end its subprime lending business, due to “unsafe and unsound banking practices and violations of law,” including operating with “a large volume of poor quality loans”; “unsatisfactory lending practices”; “excessive risk”; and inadequate capital. 938 The FDIC also determined that the bank lacked effective risk management practices, lacked adequate mortgage underwriting criteria, and was “approving loans with loan- to-value ratios approaching or exceeding 100 percent of the value of the collateral.” 939 Many of the specific practices cited in the cease and desist order mirror the FDIC and OTS criticisms of WaMu. For example, the FDIC determined that Fremont was “marketing and extending adjustable-rate mortgage (‘ARM’) products to subprime borrowers in an unsafe and unsound manner that greatly increase[d] the risk that borrowers will default”; “qualifying borrowers for loans with low initial payments based on an introductory or ‘start’ rate that will expire after an initial period”; “approving borrowers without considering appropriate documentation and/or verification of the their income”; and issuing loans with “features likely to require frequent refinancing to maintain an affordable monthly payment and/or to avoid foreclosure.” 940 Fremont later reported receiving default notices on $3.15 billion in subprime mortgages it had sold to investors. 941 One year later, in March 2008, the FDIC filed another public enforcement action against the bank, for failing to provide an acceptable capital restoration plan or obtaining sufficient capital, and ordered the bank’s parent company to either adequately capitalize the bank within 60 days or sell it. 942 The bank was then sold to CapitalSource, Inc. The FDIC took action against Fremont much earlier – in March 2007 – than other regulators did with respect to other financial institutions, including OTS’ nonpublic enforcement actions against WaMu in March and September 2008; the FDIC’s seizure of IndyMac in July 2008; the SEC’s action against Countrywide in June 2009; and the SEC’s action against New 936 In re Fremont General Corporation, Case No. 8:08-bk-13421-ES (US Bankruptcy Court, CD Calif.), First Status Report (July 30, 2010) (included in 7/30/2010 Fremont General Corporation 8K filing with the SEC). 937 2006 Fremont 10-K Statement with the SEC. 938 Fremont Cease and Desist Order at 1-3. See also 3/7/2007 FDIC press release, “FDIC Issues Cease and Desist Order Against Fremont Investment & Loan, Brea, California, and its Parents.” 939 Fremont Cease and Desist Order at 2-4. 940 Id. at 3. 941 See 3/4/2008 Fremont General Corporation press release, “Fremont General Corporation Announces Receipt of Notice of Covenant Default With Respect to Guaranties Issued in Connection With Certain Prior Residential Sub- Prime Loan Sale Transactions,” http://media.corporate-ir.net/media_files/irol/10/106265/08-03- 04N%20FGCAnnouncesDefaultNoticewithRRELoanTransactions.pdf. See also “CapitalSource to Acquire Fremont’s Retail Arm,” New York Times (4/14/2008). 942 In re Fremont Investment & Loan, Supervisory Prompt Corrective Action Directive, Docket No. FDIC-08-069 PCAS ( March 26, 2008). CHRG-111hhrg56241--167 Mr. Cleaver," I was wondering if you could do an overlay with what happened with the mortgages--the banks, mortgage companies, that did not go into the subprime scam even though they didn't make as much money. Now, if you look at their books, they did better. And so the question that I raise was based on what I have seen with the subprime industry. And do you think that the--particularly the Wall Street so-called investment banks will change their compensation structure without congressional legislative encouragement? Ms. Minow? Ms. Minow. As I discussed in my testimony, the fact that following the bailout just over the last year, they have essentially poured gasoline on the fire of excessive compensation suggests to me that they need a much stronger message from Congress. " CHRG-111shrg55117--87 Mr. Bernanke," I understand the motivation. I understand why people are concerned that the Fed and others have not been sufficiently active on this and they think that maybe having a separate agency would be more committed to these issues. I do think, though, that there are some costs to splitting consumer compliance regulation from safety and soundness regulation. It means banks have to go through two separate sets of examinations. It means there are certain areas, like underwriting and others, that bear on both safety and soundness and on consumer protection which are not being jointly considered. And it may mean that there is not sufficient feedback from what is going on in the banks to the rule writers at the agency. So I think there are some costs there. I understand the motivation of those who would like to have such an agency, and I am not here to criticize that, but your particular point about some cost about splitting the safety and soundness and the consumer compliance, I think there is some validity to that. Senator Vitter. Well, my concern is when you look at the recent crisis, some of the causes--not all, I mean, we can point to a lot of different things--but some of the causes at Fannie Mae, Freddie Mac, in mandates like the Consumer Reinvestment Act, are consumer-driven, politically driven mandates that essentially got ahead of safety and soundness, in my opinion, promoting subprime lending, et cetera, beyond reasonable safety and soundness guidelines. Aren't we at risk of broadening and institutionalizing that danger by having this very powerful separate consumer issues regulator again structurally divorced from safety and soundness? " CHRG-111shrg57322--326 Mr. Birnbaum," Well, the mortgage market is a big market. You have agency mortgages, you have non-agency mortgages, you have prime mortgages, subprime mortgages. Senator Tester. Sure. " CHRG-111hhrg52406--107 Mr. Hensarling," Let me ask this question then, if I could, for those particularly who support the legislation. I want to talk about a few financial products and ask if you believe they are unfair or anti-consumer. And if you would raise your hand if you believe they are unfair or anti-consumer. If you don't believe or you don't have an opinion, you can leave your hand down. Negative amortization ARMs, does anybody believe those are unfair or anti-consumer? Okay. We have a couple of hands there. Subprime mortgages, the entire universe of subprime mortgages? Ms. Warren. Congressman, I can't understand this without seeing what the paperwork is that accompanies them and what the disclosure is that is given to the consumer. " fcic_final_report_full--563 Competitive Banks” (February 1991), p. 55. 27. Testimony of John LaWare, Governor, Federal Reserve Board, at Hearings before Subcommittee on Economic Stabilization of the Committee on Banking, Finance, and Urban Affairs on the “Economic Implications of the Too Big to Fail Policy,” May 9, 1991, p. 11, http://fraser.stlouisfed.org/ publications/tbtf/issue/3954/download/61094/housetbtf1991.pdf. FDIC, History of the Eighties: Lessons for the Future , 1:251. 28. George G. Kaufman, “Too Big to Fail in U.S. Banking: Quo Vadis?” in Too Big to Fail: Policies and Practices in Government Bailouts, ed. Benton E. Gup (Westport, CT: Praeger, 2004), p. 163. 29. FCIC, “Preliminary Staff Report: Too-Big-to-Fail Financial Institutions,” August 31, 2010, pp. 6– 9.(Rep. McKinney is quoted from the transcript of the hearing before the House Committee on Banking, Housing, and Urban Affairs). 30. Ibid., pp. 10, 19. Chapter 3 1. Federal National Mortgage Association, Federal National Mortgage Association, Background and History (1975). 2. Department of Housing and Urban Development, 1986 Report to Congress on the Federal National Mortgage Association (1987), p. 100. 3. See, e.g., Kenneth H. Bacon, “Privileged Position: Fannie Mae Expected to Escape Attempt at Tighter Regulation,” Wall Street Journal , June 19, 1992, and Stephen Labaton, “Power of the Mortgage Twins: Fannie and Freddie Guard Autonomy,” New York Times , November 12, 1991. 4. Armando Falcon Jr., written testimony for the FCIC, Hearing on Subprime Lending and Securitiza- tion and Government-Sponsored Enterprises (GSEs), day 3, session 2: Office of Federal Housing Enter- prise Oversight, April 9, 2010, p. 2. 5. Wayne Passmore, “The GSE Implicit Subsidy and the Value of Government Ambiguity,” Federal Re- serve Board Staff Working Paper 2005–05. See also Congressional Budget Office, “Updated Estimates of the Subsidies to the Housing GSEs,” April 8, 2004. 6. Federal Housing Finance Agency, Report to Congress, 2009 (2010), pp. 141, 158. 7. Fannie Mae Charter Act of 1968, §309(h), codified at 12 U.S.C. §1723a(h). The 1992 Federal Hous- ing Enterprises Financial Safety and Soundness Act repealed this provision and replaced it with more elaborate provisions. Currently, the GSEs typically define low- and moderate-income borrowers as those with income at or below median income for a given area. 8. Department of Housing and Urban Development, “Regulations Implementing the Authority of the Secretary of the Department of Housing and Urban Development over the conduct of the Secondary market Operations of the Federal National Mortgage Association (FNMA),” Federal Register 43, no. 158 (August 15, 1978): 36199–226. 9. President William J. Clinton, “Remarks on the National Homeownership Strategy,” June 5, 1995. 10. President George W. Bush, “President’s Remarks to the National Association of Home Builders,” Greater Columbus Convention Center, Columbus, Ohio, October 2, 2004. 11. Andrew Cuomo, interview by FCIC, December 17, 2010. 12. Daniel Mudd, testimony before the FCIC, Hearing on Subprime Lending and Securitization and Government-Sponsored Enterprises (GSEs), day 3, session 1: Fannie Mae, April 9, 2010, transcript, pp. 18–19. 13. Richard Syron, interview by FCIC, August 31, 2010. 14. Senate Lobbying Disclosure Act Database (www.senate.gov/legislative/Public_Disclosure/ LDA_reports.htm); figures on employees and PACs compiled by the Center for Responsive Politics from Federal Elections Commission data. 15. Falcon, written testimony for the FCIC, April 9, 2010, p. 5. 16. James Lockhart, written testimony for the FCIC, Hearing on Subprime Lending and Securitiza- tion and Government-Sponsored Enterprises (GSEs), day 3, session 2: Office of Federal Housing Enter- prise Oversight, pp. 4–8, 17 (quotation). 17. Senator Mel Martinez, interview by FCIC, September 28, 2010. 18. June E. O’Neill, remarks before the Conference on Appraising Fannie Mae and Freddie Mac, CHRG-111hhrg48868--82 Mr. Garrett," I appreciate that. Mr. Polakoff, $80 billion left out there; $50 billion of that is on the subprime situation, right? [no verbal response] " CHRG-111hhrg53240--105 Chairman Watt," Press that button and pull it close to you. Ms. McCoy. Chairman Watt, Ranking Member Paul, and members of the subcommittee, thank you for inviting me here today to discuss restructuring financial regulation. Today I will testify in support of the Consumer Financial Protection Agency Act of 2009. This bill would transfer consumer protection and financial services from Federal banking regulators to one agency dedicated to consumer protection. We need this to fix two problems: first, during the housing bubble, fragmented regulation encouraged lenders to shop for the easiest regulators and laws; and second, banking regulators often dismiss consumer protection in favor of the short-term profitability of banks. Under our fragmented system of credit regulation, lenders could and did shop for the easiest laws and regulators. One set of laws applies to federally chartered banks and thrifts and their operating subsidiaries. Another set of laws applies to independent nonbank lenders and mortgage brokers. Because lenders could threaten to change charters, they were able to play regulators off one another. This put pressure on regulators, both State and Federal, to relax their standards and enforcement. Countrywide, for example, turned in its charters in early 2007 in order to drop the OCC and Federal Reserve regulators and to switch to the OTS. The result was a regulatory race to the bottom that only the Fed had the power to stop. During the housing bubble, three of the four Federal banking regulators--the Federal Reserve, the OCC, and the OTS--succumbed to pressure to loosen loan underwriting standards and safeguards for consumers. Today I will focus on the Fed. Under Chairman Alan Greenspan, the Federal Reserve Board failed to stop the mortgage crisis in thee crucial ways: First, the Federal Reserve was the only agency that could have stopped the race to the bottom. That was because it had the ability to prohibit unfair and deceptive lending for all lenders nationwide under the Home Ownership Equity Protection Act. But Chairman Greenspan refused to exercise that authority. The Fed did not change its mind until last summer when it finally issued such a rule. At that point, the horse was out of the barn. Second, the Fed as a matter of policy did not do regular examinations of the nonbank subprime lenders under its jurisdiction. These included the biggest subprime lender in 2006, HSBC Finance, and Countrywide ranked number three. Finally, the last time the Fed did a major overhaul of its Truth in Lending Act mortgage disclosures was 28 years ago, in 1981. With the rise in subprime loans and nontraditional ARMs, those disclosures became solely obsolete. Nevertheless, the Fed did not even open a full review of its mortgage disclosure rules until 2007, and it still has not completed that review. So why did the Federal Reserve drop the ball? One reason was its overriding belief in deregulation. Another, however, was an attitude that a good way to improve bank safety and soundness was to bolster fee income at banks. We still see that today with respect to rate hikes with credit cards still going on. This focus on short-term profits not only hurt consumers, it undermined our Nation's financial system. The Act would fix these problems in three ways: first, it would stop shopping by providing one set of consumer protection rules for all providers nationwide; second, the Act puts the authority for administering those standards in one Federal agency whose sole mission is consumer protection. We are asking the Fed to do too much when we ask it to excel at four things: monetary policy; systemic risk regulation; bank safety and soundness; and consumer protection. Housing consumer protection in a separate agency in fact will provide a healthy check on the tendency of Federal banking regulators to underestimate risk at the top of the business cycle. Finally, to avoid any risk of future inaction by the new agency, the Act gives backup enforcement authority to the Fed and other Federal banking regulators in the States. My time is up. Thank you and I will welcome any questions. [The prepared statement of Professor McCoy can be found on page 161 of the appendix.] " CHRG-111hhrg56766--89 Mrs. Capito," Thank you. On page three of your testimony, you talk about contrasting larger lending institutions with smaller lending institutions, and you say bank lending continues to contract, reflecting both tightened lending standards and weak demand for credit and uncertain economic prospects. My question is that I have heard from our community bankers that they have the capital to lend but they are getting conflicting messages from regulators. How can we ensure prudent lending and capital levels while working with these institutions but to expand on the question, too, they have the capital to lend, but creditworthy customers are not the ones coming in the door looking for expansion of their business because they lack confidence in where the economy is now, where we will be a year from now. That is my first question. Thank you. " CHRG-110shrg50415--21 Mr. Rokakis," Thank you, Mr. Chairman and Members of the committee, for the opportunity to speak to you today. I am the Treasurer of Cuyahoga County, Ohio, the State's largest county, representing Cleveland and 59 cities, villages, and townships. While the events of the past several months have focused the attention of the entire financial world on the practices of the subprime lending industry, we have suffered the consequences of reckless and irresponsible lending for many years. Since the late 1990's, Ohio and Cuyahoga County have consistently led the Nation in this sad statistic of foreclosure filings. Consider these numbers. In 1995, 3,300 private mortgage foreclosures were filed in Cuyahoga County and about 16,000 in the State of Ohio. By 2000, the number in Cuyahoga County had more than doubled to over 7,500 private mortgage foreclosures and over 35,000 in Ohio--better than double the number for 5 years earlier. In 2006, there were 13,000 foreclosures--13,600, actually, filed in Cuyahoga County; 15,000 filed in Cuyahoga County in 2007. And, sadly, we are on pace to foreclose on an additional 15,000 properties in Cuyahoga County in 2008. I am accompanied here today by Professor Howard Katz, a professor of law from Elon University, who was our Director of Strategic Planning in Cuyahoga County back in 2000. Professor Katz and I approached the Federal Reserve Bank of Cleveland in the fall of 2000 to ask for their help in controlling the reckless lending practices that were doing real harm to Cleveland neighborhoods, harm I describe in detail in an article I wrote for the Post entitled ``Shadow of Debt.'' We knew the Fed had the authority to act under HOEPA, the Home Ownership Equity Protection Act, and under the truth-in-lending laws. Our hope was that the Fed would step up once they knew the extent of the problem. That was our hope. The Fed cosponsored a 1-day conference in March of 2001 entitled ``Predatory Lending in Ohio'' where we discussed potential solutions, Federal, State, and local. Our keynote speaker, Mr. Chairman, was Ed Gramlich, the late Fed Governor who passed away in 2007. We had contacts from the Fed that said that late Governor Gramlich understood the nature of the problem. As we all know now, he had warned Fed Chairman Greenspan about the need to regulate these practices. Nothing of substance came from this conference. In frustration, local ordinances were passed later that year in Cleveland, Dayton, and Toledo to try to slow down the practices of the mortgage bankers and brokers. Within 90 days of these ordinances passing, the Ohio Legislature passed a law pre-empting the right of Ohio cities to regulate in this area. In early 2005, I approached the U.S. Attorney of the Northeast District of Ohio, U.S. Attorney Greg White, and requested a meeting of Federal and local officials to deal with these practices from the enforcement side. We knew we were the victims of fraud on an industrial scale. This meeting included U.S. Attorney White, other Assistant U.S. Attorneys, FBI agents, and postal inspectors where we begged that Federal authorities make this enforcement issue a high priority. I still remember one Assistant U.S. Attorney making the point that they had received not a single complaint from any of the mortgage banks involved in these loans. He asked me, and I remember, ``If they aren't complaining, who are the victims?'' Well, Mr. Chairman, the victim was the homeowner who lived on a stable street and woke up 1 day and found that there was a vacant house next to him, and a month later one across the street, and a year later three more on that street. That entire neighborhood was victimized by this, and as we have come to learn now, Mr. Chairman, the victim is the entire world. For the record, a very limited number of prosecutions came as a result of these meetings. The only significant prosecutions in our community have been by the county prosecutor's office. We tried, Mr. Chairman and Members of the Committee, we did try. We were ignored. There were others who tried to warn the Federal Government about this problem, the Fed, but we were no match for Wall Street. Mr. Chairman, I would like to take my remaining time to discuss the attempts, as you have and others here, to pin this entire crisis on the Community Reinvestment Act of 1977. You all know what the CRA is, what it does. I do not need to get into the details. But if you really want to understand how silly this allegation is, all you need to do is look at the lending data for the city of Cleveland. The peak year for home purchase mortgage origination in Cleveland was 2005. A local nonprofit research organization, the Housing Research and Advocacy Center, has analyzed the HMDA data for that year. They found that of the top ten mortgage originators in the city that year, only four were affiliated in any way with local depository banks, and those four accounted for less than 15 percent of the total mortgages originated. Of the 7,100 Cleveland mortgages reported in HMDA data that year, 1,258--almost 18 percent--were originated by the now defunct subprime lender Argent Mortgage. Argent was never covered by the CRA. The second largest Cleveland lender that year was New Century Mortgage, also now defunct, with about 5 percent of the total. The third largest lender, also accounting for about 5 percent, was Third Federal Savings, which I have to say, Mr. Chairman, there are some heroes in this crisis. Third Federal Savings and Loan has been one of the few really good guys in this industry, at least in our community. They have done an outstanding job. They did not make these kinds of loans. Numbers 4, 5, and 6 and others on that list, again, were companies like Aegis, Long Beach Mortgage, and others, which were not covered by CRA. Finally, way down that list, we get to banks like Charter One, National City, and Fifth Third, but they each only had about 3 percent of the market, adding up to about 648 loans. Did they make these loans to help their parent institutions' CRA ratings look better? Possibly. Did these 648 loans play a major role in the city's default and foreclosure crisis? Hardly. I realize I am out of time, but I would like to just point to one bit of statistic. As dangerous as mortgages, Mr. Chairman and Members of the Committee, were the home refis. If you look at the home refi data, you will find that they, first of all, equaled the number of home purchase mortgages. Refis have been very destructive in our community, have resulted in many foreclosures. And if you look at the refi data, Mr. Chairman, only 7 percent of those loans were made by CRA-affiliated institutions. The foreclosure crisis in Cleveland for the last 6 years has not been driven by CRA-covered depository banks, even though some of them--notably National City--were minor players. The problem has been driven by Argent, New Century, Aegis, Countrywide, Long Beach, and others, dozens of other subprime and high-cost loan peddlers with no local depository services and no CRA obligations in our community. Thanks for the chance to be on this distinguished panel. " CHRG-111shrg57322--46 Mr. Sparks," Fremont originated subprime loans. People understood that. Senator Levin. Yes or no, were you aware of their poor reputation and high default rate. " FinancialCrisisReport--191 In 1999, WaMu’s parent holding company, Washington Mutual Inc., purchased Long Beach Mortgage Company (Long Beach). Long Beach’s business model was to issue subprime loans initiated by third party mortgage lenders and brokers and then sell or package those loans into mortgage backed securities for sale to Wall Street firms. Beginning in 1999, Washington Mutual Bank worked closely with Long Beach to sell or securitize its subprime loans and exercised oversight over its lending and securitization operations. Because Long Beach was a subsidiary of Washington Mutual Inc., the holding company, however, and not a subsidiary of Washington Mutual Bank, OTS did not have direct regulatory authority over the company, but could review its operations to the extent they affected the holding company or the bank itself. OTS was aware of ongoing problems with Long Beach’s management, lending and risk standards, and issuance of poor quality loans and mortgage backed securities. OTS reported, for example, that Long Beach’s “early operations as a subsidiary of [Washington Mutual Inc.] were characterized by a number of weaknesses” including “loan servicing weaknesses, documentation exceptions, high delinquencies, and concerns regarding compliance with securitization-related representations and warranties.” 717 OTS also reported that, in 2003, “adverse internal reviews of [Long Beach] operations led to a decision to temporarily cease securitization activity” until a “special review” by the WaMu legal department ensured that file documentation “adequately supported securitization representations and warranties” made by Long Beach. 718 OTS was aware of an examination report issued by a state regulator and the FDIC after a review of 2003 Long Beach loans, which provides a sense of the extent of problems with those loans at the time: “An internal residential quality assurance (RQA) report for [Long Beach]’s first quarter 2003 … concluded that 40% (109 of 271) of loans reviewed were considered unacceptable due to one or more critical errors. This raised concerns over [Long Beach]’s ability to meet the representations and warranty’s made to facilitate sales of loan securitizations, and management halted securitization activity. A separate credit review report … disclosed that [Long Beach]’s credit management and portfolio oversight practices were unsatisfactory. … Approximately 4,000 of the 13,000 loans in the warehouse had been reviewed … of these, approximately 950 were deemed saleable, 800 were deemed unsaleable, and the remainder contained deficiencies requiring remediation prior to sale. … [O]f 4,500 securitized loans eligible for foreclosure, 10% could not be foreclosed due to documentation issues.” 719 Despite these severe underwriting and operational problems, Long Beach resumed securitization of its subprime loans in 2004. In April 2005, OTS examiners circulated an internal email commenting on the poor quality of Long Beach loans and mortgage backed securities compared to its peers: 717 12/21/2005 OTS internal memorandum by OTS examiners to OTS Deputy Regional Director, OTSWMS06-007 0001010, Hearing Exhibit 4/16-31. 718 Id. 719 1/13/2004 FDIC-Washington State joint visitation report, FDIC-EM_00102515-20, Hearing Exhibit 4/13-8b. OTS held a copy of this report in its files, OTSWME04-0000029592. “Performance data for 2003 and 2004 vintages appear to approximate industry average while issues prior to 2003 have horrible performance. . . . [Long Beach] finished in the top 12 worst annualized [Net Credit Losses] in 1997 and 1999 thru 2003. [Long Beach nailed down the number 1 spot as top loser with an [Net Credit Loss] of 14.1% in 2000 and placed 3 rd in 2001 with 10.5%. … For ARM [adjustable rate mortgage] losses, [Long CHRG-111shrg54675--6 Mr. Hopkins," Chairman Johnson, Ranking Member Crapo, and Members of the Subcommittee, thank you very much for the opportunity to provide you with the community bank perspective on the impact of the credit crisis in rural areas. My name is Jack Hopkins, and I am President and CEO of CorTrust Bank in Sioux Falls, South Dakota. I am testifying on behalf of the Independent Community Bankers of America, and I serve on the ICBA's Executive Committee. I am a past President of the Independent Community Bankers of South Dakota and have been a banker in South Dakota for 25 years. CorTrust Bank is a national bank with 24 locations in 16 South Dakota communities and assets of $550 million. Eleven of the communities we serve have fewer than 2,000 people. In seven of those communities, we are the only financial institution. The smallest community has a population of 122 people. Approximately 20 percent of our loan portfolio is agricultural lending to businesses that rely heavily on the agricultural economy. CorTrust Bank is also one of the leading South Dakota lenders for the USDA's Rural Housing Service home loan program. Mr. Chairman, as we have often stated before this Committee, community banks played no part in causing the financial crisis fueled by exotic lending products, subprime loans, and complex and highly leveraged investments. However, rural areas have not been immune from rising unemployment, tightening credit markets, and the decline in home prices. We believe that, although the current financial crisis is impacting all financial institutions, most community banks are well positioned to overcome new challenges, take advantage of new opportunities, and reclaim some of the deposits lost to larger institutions over the last decade. A recent Aite study shows that even though some community banks are faced with new lending challenges, they are still lending, especially when compared to larger banks. In fact, while the largest banks saw a 3.23-percent decrease in 2008 net loans and leases, institutions with less than $1 billion in assets experienced a 5.53-percent growth. Mr. Chairman, small businesses are the lifeblood of rural communities. We believe small businesses will help lead us out of the recession and boost needed job growth. Therefore, it is vitally important to focus on the policy needs of the small business sector during this economic downturn. As I mentioned earlier, most of my commercial lending is to small businesses dependent on agriculture. The Small Business Administration programs are an important component of community bank lending. SBA must remain a viable and robust tool in supplying small business credit. The frozen secondary market for small business loans continues to impede the flow of credit to small business. Although several programs have been launched to help unfreeze the frozen secondary market for pools of SBA-guaranteed loans, including the new Term Asset-Backed Securities Loan Facility--TALF and a new SBA secondary market facility, they have yet to be successful due to the program design flaws and unworkable fees. ICBA recommends expanding these programs to allow their full and considerable potential. Several of my colleagues have told us about the mixed messages they received from bank examiners and from policy makers regarding lending. Field examiners have created a very harsh environment that is killing lending as examiners criticize and require banks to write down existing loans, resulting in capital losses. Yet policy makers are encouraging lending from every corner. Some bankers are concerned that regulators will second-guess their desire to make additional loans, and others are under pressure from their regulators to decrease their loan-to-deposit ratios and increase capital levels. Generally, the bankers' conclusions are that ample credit is available for creditworthy borrowers. They would like to make more loans, and they are concerned about the heavy-handedness from the regulators. Finally, Mr. Chairman, community bankers are looking closely at the regulatory reform proposals. ICBA supports the administration's proposal to prevent too-big-to-fail banks or nonbanks from ever threatening the collapse of the financial system again. Community banks support the dual system of State and Federal bank charters to provide checks and balances which promote consumer choice and a diverse and competitive financial system sensitive to the financial institutions of various complexity and size. Washington should allow community banks to work with borrowers in troubled times without adding to the costs and complexity of working with customers. Mr. Chairman, ICBA stands ready to work with you and the Senate Banking Committee on all of the challenges facing the financial system and how we may correct those issues gone awry and buttress those activities that continue to fuel the economies in rural areas. I am pleased to answer any questions you may have. " CHRG-111hhrg54868--39 Mr. Neugebauer," Thank you, Mr. Chairman. I want to go back to some of the comments I made in my opening statement. Chairman Bair, we will start with you. What was the FDIC doing in relationship to consumer protection, say, over the last 5 or 10 years? In other words--because quite honestly, as I said, some folks don't think you all were doing anything. Ms. Bair. The first thing I would like to say is we don't have the authority to write consumer rules. We have never had that. That has always been vested in the Federal Reserve Board. Two years ago, I came to this committee and asked for the ability to do that. Mr. Dugan did the same thing. I will be happy to give you our comment letters to the Federal Reserve Board on subprime lending, on yield spread premiums, on credit cards, and on overdraft protection. We have vigorously pressed for a number of years for stronger consumer protections in key areas. My examiners are only as good as the rules they have to enforce. So that is that. Number two, in enforcing the rules we do have, we have done a reasonable job. Could we do better? Yes. That has been one of the things that I have tried to do as Chairman of the FDIC. We have increased the number of our compliance examiners, we have increased and streamlined our General Counsel section that brings these enforcement cases, and overall, we do have a pretty good record. I am happy to give you the numbers concerning our enforcement cases if you would like. We care about consumer protection. We care about protecting bank customers. No, we don't want to lose that. And if you want to call that turf, that is fine, but that is who we are. " FinancialCrisisInquiry--243 Chairman Greenspan said—encouraged people to take these loans. Remember one of those statements he made, and I couldn’t believe he said that. And he did. He apologized after the fact for it. But he did say it. BORN: Ms. Gordon, do you have any input on this? GORDON: My only input is to agree that the regulators—all of them, not just the Fed—had ample information to know that there was a problem. When we did our report on subprime mortgages in 2006 and looked back at the longitudinal performance of loans by origination year, I mean, we could see that the subprime loans had very high failure rates from very early on—from 1998 through 2001. And the regulators, presumably, would have had the same ability to find this information as we did. You know, by 2005, quite a number of the subprime originators had already collapsed or been the targets of major law enforcement actions. There was, you know, Household and an associates and Ameriquest—there was a ton of stuff out there. You know, the OTS had examiners on site at WaMu. I don’t know what they were doing, but they weren’t noticing the risky loans that were going on. BORN: Well, and all the federal banking supervisors should have had examiners in the national banks, the bank-holding companies, the thrifts. And they should have been examining for prudential—for prudential standards, shouldn’t they? ZANDI: Can I give my $0.03 on the topic? BORN: FOMC20070509meeting--5 3,MR. FISHER.," I have two questions. On page 2, when you talk about subprime paper, do we have any data that can tell us anything about the stress in the alt-A markets specifically?" CHRG-110hhrg45625--65 Mr. Bernanke," I was just going to comment that they did not make subprime loans, but they do have residential loans and commercial real estate loans, and I think that there will be issues there. " fcic_final_report_full--517 Activities,” 121 the authors noted in slide 10 that AH goal costs had risen from $2,632,500 in 2000 to $13,447,500 in 2003. Slide 17 is entitled: “Meeting Future HUD Goals Appear Quite Daunting and Potentially Costly” and reports, “Based on 2003 experience where goal acquisition costs (relative to Fannie Mae model fees) cost between $65 per goals unit in the first quarter to $370 per unit in the fourth quarter, meeting the shortfall could cost the company $6.5-$36.5 million to purchase suffi cient units.” The presentation concludes (slide 20): “Cost of mission activities— explicit and implicit—over the 2000-2004 period likely averaged approximately $200 million per year.” Earlier, I noted the efforts of Fannie and Freddie to window-dress their records for HUD by temporarily acquiring loans that would comply with the AH goals, while giving the seller the option to reacquire the loans at a later time. In 2005, we begin to see efforts by Fannie’s staff to accomplish the same window-dressing in another way--delaying acquisitions of non-goal-eligible loans so Fannie can meet the AH goals in that year; we also see the first efforts to calculate systematically the effect of goal-compliance on Fannie’s profitability. In a presentation dated September 30, 2005, Barry Zigas, the key Fannie offi cial on affordable housing, outlined a “business deferral option.” Under that initiative, Fannie would ask seven major lenders to defer until 2006 sending non-goal loans to Fannie for acquisition. This would reduce the denominator of the AH goal computation and thus bring Fannie nearer to goal compliance in the 4th quarter of 2005. The cost of the deferral alone was estimated at $30-$38 million. 122 In a presentation to HUD on October 31, 2005, entitled “Update on Fannie Mae’s Housing Goals Performance,” 123 Fannie noted several “Undesirable Tradeoffs Necessary to Meet Goals.” These included significant additional credit risk, and negative returns (“Deal economics are well below target returns; some deals are producing negative returns” and “G-fees may not cover expected losses”). One of the most noteworthy points was the following: “Liquidity to Questionable Products: Buying exotic product encourages continuation of risky lending; many products present with significant risk-layering; consumers are at risk of payment shock and loss of equity; potential need to waive our responsible lending policies to get goals business.” Much of the narrative about the financial crisis posits that unscrupulous and unregulated mortgage originators tricked borrowers into taking on bad mortgages. The idea that predatory lending was a major source of the NTMs in the financial system in 2008 is a significant element of the Commission majority’s report, although the Commission was never able to provide any data to support this point. This Fannie slide suggests that loans later dubbed “predatory” might actually have been made to comply with the AH goals. This possibility is suggested, too, in a message sent in 2004 to Freddie’s CEO, Richard Syron, by Freddie’s chief risk manager, David Andrukonis, when Syron was considering whether to authorize a “Ninja” (no income/no jobs/no assets) product that he ultimately approved. Andrukonis argued against authorizing Freddie’s purchase: “The potential for the perception and reality 121 122 123 Fannie Mae, “Costs and Benefits of Mission Activities, Project Phineas,” June 14, 2005. Barry Zigas, “Housing Goals and Minority Lending,” September 30, 2005. Fannie Mae, “Update on Fannie Mae’s Housing Goals Performance,” Presentation to the U.S. Department of Housing and Development, October 31, 2005. 513 of predatory lending, with this product is great.” 124 But the product was approved by Freddie, probably for the reason stated by another Freddie employee: “The Alt-A [(low doc/no doc)] business makes a contribution to our HUD goals.” 125 On May 5, 2006, a Fannie staff memo to the Single Family Business Credit Committee revealed the serious credit and financial problems Fannie was facing when acquiring subprime mortgages to meet the AH goals. The memo describes the competitive landscape, in which “product enhancements from Freddie Mac, FHA, Alt-A and subprime lenders have all contributed to increased competition for goals rich loans…On the issue of seller contributions [in which the seller of the home pays cash expenses for the buyer] even FHA has expanded their guidelines by allowing 6% contributions for LTVs up to 97% that can be used toward closing, prepaid expenses, discount points and other financing concessions.” 126 The memorandum is eye-opening for what it says about the credit risks Fannie had to take in order to get the goals-rich loans it needed to meet HUD’s AH requirements for 2006. Table 11 below shows the costs of NTMs in terms of the guarantee fee (G-fee) “gap.” (In order to determine whether a loan contributed to a return on equity, Fannie used a G-fee pricing model that took into account credit risk as well as a number of other factors; a G-fee “gap” was the difference between the G-fees required by the pricing model for a particular loan to contribute to a return on equity and a loan that did not.) The table in this memo shows the results for three subprime products under consideration, a 30 year fixed rate mortgage (FRM), a 5 year ARM, and 35 and 40 year fixed rate mortgages. For simplicity, this analysis will discuss only the 30 year fixed rate product. The table shows that the base product, the 30 year FRM, with a zero downpayment should be priced according to the model at a G-fee of 106 basis points. However, the memo reports that Fannie is actually buying loans like that at a price consistent with an annual fee of 37.50 basis points, producing a gap (or loss from the model) of 68.50 basis points. The reason the gap is so large is shown in the table: the anticipated default rate on that zero- down mortgage was 34 percent . The table then goes on to look at other possible loan alternatives, with the following results: 124 fcic_final_report_full--529 The most controversial element of the vast increase in NTMs between 1993 and 2008 was the role of the CRA. 149 The act, which is applicable only to federally insured depository institutions, was originally adopted in 1977. Its purpose in part was to “require each appropriate Federal financial supervisory agency to use its authority when examining financial institutions to encourage such institutions to help meet the credit needs of the local communities in which they are chartered consistent with the safe and sound operations of such institutions.” The enforcement provisions of the Act authorized the bank regulators to withhold approvals for such transactions as mergers and acquisitions and branch network expansion if the applying bank did not have a satisfactory CRA rating. CRA did not have a substantial effect on subprime lending in the years after its enactment until the regulations under the act were tightened in 1995. The 1995 regulations required insured banks to acquire or make “flexible and innovative” mortgages that they would not otherwise have made. In this sense, the CRA and Fannie and Freddie’s AH goals are cut from the same cloth. There were two very distinct applications of the CRA. The first, and the one with the broadest applicability, is a requirement that all insured banks make CRA loans in their respective assessment areas. When the Act is defended, it is almost always discussed in terms of this category—loans in bank assessment areas. Banks (usually privately) complain that they are required by the regulators to make imprudent loans to comply with CRA. One example is the following statement by a local community bank in a report to its shareholders: Under the umbrella of the Community Reinvestment Act (CRA), a tremendous amount of pressure was put on banks by the regulatory authorities to make loans, especially mortgage loans, to low income borrowers and neighborhoods.  The regulators were very heavy handed regarding this issue.  I will not dwell on it here but they required [redacted name] to change its mortgage lending practices to meet certain CRA goals, even though we argued the changes were risky and imprudent. 150 On the other hand, the regulators defend the act and their actions under it, and particularly any claim that the CRA had a role in the financial crisis. The most frequently cited defense is a speech by former Fed Governor Randall Kroszner on 147 Fannie Mae Foundation, “Making New Markets: Case Study of Countrywide Home Loans,” 2000, http://content.knowledgeplex.org/kp2/programs/pdf/rep_newmortmkts_countrywide.pdf. 148 “Questions and Answers from Countrywide about Lending,” December 11, 2007, available at http:// www.realtown.com/articles/article/print/id/768. 149 150 12 U.S.C. 2901. Original letter in author’s files. 525 CHRG-111hhrg48674--58 Mrs. Maloney," Lend. Lend and guarantee. " CHRG-111hhrg48873--19 Mr. Bernanke," Thank you, Chairman Frank, Ranking Member Bachus, and other members of the committee. I appreciate having this opportunity to discuss the Federal Reserve's involvement with AIG. In my testimony, I will describe why supporting AIG was a difficult but necessary step to protect our economy and stabilize our financial system. I will also discuss issues related to compensation and note two matters raised by this experience that merit congressional attention. We at the Federal Reserve, working closely with the Treasury, made our decision to lend to AIG on September 16th of last year. It was an extraordinary time. Global financial markets were experiencing unprecedented strains and a worldwide loss of confidence. Fannie Mae and Freddie Mac had been placed into conservatorship only 2 weeks earlier, and Lehman Brothers had filed for bankruptcy the day before. We were very concerned about a number of other major firms that were under intense stress. AIG's financial condition had been deteriorating for some time, caused by actual and expected losses on subprime mortgage-backed securities and on credit default swaps that AIG's Financial Products unit, AIG FP, had written on mortgage-related securities. As confidence in the firm declined and with efforts to find a private-sector solution unsuccessful, AIG faced severe liquidity pressures that threatened to force it imminently into bankruptcy. The Federal Reserve and the Treasury agreed that AIG's failure under the conditions then prevailing-- " CHRG-111hhrg53241--7 The Chairman," The gentlewoman from California, Ms. Waters, for 2\1/2\ minutes. Ms. Waters. Thank you very much, Mr. Chairman, and members. I am still shaken from yesterday when we had the financial services community representatives, bankers, etc., come before us and take on the consumer financial agency with great opposition, giving us 101 reasons why we didn't need it, how it was going to cost the taxpayer more money, how it would interfere with safety and soundness, and on and on and on. But I am even more shaken with what is happening in the underground with the huge amount of money that the bankers and financial services community representatives are going to spend to lobby Members of Congress. I understand they almost have hired a lobbyist for each one of us. I never expected, given the subprime meltdown and the number of foreclosures we have, that we would get that kind of opposition. How soon we forget. And I am more concerned that there are Members of Congress who are beginning to take on the arguments of the financial services industry about why a consumer financial agency is not necessary. Many of the people who are before us today have been fighting as nonprofits against predatory lending, opposition to bank mergers, forcing mortgage disclosure. I remember being in the fight with some on redlining, fighting to create CRA, helping to create the Cooling Off Period, Truth in Lending. And they are forever chasing the very-well-heeled financial services community, trying to protect the consumers. And now we have an opportunity to really show that we want to protect the consumers with an agency that will have the word ``consumer'' in it, and we have people who are backing off. I am even more shocked that, as this chairman has provided opportunities for us to interact with the financial services industry, it has basically been dishonored. Even yesterday, when we were engaged with consumer advocates, one member got up and left and went to a fundraiser with the banking community in the middle of all of that. Well, all I have to say is I am hopeful that our advocates will be stronger than ever and that we will fight against this opposition. We will respect our consumers. We will not forget the still-growing number of foreclosures that are out there created by greedy loan initiators, and we will do a job for the consumers despite the lobbyists and the money and the opposition to this. I yield back the balance of my time. " fcic_final_report_full--616 August 2008 (last revised September 8, 2008), p. 3. 51. Paulson, interview. 52. Christopher H. Dickerson (FHFA Acting Deputy Director, Division of Enterprise Regulation), let- ter to Daniel H. Mudd (President and CEO of Fannie Mae), “Re: Notice of Proposed Capital Classifica- tion at June 30, 2008,” August 22, 2008, pp. 1, 2; Christopher H. Dickerson (FHFA Acting Deputy Director, Division of Enterprise Regulation), letter to Richard F. Syron (President and CEO of Freddie Mac), “Re: Notice of Proposed Capital Classification at June 30, 2008,” August 22, 2008. 53. “Draft—Mid-year Letter,” pp. 11–13 (quotation, p. 13), attached to Christopher H. Dickerson, let- ter to Daniel H. Mudd, September 4, 2008. 54. Dickerson to Mudd, September 4, 2008; Christopher H. Dickerson, letter to Richard Syron, Sep- tember 4, 2008, with “Draft Mid Year Letter” attached. 55. “Draft—Mid-year Letter” (Fannie), pp. 5–7. 56. Ibid., p. 5. 57. Ibid., p. 6. 58. Ibid., pp. 9–10. 59. “Draft Mid Year Letter” (Freddie), pp. 1, 1–2, 7. 60. Ibid., p. 8. 61. Mudd, interview. 62. Christopher H. Dickerson to James B. Lockhart III, memorandum, “Proposed Appointment of the Federal Housing Finance Agency as Conservator for the Federal Home Loan Mortgage Corporation,” September 6, 2008 (hereafter Freddie conservatorship memorandum); Christopher H. Dickerson to James B. Lockhart III, memorandum, Proposed Appointment of the Federal Housing Finance Agency as Conservator for the Federal National Mortgage Association,” September 6, 2008 (hereafter Fannie con- servatorship memorandum). 63. Paulson, interview; Lockhart, interview; Paulson, On the Brink, p. 8. 64. Lockhart, testimony before the FCIC, April 9, 2010, transcript, p. 191. 65. Paulson, interview; Paulson, On the Brink, p. 10. 66. Paulson, On the Brink, p. 10. 67. Lund, interview. 68. Levin, interview. 69. Mudd, interview. 70. FHFA, Fannie conservatorship memorandum, pp. 2, 29. 71. FHFA, Freddie conservatorship memorandum, pp. 3, 29. 72. Syron, interview. 73. Daniel Mudd, testimony before the FCIC, Hearing on Subprime Lending and Securitization and Government-Sponsored Enterprises (GSEs), day 3,” session 1: Fannie Mae, April 9, 2010, transcript, p. 38. 74. Paul Nash, FDIC, letter to FCIC, providing responses to follow-up questions to Sheila Bair’s testi- mony during the September 2, 2010, hearing, p. 5. 75. Paulson, interview. 76. Neel Kashkari, interview by FCIC, November 2, 2010. 77. Tom Baxter, interview by FCIC, April 30, 2010; Kevin Warsh, interview by FCIC, October 28, 2010. 78. Warsh, interview. 79. Lockhart, testimony before the FCIC, April 9, 2010, transcript, p. 232. 80. Staff of the Federal Reserve System, Division of Banking Supervision and Regulation, memoran- dum to the Board of Governors, “Stress Scenarios on Bank Exposures to Government Sponsored Enter- prise (GSE) Debt,” January 24, 2005, p. 5. 81. Daniel Mudd, written testimony for the FCIC, Hearing on Subprime Lending and Securitization and Government-Sponsored Enterprises (GSEs), day 3, session 1: Fannie Mae, April 9, 2010, p. 3. 82. John Kerr, Scott Smith, Steve Corona (FHFA examination manager), and Alfred Pollard (FHFA general counsel), group interview by FCIC, March 12, 2010. 613 83. Lockhart, interview. 84. Edward DeMarco, interview by FCIC, March 18, 2010. 85. Mudd, interview. 86. Henry Cisneros, interview by FCIC, October 13, 2010. 87. Mudd, testimony before the FCIC, April 9, 2010, transcript, p. 104. 88. Robert Levin, testimony before the FCIC, Hearing on Subprime Lending and Securitization and Government-Sponsored Enterprises (GSEs), day 3, session 1: Fannie Mae, April 9, 2010, transcript, p. 104. FinancialCrisisReport--223 The WaMu Examiner-in-Charge, Benjamin Franklin, responded: “I didn’t intend to send a memo until I got a blessing from [the Western Region Director] or DC on what our official policy is on this. … [M]any of our larger institutions now do NINAs (including Countrywide) .… Apparently [OTS policy official] Bill Magrini is the lone ranger in his view that NINA’s are imprudent. West region position seems to be that FICO, appraisal, and other documentation … is sufficient to assess the borrower’s ability to repay in all but subprime loans. While I probably fall more into the Magrini camp (until we get empirical data to support NINAs are not imprudent) we will just document our findings … until the ‘official’ policy on this has been worked out.” 848 A year later, in October 2008, after WaMu’s failure, the same Examiner-in-Charge, Benjamin Franklin, wrote to a colleague: “[N]ot one regulatory agency had a rule or guideline saying you couldn’t do stated income lending, even to this day. That, I find incredible. We criticized stated income lending at WaMu but they never got it completely fixed. … [I]n hindsight, I’m convinced that it is just a flawed product that can’t be fixed and never should have been allowed in the first place. How do you really assess underwriting adequacy when you allow the borrower to tell you what he makes without verification. We used to have documentation requirements for underwriting in the regs, but when those were taken out, the industry slowly migrated to an anything goes that got us into this mess. … When I told Scott Polakoff [OTS Deputy Director] that stated income subprime should not be made under any circumstance, I was corrected by Mike Finn [OTS Western Region head] that that was not the West Region’s position. I rest my case.” 849 Data compiled by the Treasury and FDIC Inspectors General shows that, by the end of 2007, stated income loans – loans in which the bank did not verify the borrower’s income – represented 50% of WaMu’s subprime loans, 73% of its Option ARMs, and 90% of its home equity loans. 850 At the Subcommittee hearing, virtually every witness condemned stated income loans as unsafe and unsound. 851 OTS Director John Reich testified that he regretted not doing more to prevent supervised thrifts from issuing stated income loans. 852 Subcommittee interviews with OTS examiners who worked at WaMu found those examiners to be demoralized and frustrated at their inability to effect change at the bank. They 848 Id. 849 10/7/2008 email exchange between OTS Examiner-in-Charge Benjamin Franklin and OTS examiner Thomas Constantine, “West Region Update,” Franklin_Benjamin-00034415_001, Hearing Exhibit 4/16-14. 850 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 Exhibit 4/16-82. 851 See, e.g., April 16, 2010 Subcommittee Hearing at 14-15, 41-42. 852 Id. at 42 (“In hindsight, I regret it.”). had identified serious deficiencies at the bank year after year, with no enforcement consequences; some tried to interpret OTS standards in ways that would reduce risk, only to be rebuffed by their leaders; and others were told that the NTM Guidance being enforced by other agencies did not have standards that could be enforced by OTS examiners. Days after WaMu’s failure, one OTS examiner had this to say about OTS leadership: “My examination history here is filled with the editing and removal of my comments as well as predictions (that turned out to be true) by EICs [Examiners-in-Charge]. No system in place to keep that from happening. Instead we put whitewashers and scaredity cats in charge of the most problematic shops. I don’t know what happened to you at WAMU, but I was critical of their accounting at Card Services and the AP. Fortunately, I think I made the ‘don’t let him come back here’ list. … [O]ur leadership screwed us and can’t acknowledge it. They should resign.” 853 (c) Narrow Regulatory Focus CHRG-110shrg46629--3 STATEMENT OF SENATOR RICHARD C. SHELBY Senator Shelby. Thank you, Chairman Dodd. Chairman Bernanke, we are pleased again to have you before this Committee. This hearing, as Senator Dodd has pointed out, provides the Congress a very important opportunity to have an open and detailed discussion about the Fed's monetary policy goals and their implementation. I also expect that Members of the Committee here, including myself, will take advantage of your appearance, Mr. Chairman, to raise some other issues that fall under the jurisdiction of the Federal Reserve. I would also like to join Senator Dodd in welcoming our colleagues from the European Union Parliament that are here today. I had a nice meeting with them yesterday and we look forward to these transatlantic visits. I think they are healthy. I trust that your visit here today will be enlightening and provide you with much to discuss with the European Central Bank. Chairman Bernanke, your testimony and report this morning note the continued healthy performance of the economy in the first half of 2000. Although real gross domestic product, GDP, increased 0.7 percent in the first quarter the consensus view among economists is that growth for the second quarter will show a rebound in the neighborhood of 2.5 percent. Along with continued GDP growth, we have seen positive news on the job front. Gains in the payroll employment average 140,000 jobs per month in the first half of 2007. We continue to enjoy low unemployment rate in this country, both historically and relative to other industrialized nations in the world. The global economy also continues to be strong with Canada, Europe, Japan, and the United Kingdom experiencing above trend growth rates in the first quarter. This is good news, I believe, for American businesses seeking to expand their exports around the world. In its statement following the June 28, 2007, meeting the FOMC suggested that while core inflation readings had moderated ``sustained moderation in inflation pressures has yet to be convincingly demonstrated.'' There is a lot in those words. Inflation risks, not slow growth, remains the predominant concern as we continue to see a rise in energy and food prices. I also share, Mr. Chairman, your view on the importance of low inflation in promoting growth, efficiency, and stability which in turn equal maximum sustainable employment. Chairman Bernanke, your statement also includes an extensive discussion of the Federal Reserve's recent activities relating to subprime mortgage lending, which is a concern to all of us. The recent sharp increases in subprime mortgage loan delinquencies are troubling. The rating agency's recent moves are also very interesting too. The initiatives that you highlight in your testimony are welcome. However, I am concerned that the weaknesses, Mr. Chairman, in the subprime market may have broader systemic consequences than we are seeing yet. We have been told that the problem is largely isolated and contained but I am concerned that that may not be the case. I will be particularly interested in hearing your views on the scope and depth of the problem and how the Federal Reserve will monitor and manage the situation hopefully going forward. We are pleased to have you with us this morning, as I said, and we look forward to the rest of the hearing and my colleagues testimony. " fcic_final_report_full--94 But problems persisted, and others would take up the cause. Through the early years of the new decade,  “the really poorly underwritten loans, the payment shock loans” continued to proliferate outside the traditional banking sector, said FDIC Chairman Sheila Bair, who served at Treasury as the assistant secretary for financial institutions from  to . In testimony to the Commission, she observed that these poor-quality loans pulled market share from traditional banks and “created negative competitive pressure for the banks and thrifts to start following suit.” She added, [Subprime lending] was started and the lion’s share of it occurred in the nonbank sector, but it clearly created competitive pressures on banks. . . . I think nipping this in the bud in  and  with some strong consumer rules applying across the board that just simply said you’ve got to document a customer’s income to make sure they can re- pay the loan, you’ve got to make sure the income is sufficient to pay the loans when the interest rate resets, just simple rules like that . . . could have done a lot to stop this.  After Bair was nominated to her position at Treasury, and when she was making the rounds on Capitol Hill, Senator Paul Sarbanes, chairman of the Committee on Banking, Housing, and Urban Affairs, told her about lending problems in Baltimore, where foreclosures were on the rise. He asked Bair to read the HUD-Treasury report on predatory lending, and she became interested in the issue. Sarbanes introduced legislation to remedy the problem, but it faced significant resistance from the mort- gage industry and within Congress, Bair told the Commission. Bair decided to try to get the industry to adopt a set of “best practices” that would include a voluntary ban on mortgages that strip borrowers of their equity, and would offer borrowers the op- portunity to avoid prepayment penalties by agreeing instead to pay a higher interest rate. She reached out to Edward Gramlich, a governor at the Fed who shared her con- cerns, to enlist his help in getting companies to abide by these rules. Bair said that Gramlich didn’t talk out of school but made it clear to her that the Fed avenue wasn’t going to happen.  Similarly, Sandra Braunstein, the director of the Division of Con- sumer and Community Affairs at the Fed, said that Gramlich told the staff that Greenspan was not interested in increased regulation.  When Bair and Gramlich approached a number of lenders about the voluntary program, Bair said some originators appeared willing to participate. But the Wall Street firms that securitized the loans resisted, saying that they were concerned about possible liability if they did not adhere to the proposed best practices, she recalled. The effort died.  FinancialCrisisReport--481 Loan Repurchase Campaign. In addition to its sales and writedowns, the Mortgage Department intensified its efforts to identify and return defaulted or otherwise deficient loans to the originating lender from which they had been purchased in exchange for a refund of the purchase price. Altogether in 2006 and 2007, Goldman made about $475 million in repurchase claims for securitized loans, and recovered about $82 million. 2032 It also made about $40 million in repurchase claims for unsecuritized loans, and recovered about $17 million. 2033 In the years leading up to the financial crisis, most subprime loan purchase agreements provided that if a loan experienced an early payment default (EPD), meaning the borrower failed to make a payment within three months of the loan’s purchase, or if the loan breached certain representations or warranties, such as representations related to the loan’s characteristics or documentation, the loan could be returned or “put back” to the seller which was then obligated to repurchase it. In late 2006, as subprime loans began to experience accelerated rates of EPDs and fraud, 2034 Wall Street firms began to intensify their efforts to return those loans for refunds. Some subprime lenders began to experience financial distress due to unprecedented waves of repurchase requests that drained their cashflows. 2035 Although Goldman, either directly or through a third party due diligence firm, routinely conducted due diligence reviews of the mortgage loan pools it bought from lenders or third party brokers for use in its securitizations, those reviews generally examined only a sample of the loans 2031 2/13/2007 email from Richard Ruzika to Gary Cohn, “Catch Up, ” GS MBS-E-019794071. Mr. Cohn forwarded Mr. Ruzika ’s report to M essrs. Blankfein and W inkelried. Id. See also 6/8/2007 email from Kevin Gasvoda, “Project Omega - Mortgages MTM of Resids, ” GS MBS-E-013411815 (working on potential deal to sell marked- down mortgage residuals). 2032 2033 2034 See Goldman Sachs response to Subcommittee QFR at PSI_QFR_GS0039. Id. Using loan data, the U.S. mortgage industry had developed anticipated default rates, including EPDs, for different mortgage classes, such as subprime, Alt A, and prime loans. These default rates, however, were based in large part on past loan underwriting practices and loan types that bore little resemblance to the loans issued in the years leading up to the financial crisis, as explained in Chapter V of this Report. In 2006, subprime loans began to experience higher than anticipated EPD rates, and lenders were hit by unanticipated repurchase demands they could not afford to pay. The first EPD-related mortgage lender failures occurred in late 2006, and bankruptcies continued throughout 2007. 2035 See, e.g., 3/26/2007 “Subprime Mortgage Business,” Goldman presentation to Board of Directors, at 3-5, GS MBS-E-005565527 at 532, Hearing Exhibit 4/27-22 (timeline showing Ownit, a subprime lender, filed for bankruptcy on December 28, 2006, and list of subprime related businesses bankrupted, suspended, closed, sold, or put up for sale). and did not attempt to identify and weed out all deficient mortgages. 2036 Instead, Goldman purchased loan pools with the expectation that they would incur a certain rate of defaults. In late 2006, however, like other Wall Street firms, Goldman began to see much higher than anticipated delinquency and default rates in the loan pools in its inventory and warehouse accounts, and in the subprime RMBS and CDO securitizations it originated. 2037 Defaulted loans generally could not be sold or securitized, and had to be terminated through foreclosure proceedings or sold in so-called “scratch and dent” pools that generally produced less money than the loans cost to buy. In addition, defaulted loans meant that the borrowers who took out those loans stopped making loan payments to the securitized loan pool, reducing the cashflow into the related securities. RMBS and CDO securities whose underlying assets incurred high rates of loan delinquencies and defaults experienced reduced cashflows, lost value, and sometimes failed altogether, resulting in substantial losses for investors. CHRG-111hhrg54868--191 Mr. Bachus," I understand that, but I think even banks--and one of the problems was not only were they unregulated subprime lenders, but they were also--the depository institutions purchased them. And it was actually Wachovia who did that, Bank of America, Merrill Lynch. You could go on and on. " CHRG-111hhrg54872--155 Mr. Marchant," Well, many of the Alt-A loans and many of the subprime loans that were made in 2007 and 2008 were actually originated and insured by--not originated by but were insured by and were done on Fannie Mae and Freddie Mac forms. " CHRG-110hhrg46591--389 Mr. Ellison," Now, another question. If you were to--let's just say you did not have these derivative instruments that have developed, but you did have the poor underwriting standards that were associated with subprime mortgages. Would we be in the financial circumstances we are in today? " CHRG-111shrg54675--9 Mr. Michael," Chairman Johnson, Ranking Member Crapo, and Members of the Subcommittee, thank you very much for the opportunity to testify at today's hearing on behalf of the Credit Union National Association. My name is Frank Michael, and I am President and CEO of Allied Credit Union in Stockton, California. Allied is a small institution with $20 million in assets and approximately 2,600 member owners. Credit unions--rural, urban, large, and small--did not contribute to the subprime meltdown or the subsequent credit market crisis. Credit unions are careful lenders. As not-for-profit cooperatives, our objective is to maximize member service. Incentives at credit unions are aligned in a way that ensures little or no harm is done to our member owners. Rural credit unions are unique in many respects. There are nearly 1,500 U.S. credit unions with a total of $60 billion in assets headquartered in rural areas. Rural credit unions tend to be small--even by credit union standards. Over half of the rural credit unions are staffed by five or fewer full-time equivalent employees. Even in good times, rural credit unions tend to face challenges in a way that larger institutions do not. Competitive pressures from large multistate banks and nontraditional financial services providers, greater regulatory burdens, growing member sophistication, and loss of sponsors loom large for most of the Nation's small credit unions. A bad economy can make things even worse. Small credit unions come under tremendous pressure as they attempt to advise, consult with, and lend to their members. In addition, all credit unions have suffered as a result of the effects of the financial crisis of corporate credit unions. Despite these substantial hurdles, rural credit unions are posting comparatively strong results, and they continue to lend. Loans grew by 7 percent in the 12 months ending in March compared to a 3-percent decline at all banks. There are several concerns raised by small credit unions, and rural credit unions in particular, that deserve mention. The credit union movement has seen small institutions merge into larger credit unions at an alarming pace. And by far, the largest contributor to this consolidation is the smothering effect of the current regulatory environment. Small credit union leaders believe that the regulatory scrutiny they face is inconsistent with both their exemplary behavior and their nearly imperceptible financial exposure they represent. A large community of credit unions, free of unnecessary regulatory burden, would benefit the public at large and especially our rural communities. As the Subcommittee considers regulatory restructuring proposals, we strongly urge you to continue to keep these concerns in the forefront of your decision making. Moreover, we implore you to look for opportunities to provide exemptions from the most costly and time-consuming initiatives to cooperatives and other small institutions. As noted above, credit unions have generally continued to lend while many other lenders have pulled back. This is certainly true in the business lending arena. Currently, 26 percent of all rural credit unions offer member business loans to their members. These loans represent over 9 percent of the total loans in rural credit union portfolios. In contrast, member business loans account for less than 6 percent of all total loans in the movement as a whole. Total member business loans at rural credit unions grew by over 20 percent in the year ending March 2009, with agricultural loans increasing by over 12 percent. Agricultural loans at rural credit unions now account for over one-third of the total member business loans. This is strong evidence that rural credit unions remain ``in the game'' during these trying times. But more could be done. And more should be done. A chorus of small business owners complains that they cannot get access to credit. Federal Reserve surveys show that the Nation's large banks tightened underwriting standards for the better part of the past year, and SBA research shows that large bank consolidation is making it more difficult for small businesses to obtain loans. The chief obstacle for credit union business lending is the statutory limits imposed by Congress in 1998 under which credit unions are restricted from member business lending in excess of 12.25 percent of their total assets. This arbitrary cap has no basis in either actual credit union business lending or safety and soundness considerations. Indeed, a report by the U.S. Treasury Department found that delinquencies and charge-offs for credit union business loans were much lower than those of banks. While we support strong regulatory oversight of how credit unions make member business loans, there is no safety and soundness rationale for the current law which restricts the amount of credit union business lending. There is, however, a significant economic reason to permit credit unions to lend without statutory restriction, as they were able to do prior to 1998. A growing list of small business and public policy groups agree that now is the time to eliminate the statutory credit union business lending cap. We urge Congress to eliminate the cap and provide NCUA with the authority to permit a credit union to engage in business lending above 20 percent of assets if safety and soundness considerations are met. If the cap were removed, credit unions could safely and soundly provide as much as $10 billion in new loans for small businesses within the first year. This is an economic stimulus that would truly help small business and not cost the taxpayers a dime. In conclusion, Chairman Johnson and Ranking Member Crapo, and all the Members of the Subcommittee, we appreciate your review of these issues today. " CHRG-111hhrg54869--35 Mr. Bachus," There were loans that banks couldn't make. They wouldn't make it under their own underwriting standards. They wouldn't originate them in the banks so they went out and bought an unregulated subprime lender to make loans that they would never make. " fcic_final_report_full--179 DISCLOSURE AND DUE DILIGENCE: “A QUALITY CONTROL ISSUE IN THE FACTORY ” In addition to the rising fraud and egregious lending practices, lending standards de- teriorated in the final years of the bubble. After growing for years, Alt-A lending in- creased another  from  to . In particular, option ARMs grew  during that period, interest-only mortgages grew , and no-documentation or low-docu- mentation loans (measured for borrowers with fixed-rate mortgages) grew . Overall, by  no-doc or low-doc loans made up  of all mortgages originated. Many of these products would perform only if prices continued to rise and the bor- rower could refinance at a low rate.  In theory, every participant along the securitization pipeline should have had an interest in the quality of every underlying mortgage. In practice, their interests were often not aligned. Two New York Fed economists have pointed out the “seven deadly frictions” in mortgage securitization—places along the pipeline where one party knew more than the other, creating opportunities to take advantage.  For example, the lender who originated the mortgage for sale, earning a commission, knew a great deal about the loan and the borrower but had no long-term stake in whether the mortgage was paid, beyond the lender’s own business reputation. The securitizer who packaged mortgages into mortgage-backed securities, similarly, was less likely to retain a stake in those securities. In theory, the rating agencies were important watchdogs over the securitization process. They described their role as being “an umpire in the market.”  But they did not review the quality of individual mortgages in a mortgage-backed security, nor did they check to see that the mortgages were what the securitizers said they were. So the integrity of the market depended on two critical checks. First, firms pur- chasing and securitizing the mortgages would conduct due diligence reviews of the mortgage pools, either using third-party firms or doing the reviews in-house. Sec- ond, following Securities and Exchange Commission rules, parties in the securitiza- tion process were expected to disclose what they were selling to investors. Neither of these checks performed as they should have. Due diligence firms: “Waived in” As subprime mortgage securitization took off, securitizers undertook due diligence on their own or through third parties on the mortgage pools that originators were selling them. The originator and the securitizer negotiated the extent of the due dili- gence investigation. While the percentage of the pool examined could be as high as , it was often much lower; according to some observers, as the market grew and originators became more concentrated, they had more bargaining power over the mortgage purchasers, and samples were sometimes as low as  to .  Some secu- ritizers requested that the due diligence firm analyze a random sample of mortgages from the pool; others asked for a sampling of those most likely to be deficient in some way, in an effort to efficiently detect more of the problem loans. CHRG-111shrg57322--763 Mr. Viniar," I have not read any of it. Senator Ensign. Because I think this goes to one of the--when you said you had responsibility, I am glad you said that Goldman Sachs actually does have some responsibility. This is kind of an explanation of some of what was happening in the financial markets. According to Steve Eisman, Goldman Sachs and Deutsche Bank, on the fate of the BBB tranche of subprime mortgage-backed bonds without fully understanding why those firms were so eager to accept them. He didn't know at the time. Later, he figured, at least he thinks he figured it out. The credit default swaps filtered through the CDOs were used to replicate bonds backed by actual home loans. ``There weren't enough Americans,'' and I am quoting here, so excuse the language, ``there weren't enough Americans with shi**y credit ratings taking out loans to satisfy investors' appetite for the end product. Wall Street needed his bets in order to synthesize more of them. `They weren't satisfied getting lots of unqualified borrowers to borrow money to buy a house they couldn't afford,' said Eisman. They were creating them out of whole cloth, 100 times over. That is why the losses in the financial system are so much greater than the subprime loans.'' The premise that, or at least what his analysis was of the reason that it became--even though the subprime market itself was bad, the collapse of that market wouldn't have been nearly as bad for the entire rest of the economy if it wasn't for a lot of the synthetic instruments that were created by firms like Goldman Sachs and others. Would you agree with that statement? " CHRG-110shrg46629--28 Chairman Bernanke," Senator, let me address the financial side. We have talked about this effect on homeowners. On the financial side, I am not sure there is anything essentially wrong with structured credit products, per se. But what we have learned since early this year is that a lot of the subprime mortgage paper is not as good as was thought originally. And there clearly are going to be significant financial losses associated with defaults and delinquencies on these mortgages. As a result, the credit quality of many of the structured projects that include in them substantial amounts of subprime mortgage paper is being downgraded. The one issue is that the structured credit products are quite complex. They include many different kinds of assets. Then the risks are divided up in different so-called ``tranches.'' So it takes quite a complex model or analysis to determine what the real value of these things is. Senator Shelby. But the value seems to be going down instead of up. " CHRG-110hhrg46591--391 Mr. Ellison," I guess my question is, to what degree is the credit default swap proliferation and the derivative market, to what extent did it accelerate the problems associated with the subprime market? Do you understand my question? " fcic_final_report_full--234 RATING DOWNGRADES: “NEVER BEFORE ” Prior to , the ratings of mortgage-backed securities at Moody’s were monitored by the same analysts who had rated them in the first place. In , Nicolas Weill, Moody’s chief credit officer and team managing director, was charged with creating an independent surveillance team to monitor previously rated deals.  In November , the surveillance team began to see a rise in early payment de- faults in mortgages originated by Fremont Investment & Loan,  and downgraded several securities with underlying Fremont loans or put them on watch for future downgrades. “This was a very unusual situation as never before had we put on watch deals rated in the same calendar year,” Weill later wrote to Raymond McDaniel, the chairman and CEO of Moody’s Corporation, and Brian Clarkson, the president of Moody’s Investors Service.  In early , a Moody’s special report, overseen by Weill, about the sharp in- creases in early payment defaults stated that the foreclosures were concentrated in subprime mortgage pools. In addition, more than . of the subprime mortgages securitized in the second quarter of  were  days delinquent within six months, more than double the rate a year earlier (.). The exact cause of the trouble was still unclear to the ratings agency, though. “Moody’s is currently assessing whether this represents an overall worsening of collateral credit quality or merely a shifting forward of eventual defaults which may not significantly impact a pool’s overall ex- pected loss.”  For the next few months, the company published regular updates about the sub- prime mortgage market. Over the next three months, Moody’s took negative rating actions on . of the outstanding subprime mortgage securities rated Baa. Then, on July , , in an unprecedented move, Moody’s downgraded  subprime mort- gage-backed securities that had been issued in  and put an additional  securi- ties on watch. The . billion of securities that were affected, all rated Baa and lower, made up  of the subprime securities that Moody’s rated Baa in . For the time being, there were no downgrades on higher-rated tranches. Moody’s attributed the downgrades to “aggressive underwriting combined with prolonged, slowing home price appreciation” and noted that about  of the securities affected contained mortgages from one of four originators: Fremont Investment & Loan, Long Beach Mortgage Company, New Century Mortgage Corporation, and WMC Mortgage Corp.  fcic_final_report_full--504 By 2004, Fannie and Freddie were suffi ciently in need of subprime loans to meet the AH goals that their CEOs, as the following account shows, went to a meeting of mortgage bankers to ask for more subprime loan production: The top executives of Freddie Mac and Fannie Mae [Richard Syron and Franklin Raines] made no bones about their interest in buying loans made to borrowers formerly considered the province of nonprime and other niche lenders. …Fannie Mae Chairman and [CEO] Franklin Raines told mortgage bankers in San Francisco that his company’s lender-customers ‘need to learn the best from the subprime market and bring the best from the prime market into [the subprime market].’ He offered praise for nonprime lenders that, he said, ‘are some of the best marketers in financial services.’… We have to push products and opportunities to people who have lesser credit quality, ” he said. 99 [emphasis supplied] Accordingly, by 2004, when HUD put new and tougher AH goals into effect, Fannie and Freddie were using every available resource to meet the goals, including subprime loans, Alt-A loans and the purchase of PMBS. Some observers, including the Commission’s majority, have claimed that the GSEs bought NTM loans and PMBS for profit—that these instruments did not assist Fannie and Freddie in meeting the AH goals and therefore must have been acquired because they were profitable. However, the statement by Adolfo Marzol reported above, and the data in Table 5 furnished to the Commission by Fannie Mae shows that all three categories of NTMs—subprime loans (i.e., loans to borrowers with FICO scores less than 660), Alt-A loans and PMBS (called PLS for “Private Label Securities” in the table)— fulfilled the AH goals or subgoals for the years and in the percentages shown below. (Bolded numbers exceeded the applicable goal.) Table 5 also shows, significantly, that the gradual increase in Fannie’s purchases of these NTMs closely followed the gradual increase in the goals between 1996 and 2008. 99 Neil Morse, “Looking for New Customers,” Mortgage Banking , December 1, 2004. It may be significant that the chairman of Freddie Mac at the time, Leland Brendsel, did not attend the 2000 press conference or pledge support for HUD’s new goals. Raines must have forgotten his 1999 pledge to Secretary Cuomo and his speech to the mortgage bankers when he wrote in a letter to The Wall Street Journal on August 3, 2010: “The facts about the financial collapse of Fannie and Freddie are pretty clear and a matter of public record. The company managers, their regulator and the Treasury have all said that the losses which crippled the companies were caused by the purchase of loans with lower credit standards between 2005 and 2007. The companies explicitly changed their credit standards in order to regain market share after Wall Street began to define market credit standards in 2004.” CHRG-110hhrg46591--320 Mr. Bartlett," Congressman, you have it about right. During the crisis of subprime, 50 percent of all of the subprime mortgages were originated by a totally unregulated mortgage lender. Fifty-eight percent total were sold by mortgage brokers, but it is actually worse than that because then the other 50 percent that were originated by regulated lenders, regardless of the nature of those loans, were mostly then sold to Wall Street, to a different set of regulators, either lightly regulated or not regulated at all, that were then packaged up into another set of unregulated mortgage pools, that were then brought back to mortgage insurance, which was regulated by 50 State regulators, and that were all sort of certified by credit rating agencies that were not regulated at all. So, as to the system as a whole, you are right. Half of it originated was totally unregulated, but the rest of the system that was regulated was virtually unregulated at least with the gaps. So it is the system that needs to be reformed systemically. " CHRG-111hhrg52261--132 Chairwoman Velazquez," Ms. Donovan? Ms. Donovan. Madam Chair, most credit unions today have sufficient capital. We have good capital on hand. Unfortunately, the artificial cap that is on member lending is what is refraining us from lending that out. I am a very small credit union, as I noted. We have hardly any member-business lending, very little. However, we do have the capital to lend to the small businesses in our community. And most credit unions do have that at this point. " CHRG-111shrg57320--16 Mr. Thorson," I agree completely with that. I think the truth is, the strength of the borrower, tremendous strength of a borrower may make in some odd situation that I can't really think of, make that worthwhile. But in that case, you would have a borrower so strong they wouldn't need that. Yes, sir, I would agree with Mr. Rymer on that. Senator Levin. All right. Take a look at Exhibit 1c,\1\ if you would. Now, this chart summarizes some of the key criticisms that OTS made of WaMu each year from the years 2004 to 2008. That chart is really not the half of it. I want to read you what those excerpts come from. This is what OTS found in those years.--------------------------------------------------------------------------- \1\ See Exhibit No. 1c, which appears in the Appendix on page 199.--------------------------------------------------------------------------- In 2004--this is Exhibit 1d \2\--``Underwriting of SFR loans remains less than satisfactory.'' One of the three causes of underwriting deficiency was ``a sales culture focused on building market share.'' Further down, ``The level of underwriting exceptions in our samples has been an ongoing examination issue for several years and one that the management has found difficult to address.'' The ``review of 2003 originations disclosed critical error rates as high as 57.3 percent of certain loan samples. . . .''--------------------------------------------------------------------------- \2\ See Exhibit No. 1d, which appears in the Appendix on page 200.--------------------------------------------------------------------------- In 2005, single-family residential loan underwriting, ``This has been an area of concern for several exams.'' The next quote on Exhibit 1d, ``[Securitizations] prior to 2003 have horrible performance. . . . At 2/05 Long Beach was #1 with a 12% delinquency rate.'' Next, ``We continue to have concerns regarding the number of underwriting exceptions and with issues that evidence lack of compliance with Bank policy.'' The next quote, ``[T]he level of deficiencies, if left unchecked, could erode the credit quality of the portfolio. Our concerns are increased when the risk profile of the portfolio is considered, including concentrations in Option ARM loans to higher-risk borrowers, in low and limited documentation loans and loans, with subprime or higher-risk characteristics.'' Then in 2006, first quote on that exhibit, near the bottom, ``[U]nderwriting errors [] continue to require management's attention.'' Next, ``Overall, we concluded that the number and severity of underwriting errors noted remain at higher than acceptable levels.'' Next, ``The findings of this judgmental sample are of particular concern since loans with risk layering . . . should reflect more, rather than less, stringent underwriting.'' In 2007, ``Underwriting policies, procedures, and practices were in need of improvement, particularly with respect to stated income lending.'' Next, ``Based on our review of 75 subprime loans originated by LBMC, we concluded that subprime underwriting practices remain less than satisfactory. . . . Given that this is a repeat concern, we informed management that underwriting must be promptly corrected or heightened supervisory action would be taken.'' Next, 2008, ``High single-family losses due in part to downturn in real estate market but exacerbated by: geographic concentrations, risk layering, liberal underwriting policy, poor underwriting.'' Year after year after year, we have these kind of findings by the OTS. Would you agree these are serious criticisms, Mr. Thorson? " FOMC20070628meeting--98 96,MS. LIANG.," It is around 9 percent. If you get on the Internet and try to find a subprime fixed-rate loan, it would be about that. We can’t find an official series, but roughly 9." FinancialCrisisReport--67 Mr. Schneider told the Subcommittee that the numbers listed on the chart were not projections, but the numbers generated from actual, historical loan data. 172 As the chart makes clear, the least profitable loans for WaMu were government backed and fixed rate loans. Those loans were typically purchased by the government sponsored enterprises (GSEs) Fannie Mae and Freddie Mac which paid relatively low prices for them. Instead of focusing on those low margin loans, WaMu’s management looked to make profits elsewhere, and elected to focus on the most profitable loans, which were the Option ARM, home equity, and subprime loans. In 2005, subprime loans, with 150 basis points, were eight times more profitable than a fixed rate loan at 19 basis points and more than 10 times as profitable as government backed loans. The gain on sale data WaMu collected drove not only WaMu’s decision to focus on higher risk home loans, but also how the bank priced those loans for borrowers. In determining how much it would charge for a loan, the bank calculated first what price the loan would obtain on Wall Street. As Mr. Beck explained in his testimony before the Subcommittee: “Because WaMu’s capital markets organization was engaged in the secondary mortgage market, it had ready access to information regarding how the market priced loan products. Therefore my team helped determine the initial prices at which WaMu could offer loans by beginning with the applicable market prices for private or agency-backed mortgage securities and adding the various costs WaMu incurred in the origination, sale, and servicing of home loans.” 173 (5) Acknowledging Unsustainable Housing Price Increases In 2004, before WaMu implemented its High Risk Lending Strategy, the Chief Risk Officer Jim Vanasek expressed internally concern about the unsustainable rise in housing prices, loosening lending standards, and the possible consequences. On September 2, 2004, just months before the formal presentation of the High Risk Lending Strategy to the Board of Directors, Mr. Vanasek circulated a prescient memorandum to WaMu’s mortgage underwriting and appraisal staff, warning of a bubble in housing prices and encouraging tighter underwriting. The memorandum also captured a sense of the turmoil and pressure at WaMu. Under the subject heading, “Perspective,” Mr. Vanasek wrote: “I want to share just a few thoughts with all of you as we begin the month of September. Clearly you have gone through a difficult period of time with all of the changes in the mortgage area of the bank. Staff cuts and recent defections have only added to the stress. Mark Hillis [a Senior Risk Officer] and I are painfully aware of the toll that this has taken on some of you and have felt it is important to tell you that we recognize it has been and continues to be difficult. 172 Subcommittee interview of David Schneider (2/16/2010). 173 April 13, 2010 Subcommittee Hearing at 53. “In the midst of all this change and stress, patience is growing thin. We understand that. We also know that loan originators are pushing very hard for deals. But we need to put all of this in perspective. “At this point in the mortgage cycle with prices having increased far beyond the rate of increase in personal incomes, there clearly comes a time when prices must slow down or perhaps even decline. There have been so many warnings of a Housing Bubble that we all tend now to ignore them because thus far it has not happened. I am not in the business of forecasting, but I have a healthy respect for the underlying data which says ultimately this environment is no longer sustainable. Therefore I would conclude that now is not the time to be pushing appraisal values. If anything we should be a bit more conservative across the board. Kerry Killinger and Bill Longbrake [a Vice Chair of WaMu] have both expressed renewed concern over this issue. “This is a point where we should be much more careful about exceptions. It is highly questionable as to how strong this economy may be; there is clearly no consensus on Wall Street. If the economy stalls, the combination of low FICOs, high LTVs and inordinate numbers of exceptions will come back to haunt us.” 174 CHRG-110hhrg34673--153 Mr. Bernanke," Well, the incidence of delinquencies and bankruptcies for the economy as a whole remains quite low. Because the job market is pretty good and incomes have gone up, wealth has gone up, the stock market is up, and so on. Most families, many of them, have home equity built up and have been able to manage their finances pretty effectively, and as I said, we have not seen any significant increase in financial stress in the broader economy. Now, there are pockets of problems, as I mentioned already several times, such as the variable rate subprime mortgage area. I think there are a number of approaches. The one that the Federal Reserve is particularly involved in is disclosures. We are responsible for Regulation Z, which implements the Truth in Lending Act, and it includes such things as the famous Schumer Box and other things that show to potential credit card applicants what are the terms, you know, what are the fees and so on. We are in the process now of completely reworking Reg Z for credit cards, for revolving debt, and we anticipate going out with a proposed rule in the next couple of months, and we have worked very hard on that. In particular, one thing we have done--people find it very difficult to understand the legalese that they see in the credit card applications, the credit card contracts, and yet of course the legal information has to be there. Otherwise, it is not a legitimate contract, and so the challenge is to create disclosures that meet the legal standards but that are also understandable, and so we have gone out and done a lot of consumer focus group testing and those kinds of things to try to find disclosures that will actually work in practice, and we hope that these new disclosures we are going to put out for comment in just a couple of months will be helpful in helping people understand, you know, the terms and conditions of credit cards and make them use them more responsibly. " CHRG-111shrg56376--128 RESPONSES TO WRITTEN QUESTIONS OF SENATOR BUNNING FROM DANIEL K. TARULLOQ.1. What is the best way to decrease concentration in the banking industry? Is it size limitations, rolling back State preemption, higher capital requirements, or something else?A.1. Answer not received by time of publication.Q.2. Treasury has proposed making the new banking regulator a bureau of the Treasury Department. Putting aside whether we should merge the current regulators, does placing the new regulator in Treasury rather than as a separate agency provide enough independence from political influence?A.2. Answer not received by time of publication.Q.3. Given the damage caused by widespread use of subprime and nontraditional mortgages--particularly low documentation mortgages--it seems that products that are harmful to the consumer are also harmful to the banks that sell them. If bank regulators do their job and stop banks from selling products that are dangerous to the banks themselves, other than to set standards for currently unregulated firms, why do we need a separate consumer protection agency?A.3. Answer not received by time of publication.Q.4. Since the two most recent banking meltdowns were caused by mortgage lending, do you think it is wise to have a charter focused on mortgage lending? In other words, why should we have a thrift charter?A.4. Answer not received by time of publication.Q.5. Should banking regulators continue to be funded by fees on the regulated firms, or is there a better way?A.5. Answer not received by time of publication.Q.6. Why should we have a different regulator for holding companies than for the banks themselves?A.6. Answer not received by time of publication.Q.7. Assuming we keep thrifts and thrift holding companies, should thrift holding companies be regulated by the same regulator as bank holding companies?A.7. Answer not received by time of publication.Q.8. The proposed risk council is separate from the normal safety and soundness regulator of banks and other firms. The idea is that the council will set rules that the other regulators will enforce. That sounds a lot like the current system we have today, where different regulators read and enforce the same rules different ways. Under such a council, how would you make sure the rules were being enforced the same across the board?A.8. Answer not received by time of publication. ------ fcic_final_report_full--246 These institutions had relied for their operating cash on short-term funding through commercial paper and the repo market. But commercial paper buyers and banks became unwilling to continue funding them, and repo lenders became less and less willing to accept subprime and Alt-A mortgages or mortgage-backed securities as collateral. They also insisted on ever-shorter maturities, eventually of just one day—an inherently destabilizing demand, because it gave them the option of with- holding funding on short notice if they lost confidence in the borrower. Another sign of problems in the market came when financial companies began to report more detail about their assets under the new mark-to-market accounting rule, particularly about mortgage-related securities that were becoming illiquid and hard to value. The sum of more illiquid Level  and  assets at these firms was “eye- popping in terms of the amount of leverage the banks and investment banks had,” ac- cording to Jim Chanos, a New York hedge fund manager. Chanos said that the new disclosures also revealed for the first time that many firms retained large exposures from securitizations. “You clearly didn’t get the magnitude, and the market didn’t grasp the magnitude until spring of ’, when the figures began to be published, and then it was as if someone rang a bell, because almost immediately upon the publica- tion of these numbers, journalists began writing about it, and hedge funds began talking about it, and people began speaking about it in the marketplace.”  In late  and early , some banks moved to reduce their subprime expo- sures by selling assets and buying protection through credit default swaps. Some, such as Citigroup and Merrill Lynch, reduced mortgage exposure in some areas of the firm but increased it in others. Banks that had been busy for nearly four years cre- ating and selling subprime-backed collateralized debt obligations (CDOs) scrambled in about that many months to sell or hedge whatever they could. They now dumped these products into some of the most ill-fated CDOs ever engineered. Citigroup, Merrill Lynch, and UBS, particularly, were forced to retain larger and larger quanti- ties of the “super-senior” tranches of these CDOs. The bankers could always hope— and many apparently even believed—that all would turn out well with these super seniors, which were, in theory, the safest of all. With such uncertainty about the market value of mortgage assets, trades became scarce and setting prices for these instruments became difficult. Although government officials knew about the deterioration in the subprime markets, they misjudged the risks posed to the financial system. In January , SEC officials noted that investment banks had credit exposure to struggling subprime lenders but argued that “none of these exposures are material.”  The Treasury and Fed insisted throughout the spring and early summer that the damage would be lim- ited. “The impact on the broader economy and financial markets of the problems in the subprime market seems likely to be contained,”  Fed Chairman Ben Bernanke testified before the Joint Economic Committee of Congress on March . That same day, Treasury Secretary Henry Paulson told a House Appropriations subcommittee: “From the standpoint of the overall economy, my bottom line is we’re watching it closely but it appears to be contained.”  CHRG-111shrg50814--178 Mr. Bernanke," Yes, that is what the Fed research shows. I think the number is that only 6 percent of the subprime delinquencies were based on mortgages made by CRA-covered institutions into CRA neighborhoods. " CHRG-111shrg57319--15 Mr. Cathcart," No, sir. Senator Levin. All right. Is it fair to say that WaMu was not particularly worried about the risk associated with Long Beach subprime mortgages because it sold those loans and passed the risk on to investors? Mr. Vanasek. " fcic_final_report_full--240 Mark-to-market write-downs were required on many securities even if there were no actual realized losses and in some cases even if the firms did not intend to sell the securities. The charges reflecting unrealized losses were based, in part, on credit rat- ing agencies’ and investors’ expectations that the mortgages would default. But only when those defaults came to pass would holders of the securities actually have real- ized losses. Determining the market value of securities that did not trade was diffi- cult, was subjective, and became a contentious issue during the crisis. Why? Because the write-downs reduced earnings and capital, and triggered collateral calls. These mark-to-market accounting rules received a good deal of criticism in re- cent years, as firms argued that the lower market prices did not reflect market values but rather fire-sale prices driven by forced sales. Joseph Grundfest, when he was a member of the SEC’s Committee on Improvements to Financial Reporting, noted that at times, marking securities at market prices “creates situations where you have to go out and raise physical capital in order to cover losses that as a practical matter were never really there.”  But not valuing assets based on market prices could mean that firms were not recording losses required by the accounting rules and therefore were overstating earnings and capital. As the mortgage market was crashing, some economists and analysts estimated that actual losses, also known as realized losses, on subprime and Alt-A mortgages would total  to  billion;  so far, by , the figure has turned out not to be much more than that. As of year-end , the dollar value of all impaired Alt-A and subprime mortgage–backed securities total about  billion.  Securities are im- paired when they have suffered realized losses or are expected to suffer realized losses imminently. While those numbers are small in relation to the  trillion U.S. economy, the losses had a disproportionate impact. “Subprime mortgages themselves are a pretty small asset class,” Fed Chairman Ben Bernanke told the FCIC, explaining how in  he and Treasury Secretary Henry Paulson had underestimated the repercussions of the emerging housing crisis. “You know, the stock market goes up and down every day more than the entire value of the subprime mortgages in the country. But what created the contagion, or one of the things that created the conta- gion, was that the subprime mortgages were entangled in these huge securitized pools.”  The large drop in market prices of the mortgage securities had large spillover ef- fects to the financial sector, for a number of reasons. For example, as just discussed, when the prices of mortgage-backed securities and CDOs fell, many of the holders of those securities marked down the value of their holdings—before they had experi- enced any actual losses. In addition, rather than spreading the risks of losses among many investors, the securitization market had concentrated them. “Who owns residential credit risk?” two Lehman analysts asked in a September  report. The answer: three-quarters of subprime and Alt-A mortgages had been securitized—and “much of the risk in these securitizations is in the investment-grade securities and has been almost en- tirely transferred to AAA collateralized debt obligation (CDO) holders.”  A set of large, systemically important firms with significant holdings or exposure to these se- curities would be found to be holding very little capital to protect against potential losses. And most of those companies would turn out to be considered by the authori- ties too big to fail in the midst of a financial crisis. fcic_final_report_full--113 In its public order approving the merger, the Federal Reserve mentioned the com- mitment but then went on to state that “an applicant must demonstrate a satisfactory record of performance under the CRA without reliance on plans or commitments for future action. . . . The Board believes that the CRA plan—whether made as a plan or as an enforceable commitment—has no relevance in this case without the demon- strated record of performance of the companies involved.”  So were these commitments a meaningful step, or only a gesture? Lloyd Brown, a managing director at Citigroup, told the FCIC that most of the commitments would have been fulfilled in the normal course of business.  Speaking of the  merger with Countrywide, Andrew Plepler, head of Global Corporate Social Responsibility at Bank of America, told the FCIC: “At a time of mergers, there is a lot of concern, sometimes, that one plus one will not equal two in the eyes of communities where the acquired bank has been investing. . . . So, what we do is reaffirm our intention to con- tinue to lend and invest so that the communities where we live and work will con- tinue to economically thrive.” He explained further that the pledge amount was arrived at by working “closely with our business partners” who project current levels of business activity that qualifies toward community lending goals into the future to assure the community that past lending and investing practices will continue.  In essence, banks promised to keep doing what they had been doing, and commu- nity groups had the assurance that they would. BANK CAPITAL STANDARDS:  “ARBITRAGE ” Although the Federal Reserve had decided against stronger protections for con- sumers, it internalized the lessons of  and , when the first generation of sub- prime lenders put themselves at serious risk; some, such as Keystone Bank and Superior Bank, collapsed when the values of the subprime securitized assets they held proved to be inflated. In response, the Federal Reserve and other regulators re- worked the capital requirements on securitization by banks and thrifts. In October , they introduced the “Recourse Rule” governing how much capi- tal a bank needed to hold against securitized assets. If a bank retained an interest in a residual tranche of a mortgage security, as Keystone, Superior, and others had done, it would have to keep a dollar in capital for every dollar of residual interest. That seemed to make sense, since the bank, in this instance, would be the first to take losses on the loans in the pool. Under the old rules, banks held only  in capital to protect against losses on residual interests and any other exposures they retained in securitizations; Keystone and others had been allowed to seriously understate their risks and to not hold sufficient capital. Ironically, because the new rule made the cap- ital charge on residual interests , it increased banks’ incentive to sell the residual interests in securitizations—so that they were no longer the first to lose when the loans went bad. FOMC20070321meeting--90 88,CHAIRMAN BERNANKE.," Well, we here in Washington expect to have to answer a few questions about the subprime situation, and we would be very interested in anyone’s experience. If any other Reserve Bank is involved or has any plans, we’d be interested to hear about them." CHRG-111hhrg54867--177 Mr. Manzullo," Thank you, Mr. Chairman. Thank you, Mr. Secretary. Mr. Secretary, would you agree that the root cause of the financial collapse of this country was the fact that subprimes were not regulated too closely? " CHRG-111hhrg51585--116 Mr. Royce," Thank you, Mr. Chairman. I want to thank Mr. Street and ask him a question. I made the observation that Lehman was highly leveraged; it had a significant exposure to the mortgage market. I think it was as late as 2008 that it had $6 billion in subprime exposure, and it even owned a subprime originator, B&C Mortgage. You know Orange County as I remember, I think it was about 1994, and I think you were around there at that time, Orange County took a hit. And I think a lesson was learned that it was a dangerous, dangerous endeavor for a county treasurer to use taxpayer funds to invest in products that the local governments did not understand. And maybe you can tell us and discuss the extent to which the county took responsibility for those losses and what did the county do to restructure during that period? " CHRG-111hhrg52261--59 Mr. Anderson," Well, we have got RESPA; that is number one, under HUD. We have the Truth in Lending Act. I mean that has to do with your disclosures, your good faith and truth in lending. All of this, mortgage brokers, banks savings and loans, we all operate under that umbrella. Also in our States, individual States, we have to adhere to the same policies; and some of our States have predatory lending laws. In Louisiana, we just passed a law that there are no prepayment penalties, which is a good thing. So we are all under the same umbrella, and we have to comply with our own State lending laws. And we have got the Safe Licensing Act, which is for everybody. " FinancialCrisisReport--47 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. economy. 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, the investment grade ratings could not “hold.” By acknowledging that RMBS and CDO securities containing high risk, poor quality mortgages were not safe investments and were going to incur losses, the credit rating agencies admitted the emperor had no clothes. Investors stopped buying, the value of the RMBS and CDO securities fell, and financial institutions around the world were suddenly left with unmarketable securities whose value was plummeting. The financial crisis was on. fcic_final_report_full--263 Asset-Backed Commercial Paper Outstanding At the onset of the crisis in summer 2007, asset-backed commercial paper outstanding dropped as concerns about asset quality quickly spread. By the end of 2007, the amount outstanding had dropped nearly $400 billion. IN BILLIONS OF DOLLARS $1,250 1,000 750 500 250 0 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 NOTE: Seasonally adjusted SOURCE: Federal Reserve Board of Governors Figure . market has made it impossible to value certain assets fairly regardless of their quality or credit rating.”  In retrospect, many investors regarded the suspension of the French funds as the beginning of the  liquidity crisis. August  “was the ringing of the bell” for short- term funding markets, Paul McCulley, a managing director at PIMCO, told the FCIC. “The buyers went on a buyer strike and simply weren’t rolling.”  That is, they stopped rolling over their commercial paper and instead demanded payment on their loans. On August , the interest rates for overnight lending of A- rated asset- backed commercial paper rose from . to .—the highest level since January . It would continue rising unevenly, hitting . in August , . Figure . shows how, in response, lending declined. In August alone, the asset-backed commercial paper market shrank by  bil- lion, or . On August , subprime lender American Home Mortgage’s asset- backed commercial paper program invoked its privilege of postponing repayment, trapping lenders’ money for several months. Lenders quickly withdrew from pro- grams with similar provisions, which shrank that market from  billion to  bil- lion between May and August.  The paper that did sell had significantly shorter maturities, reflecting creditors’ desire to reassess their counterparties’ creditworthiness as frequently as possible. The average maturity of all asset-backed commercial paper in the United States fell from about  days in late July to about  days by mid-September, though the over- whelming majority was issued for just  to  days.  CHRG-111hhrg56847--205 Mr. Bernanke," Well, as supervisors, we can strongly encourage them to participate, but I think it is up to Congress to make it mandatory. We don't have the power to make it mandatory. But certainly, we think it is good practice, it is good for the banks to get these things resolved. To have these loans in limbo is not good for the banks either. They need to get them resolved and stabilized as quickly as possible. So I think that there is a common interest here, and we are very interested in that point. And the Cleveland Fed and other Feds also are very interested in neighborhood stabilization, which is a related issue. When you have a lot of foreclosures in a particular area, you have a breakdown in public order or in tax revenues and property values. So that is another issue where we have been very much involved. But, again, I think the government's primary tool for this has been through the Treasury, and we have tried to support them both analytically and through our supervisory function. On competition, actually, right now, I agree with you 100 percent that small banks are critical. We work with small banks all the time, and we were very concerned when the Senate was contemplating taking us out of the small bank supervision business because we find that those connections and that input we get from them and the interaction we have with them very, very important for our regulatory and monetary policies. So we are supporting them in every way we can. I think, actually, what is happening now in many cases is that the large banks are pulling back because of, you know, a shortage of capital or because of conservatism, and it is the small community banks in many cases that are healthy, didn't have subprime mortgages and are coming forward and making the loans. So they are providing a very important service right now, and we certainly encourage that. Ms. Kaptur. Mr. Chairman, I know my time is up, but these fees on these smaller institutions are killing lending at the local level. Maybe you could take a look at that with Sheila Baird over at the FDIC. " CHRG-111shrg57319--52 Mr. Cathcart," Correct. There should be a reasonableness test when these subprime mortgages are originated. Senator Levin. And 80 of these 115--sorry, 80 of the 132 had unreasonable income. Then it says 133 had evaluation or loan decision errors. Do you see that? " CHRG-109hhrg23738--111 Mr. Greenspan," They are good friends. Ms. Lee. And thank you very much for everything that you have done to help move this agenda forward, in terms of the fairness in our economic system. I wanted to ask you a couple of things. And we have been in touch with each other over the years with regard to CRA, and I want to thank you--the Community Reinvestment Act, and why and how banks can receive an A rating when in fact they are lending to African-Americans and Latinos, in terms of home lending, between 2 and 3 percent. As it relates to the Hispanic community in California, I think it is about 18 percent, when 35 percent of the population is Latino. And your response, of course, was that CRA cannot, you know, deal with the ethnic composition of any lending transaction because they are not required to, but the enforcement of fair lending laws is what would allow for the insurance of nondiscrimination actions. But yet I have to ask you: The fair lending laws appear not to have been enforced, given the very dismal mortgage lending rates of these institutions. And so in going back and forth, over the years, I have been reading your responses, and I want to ask you today if it makes sense, then, that we ask you to look at how to conduct--or maybe the Federal Reserve could conduct--a disparity study, to really begin to look at what is taking place, because, for the life of me, I cannot understand why in fact the home lending rate is so low when in fact these institutions are getting such high ratings. And so I would like to ask for some specific solutions to this so that we can move forward to ensure more fairness in mortgage lending. " CHRG-110shrg38109--71 Chairman Bernanke," Senator, as I indicated in my opening testimony, we think we see some tentative signs of stabilization in demand in the housing market, that nevertheless takes some time yet to work its way out because of the inventories of unsold homes that still exist on the market. I would emphasize that the signs of stabilization are tentative, and we do not want to jump to conclusions. It will be helpful to see what happens when the spring selling season begins and strong demand is at that time. But it is interesting that so far the economy has done a good job of withstanding the slowdown in construction, which, although substantial relative to the last couple of years, is still similar to the late 1990's, for example. It is not that we have had a complete collapse in construction by any means. So the decline in construction, while it has slowed the economy, has obviously not thrown us into a much slower growth situation. And we have not seen substantial spillovers from the housing slowdown to consumer spending or to other parts of the economy. So it is early to say that this problem is over. I think we are going to have to continue to watch it very carefully, and as I indicated, I think it is a downside risk to the economy going forward. But so far, the economy has reasonably adapted to this adjustment in the housing market. Senator Martinez. You mentioned in your remarks also that household finance appears solid and that delinquency rates on most consumer loans, including residential mortgages, were low, but you did note the subprime mortgages with variable interest rates where delinquency rates have increases appreciably. And it is an issue that is of great concern to several of us on this Committee, the issue of predatory lending, the abuse of some of our most vulnerable consumers. Any comments on that or any issues that you see there which could impact the overall economy? " FOMC20070321meeting--6 4,MR. DUDLEY.," Well, unfortunately, the information on the alt-A market is not very good. In fact, there is disagreement about exactly what an alt-A mortgage is. If you can’t define it, it’s pretty hard to measure. That is problem number one. A good way of thinking about the mortgage market is as a continuum of loan quality extending from, at the bottom, the worst underwritten subprime mortgages that are adjustable rate up to the conforming mortgages that we always associate with the GSEs, with alt-A somewhere in the middle. Obviously, to the extent that the housing market deteriorates and home prices don’t go up, there will be more strain on the alt-A market; but I don’t get a sense that we will see the kind of underwriting problems that we have seen in the subprime mortgage area. As of this date, we don’t see a lot of evidence of a significant problem in that area; but, again, we don’t have very good information, and we’ll have to wait and see." CHRG-111shrg55117--88 Mr. Bernanke," It would depend whether the agency was involved in promulgating--actively promulgating proactively actions that the banks should take in terms of the kind of lending they should do and so on. If it is promoting certain kinds of lending, then it does raise the risk that that lending might not be safe and sound. If it is mostly involved in putting limits on the types of products that can be offered and so on, that could also have implications for bank profitability, but it doesn't have the same implications of what you are talking about, which is lending which is not safe and sound. Senator Vitter. Although bank profitability goes to safety and soundness, too. " FOMC20070131meeting--32 30,MR. DUDLEY.,"1 Thank you. In terms of market developments, I would like to focus on three major topics. First is the sharp adjustment in market expectations concerning monetary policy since the last FOMC meeting. Second, I will talk about the persistence of high risk appetites in credit markets, with a focus on what may be the most vulnerable market in the United States—the subprime mortgage sector. Third, I want to discuss the possible factors behind some of the sharp shifts we have seen in commodity prices since the last FOMC meeting, in particular whether these price movements reflect a shift in risk appetite among noncommercial investors or fundamental developments in supply and demand. First, there has been a sharp shift in market expectations with respect to interest rates since the last meeting. At the time of the December meeting, the consensus view among market participants was that the FOMC would begin to lower its federal funds rate target this spring and that this easing process would continue into 2008, with cumulative rate cuts of about 75 basis points. As you can see in chart 1, which looks at the federal funds futures market, and chart 2, which looks at the yield spreads between the March 2008 and the March 2007 Eurodollar futures contracts, expectations have shifted very sharply over the past month. There is now no easing priced in through midyear 2007 and a residual of only about 25 basis points of easing priced in beyond that. This shift in expectations can also be seen across the Treasury yield curve. As chart 3 shows, the Treasury yield curve is now slightly above where it was at the time of October FOMC meeting. Since the December FOMC meeting, there has been a rise of about 35 to 40 basis points in yields from two-year to thirty- year maturities. The shift in expectations is reflected predominately in real interest rates. As can be seen in chart 4, breakeven inflation rates have not changed much since the last FOMC meeting—the decline in breakeven rates that occurred early in the intermeeting period has been reversed more recently, and so we are at or slightly above where we were at the December meeting. This upward shift in real rates appears to reflect a reassessment by market participants not only about the near-term path of short-term rates but also about what level of real short-term rates is likely to prove sustainable over the medium and longer term. The buoyancy of the recent activity data may have caused some market participants to reassess what level of the real federal funds rate is likely to prove “neutral” over the longer term. Regarding the issue of risk appetite, there appears to be no significant change since the last FOMC meeting. Risk appetite remains very strong. Corporate credit spreads remain very tight—especially in the high-yield sector (as shown in chart 5)— and implied volatilities across the broad market categories—equities and interest rates (see chart 6) and foreign exchange rates (see chart 7)—remain unusually low. Moreover, the turbulence in some emerging debt and equity markets experienced 1 Material used by Mr. Dudley is appended to this transcript (appendix 1). early this month was mostly transient and has subsided as well. So things appear calm. But what are the areas of greatest risk? In the United States, the subprime mortgage market appears to be a particularly vulnerable sector. The vulnerability stems from four factors. First, this market is relatively new and untested. Chart 8 shows the overall trend of first residential mortgage originations and the share of these mortgages by type—conforming, jumbo, subprime, and alt-A, which is a quality category that sits above subprime but is not quite as good as conforming. As can be seen in this chart, subprime mortgage originations have climbed in recent years, even as overall originations have fallen. In 2006, subprime mortgages were 24 percent of total originations, up from a share of about 10 percent in 2003. The second factor is that credit standards in this market appear to have loosened in 2006, with the proportion of interest-only loans and low- documentation loans climbing as a share of the total. As a result, there are some signs that strains in this market are increasing. As chart 9 shows, delinquency rates have moved somewhat higher. In contrast, charge-offs remain low, held down by the rapid house price appreciation that we saw in recent years. Most noteworthy, as shown in chart 10, the most recent 2006 vintage of subprime mortgages is showing a much more rapid rise in delinquencies than earlier vintages showed. The third factor is that most outstanding subprime mortgage loans have adjustable rates. There is significant reset risk given the rise in short-term rates in 2005 and the first half of 2006 and the fact that many of these loans started with low “teaser” rates. Fourth, housing prices are under some pressure, and this could contribute to further credit strains. I see some risk of a vicious cycle. If credit spreads in the securitized market spike because loan performance is poor, a sharp downturn in lending could result as the capital market for securitized subprime mortgage products closes. This constriction of credit could put downward pressure on prices and lead to more credit problems among borrowers. The result would be additional credit quality problems, wider credit spreads, and a further contraction of credit. Fortunately, to date the news is still fairly favorable. The strong demand for the credit derivatives obligations created from subprime mortgage products has restrained the rise in credit spreads. As can be seen in chart 11, spreads are still well below the peaks reached in late 2002 and early 2003. Thus, the economics of making such loans and securitizing them into the capital markets still work. But this situation could change very quickly, especially if the labor markets were to become less buoyant and the performance of the underlying loans were to deteriorate, leading to a surge in delinquencies and charge-offs. Let me now turn to the commodity markets. The issue I wish to examine here is whether some of the sharp movements in commodity prices that we have observed since the last FOMC meeting represent shifts in the risk appetite among noncommercial investors who have put funds into commodities as a new asset class versus the contrasting view that these price movements predominantly represent changes in the underlying supply and demand fundamentals. To get a sense of this, let’s look briefly at three commodities that have moved the most and are representative of their classes—copper, corn, and crude oil. As chart 12 shows, the sharp decline in copper prices appears linked to the large rise in copper inventories at the London Metal Exchange. If anything, the price decline appears overdue. For corn, the rise in prices also appears consistent with declining stocks both in the United States and globally (see chart 13) as well as the growing demand anticipated for corn in the production of ethanol. For crude oil, the decline in prices is more difficult to tie back to inventories. Although U.S. inventories remain high relative to the five-year historical average (as shown in chart 14), this situation has persisted for some time without having a big effect on prices. Instead, the shift in oil prices appears to be driven mostly by longer-term forces. This can be seen in two ways. First, as shown in chart 15, the change in oil prices has occurred in both spot and forward prices. The oil curve has shifted downward in mostly a parallel fashion, which also calls into question the role of unseasonably warm weather as the primary driver. If weather were the primary factor, then the decline in prices should have been reflected much more strongly in the spot and very short-end of the oil price curve. Second, as shown in chart 16, OPEC spare production capacity has been increasing and is expected to continue increasing in 2007. This growing safety margin reflects both slower growth in global demand and the expansion of non-OPEC output. The improved safety margin may be an important factor behind recent developments in the energy sector. Finally, there were no foreign operations during this period. I request a vote to ratify the operations conducted by the System Open Market Account since the December FOMC meeting." CHRG-111hhrg52397--81 Mr. Pickel," Let me comment briefly on AIG. They, through their credit default swaps, were taking exposure to subprime debt, the collateralized debt obligations, certain tranches of those obligations, so they had an appetite for subprime exposure. In fact, through their regulated insurance companies, as Mr. Polakoff testified in the Senate Banking Committee in March, they were also taking on exposure to subprime past the time that the financial products company stopped taking on exposure, well into 2006 and even 2007. So that was the appetite that they had. They also looked at risk in a very narrow way. The head of FP, the Financial Products Division, was quoted as saying he could not imagine ever losing a dollar on these trades. And he was looking at that really only in respect to payouts on the transactions. He was not really looking at the mark-to-market exposure, which ultimately is what undermined AIG. They also traded on their triple A, which other institutions--in fact some of the institutions who have been the source of the greatest problems, Fannie and Freddie, some of the monolines, have traded on their triple A, resisted the providing of collateral, and even worse, agreed in certain circumstances to provide collateral on downgrades. And, frankly, ever since the Group of 30 Report published in 1993, it has been very clear that downgrade provisions, where you provide collateral on downgrades, are to be dealt with very cautiously because of the liquidity problems they can cause. In fact, the banking regulators discourage them, they do not prevent them but they do discourage the use of those types of provisions. So those are our observations on the AIG situation, and I think is very important as we look forward in reform. " FinancialCrisisReport--311 Published reports, as well as internal emails, demonstrate that analysts within both Moody’s and S&P were aware of the serious mortgage fraud problem in the industry. 1206 Despite being on notice about the problem and despite assertions about the importance of loan data quality in the ratings process for structured finance securities, 1207 neither Moody’s nor S&P established procedures to account for the possibility of fraud in its ratings process. For example, neither company took any steps to ensure that the loan data provided for specific RMBS loan pools had been reviewed for accuracy. 1208 The former head of S&P’s RMBS Group, Frank Raiter, stated in his prepared testimony for the Subcommittee hearing that the S&P rating process did not include any “due diligence” review of the loan tape or any requirement for the provider of the loan tape to certify its accuracy. He stated: “We were discouraged from even using the term ‘due diligence’ as it was believed to expose S&P to liability.” 1209 Fraud was also not factored into the RMBS or CDO quantitative models. 1210 Yet when Moody’s and S&P initiated the mass downgrades of RMBS and CDO securities in July 2007, they directed some of the blame for the rating errors on the volume of mortgage fraud. On July 10, 2007, when S&P announced that it was placing 612 U.S. subprime RMBS on negative credit watch, S&P noted the high incidence of fraud reported by MARI, “misrepresentations on credit reports,” and that “[d]ata quality concerning some of the borrower and loan characteristics provided during the rating process [had] also come under question.” 1211 In October 2007, the CEO of Fitch Ratings, another ratings firm, said in an interview that “the blame may lie with fraudulent lending practices, not his industry.” 1212 Moody’s made similar observations. In 2008, Moody’s CEO Ray McDaniel told a panel at the World Economic Forum: “In hindsight, it is pretty clear that there was a failure in some key assumptions that were supporting our analytics and our models. … [One reason for the failure was that the] 1206 See, e.g., 9/2/2006 email chain between Richard Koch, Robert Mackey, and Michael Gutierrez, “Nightmare Mortgages,” Hearing Exhibit 4/23-46a; 9/5/2006 email chain between Edward Highland, Michael Gutierrez, and Richard Koch, “Nightmare Mortgages,” Hearing Exhibit 4/23-46b; and 9/29/2006 email from Michael Gutierrez, Director of S&P, PSI-S&P-RFN-000029. 1207 See, e.g., 6/24/2010 supplemental response from S&P to the Subcommittee, Exhibit H, Hearing Exhibit 4/23- 108 (7/11/2007 “S&PCORRECT: 612 U.S. Subprime RMBS Classes Put On Watch Neg; Methodology Revisions Announced,” S&P’s RatingsDirect (correcting the original version issued on 7/10/2007)). 1208 See, e.g., 2008 SEC Examination Report for Moody’s Investor Services Inc., PSI-SEC (Moodys Exam Report)- 14-0001-16, at 7; and 2008 SEC Examination Report for Standard and Poor’s Ratings Services, Inc., PSI-SEC (S&P Exam Report)-14-0001-24, at 11 (finding with respect to each credit rating agency that it “did not engage in any due diligence or otherwise seek to verify the accuracy and quality of the loan data underlying the RMBS pools it rated”). 1209 Prepared statement of Frank Raiter, Former Managing Director at Standard & Poor’s, April 23, 2010 Subcommittee Hearing, at 3. 1210 Subcommittee interviews of Susan Barnes (3/18/2010) and Richard Gugliada (10/9/2009). 1211 6/24/2010 supplemental response from S&P to the Subcommittee, Exhibit H, Hearing Exhibit 4/23-108 (7/11/2007 “S&PCORRECT: 612 U.S. Subprime RMBS Classes Put On Watch Neg; Methodology Revisions Announced,” S&P’s RatingsDirect (correcting the original version issued on 7/10/2007)). 1212 10/12/2007 Moody’s internal email, PSI-MOODYS-RFN-000035 (citing “Fitch CEO says fraudulent lending practices may have contributed to problems with ratings,” Associated Press , and noting: “After S&P, Fitch is now blaming fraud for the impact on RMBS, at least partially.”). ‘information quality’ [given to Moody’s,] both the complete[ness] and veracity, was deteriorating.” 1213 CHRG-111hhrg53241--125 Mr. Meeks," Thank you, Madam Chairwoman. First of all, I want to agree with Ms. Zirkin, who stated in her statement that I am not against subprime loans that are responsible. Those kinds of loans can help individuals own a home, which I still believe is the greatest opportunity for wealth creation that we have and will lower the gap between those who own and don't have, particularly in regards to African Americans, Latinos, etc. The problem comes in is where the responsibility leaves, and we get into areas of predatory loans. And I think for a long period of time many individuals, on this side of the aisle, at any rate, were yelling and screaming that we should ban predatory lending because predatory lending put many of the individuals in the situations that they are currently in. Now, if it is someone who is flipping homes, that is a whole different person. We are talking about individuals who bought these homes, trying to participate in the great American dream of homeownership so they can raise their kids for a long period of time. And, to me, what we are simply trying to do here is to say, yes, we have to have safety and soundness regulations, but we also have to have someplace to go where there may be some predatory lending going on. This consumer regulatory agency can overlook and can oversee what is going on so we can make sure that the product is not having a negative impact overall. For example, there is a debate that is going on as to whether or not--you know, yield spread premiums. From my idea, we should ban yield spread premiums, because I don't see what the utilization of them are except for costing individuals more money. Now, it would seem to me that we could debate that. Because on one side, if you just leave it to the bankers and the financial institutions who--they are--part of their role is to try to make as much money as they can. But we need someone else whose role is to try to make sure that we are not doing it at the backs or at the expense of other individuals. And I think what the President's plan is simply trying to do is say, let us lay it out. And what I would think that--I had hoped yesterday and what I may comment to those who testified yesterday is, as opposed to people lining up dead set against something, I think it helps them. It would help their image if they came with some recommendations on how we could make sure consumers are also protected. Because one of the biggest problems in America right now is it is us against them, and we need to find a way to bridge that gap. And, to me, it makes sense that this is an avenue to bridge that gap so Main Street doesn't think that Wall Street is against them. But if anytime you talk about something of that nature without saying, well, here is my recommendations, how we can work it again, then it looks like Wall Street is against Main Street. And we have to figure out how we bridge that. I thought that Ms. Zirkin's testimony was right on the money in that regard. I think that is the direction we need to go in. I think that the conversation that we also need to have is--because I heard some say it needs to be an independent agency. And it gets to the question of how do we pay for it. Should it be a situation where there is a direct appropriation from Congress? Should it be by fee? Who--I hadn't heard that. Let me just throw that out. Anyone have any recommendation of how we should pay for it? " fcic_final_report_full--494 By 2004, HUD believed it had achieved the “revolution” it was looking for: Over the past ten years, there has been a ‘revolution in affordable lending’ that has extended homeownership opportunities to historically underserved households. Fannie Mae and Freddie Mac have been a substantial part of this ‘revolution in affordable lending’. During the mid-to-late 1990s, they added flexibility to their underwriting guidelines, introduced new low-downpayment products , and worked to expand the use of automated underwriting in evaluating the creditworthiness of loan applicants. HMDA data suggest that the industry and GSE initiatives are increasing the flow of credit to underserved borrowers. Between 1993 and 2003, conventional loans to low income and minority families increased at much faster rates than loans to upper-income and nonminority families . 67 [emphasis supplied] This turned out to be an immense error of policy. By 2010, even the strongest supporters of affordable housing as enforced by HUD had recognized their error. In an interview on Larry Kudlow’s CNBC television program in late August, Representative Barney Frank (D-Mass.)—the chair of the House Financial Services Committee and previously the strongest congressional advocate for affordable housing—conceded that he had erred: “I hope by next year we’ll have abolished Fannie and Freddie . . . it was a great mistake to push lower-income people into housing they couldn’t afford and couldn’t really handle once they had it.” He then added, “I had been too sanguine about Fannie and Freddie.” 68 2. The Decline of Mortgage Underwriting Standards Before the enactment of the GSE Act in 1992, and HUD’s adoption of a policy thereafter to reduce underwriting standards, the GSEs followed conservative underwriting practices. For example, in a random review by Fannie Mae of 25,804 loans from October 1988 to January 1992, over 78 percent had LTV ratios of 80 percent or less, while only 5.75 percent had LTV ratios of 91 to 95 percent. 69 High risk lending was confined primarily to FHA (which was controlled by HUD) and specialized subprime lenders who often sold the mortgages they originated to FHA. What caused these conservative standards to decline? The Commission majority, 65 Steve Cocheo, “Fair-lending pressure builds,” ABA Banking Journal , vol. 86, 1994, http://www.questia. com/googleScholar.qst?docId=5001707340. 66 67 See NCRC, CRA Commitments , 2007. Federal Register ,vol. 69, No. 211, November 2, 2004, Rules and Regulations, p.63585, http://fdsys.gpo. gov/fdsys/pkg/FR-2004-11-02/pdf/04-24101.pdf . 68 Larry Kudlow, “Barney Frank Comes Home to the Facts,” GOPUSA, August 23, 2010, available at www.gopusa.com/commentary/2010/08/kudlow-barney-frank-comes-home-to-the-facts.php#ixz z0zdCrWpCY (accessed September 20, 2010). 69 Document in author’s files. echoing Chairman Bernanke, seems to believe that the impetus was competition among the banks, irresponsibility among originators, and the desire for profit. The majority’s report offers no other explanation. CHRG-111shrg57319--253 Mr. Schneider," If you look at the charts there, those are percentages there and---- Senator Coburn. Right. They are percentages. Mr. Schneider [continuing]. The aggregate volumes went down significantly. Some of the items I focused on were subprime. I took over subprime in 2006. It was 16 percent of the volume at that time. By the time we got to 2007, it was 5 percent on a very small base. Option ARMs declined from 22 percent to 18 percent during the time I was there, and by the time we got to 2008, Option ARMs were zero. And then the other ARM product would be more conventional hybrid ARMs, so those would be loans that would be sold to Fannie Mae and Freddie Mac. Senator Coburn. Would you put up the WaMu origination and purchases by loan type, 2003 to 2007. So not only were the percentages declining, but the absolute dollars---- " FinancialCrisisReport--237 In July 2010, the three former New Century executives settled the SEC complaint for about $1.5 million, without admitting or denying wrongdoing. 928 Each also agreed to be barred from serving as an officer or director of any publicly traded corporation for five years. A larger group of about a dozen former New Century officers and directors settled several class action and other shareholder lawsuits for $88.5 million. 929 In 2007, New Century reported publicly that it was under criminal investigation by the U.S. Attorney’s Office for the Central District of California, but no indictment of the company or any executive has been filed. 930 (d) Fremont Fremont Investment & Loan was once the fifth largest subprime mortgage lender in the United States. 931 At its peak in 2006, it had $13 billion in assets, 3,500 employees, and nearly two dozen offices. 932 Fremont Investment & Loan was neither a bank nor a thrift, but an “industrial loan company” that issued loans and held insured deposits. 933 It was owned by Fremont General Credit Corporation which was owned, in turn, by Fremont General Corporation. In 2007, the bank was the subject of an FDIC cease and desist order which identified multiple problems with its operations and ordered the bank to cease its subprime lending. 934 In 2008, due to insufficient capital, the FDIC ordered Fremont General Corporation to either recapitalize the bank or sell it. The bank was then sold to CapitalSource, Inc. 935 In June 926 SEC Complaint against New Century Executives at 3. 927 See, e.g., SEC Complaint against New Century Executives at ¶¶ 24-32. 928 See 7/30/2010 SEC Litigation Release No. 21609, “SEC Settles With Former Officers of Subprime Lender New Century, “ http:www.sec.gov/litigation/litreleases/2010/lr21609.htm. 929 See, e.g., “New Century Ex-leaders to Pay $90 Million in Settlements,” Los Angeles Times (7/31/2010). 930 See 3/12/2007 New Century Financial Corporation Form 8-K, Item 8.01. 931 “Fremont Ordered by FDIC to Find Buyer; Curbs Imposed,” Bloomberg (3/28/2010), http://www.bloomberg.com/apps/news?pid=newsarchive&sid=atIgi9otRZ3k. 932 3/2006 Fremont General Corporation Form 10-K filed with the SEC. 933 Id. 934 In re Fremont Investment & Loan, Order to Cease and Desist, Docket No. FDIC-07-035b (March 7, 2007) (hereinafter “Fremont Cease and Desist Order”). 935 In re Fremont Investment & Loan, Supervisory Prompt Corrective Action Directive, Docket No. FDIC-08-069 PCAS (March 26, 2008); “CapitalSource, Inc.,” Hoover’s Company Records. See also “CapitalSource to Acquire Fremont’s Retail Arm,” New York Times (4/14/2008). 2008, Fremont General Corporation declared bankruptcy under Chapter 11 and has since reorganized as Signature Group Holdings, Inc. 936 CHRG-111hhrg54868--184 Mr. Dugan," I don't think there is any serious question that the overwhelming proportion of subprime loans that have caused the worst problems, the highest foreclosure rates were in nonbanks; that is, entities that were not regulated by banking regulators. And we have data, and we-- " FinancialCrisisInquiry--821 WALLISON: And those numbers will be supplied to the commission, and I am hoping that the commission will look at them very seriously. Are you aware, also, that Fannie and Freddie reported their 10 million subprime loans as prime loans? CHRG-111shrg57319--248 Mr. Schneider," I think that is primarily true because Long Beach tended to originate higher credit risk assets than other subprime mortgage originators. Senator Levin. All right. Now, it stopped issuing the securitizations in 2003 while it worked on correcting the problems, is that correct? " FinancialCrisisReport--263 Although ratings downgrades for investment grade securities are supposed to be relatively infrequent, in 2007, they took place on a massive scale that was unprecedented in U.S. financial markets. Beginning in July 2007, Moody’s and S&P downgraded hundreds and then thousands of RMBS and CDO ratings, causing the rated securities to lose value and become much more difficult to sell, and leading to the subsequent collapse of the RMBS and CDO secondary markets. The massive downgrades made it clear that the original ratings were not only deeply flawed, but the U.S. mortgage market was much riskier than previously portrayed. Housing prices peaked in 2006. In late 2006, as the increase in housing prices slowed or leveled out, refinancing became more difficult, and delinquencies in subprime residential mortgages began to multiply. By January 2007, nearly 10% of all subprime loans were delinquent, a 68% increase from January 2006. 1016 Housing prices then began to decline, exposing more borrowers who had purchased homes that they could not afford and could no longer refinance. Subprime lenders also began to close their doors, which the U.S. Department of Housing and Urban Development marked as the beginning of economic trouble: “Arguably, the first tremors of the national mortgage crisis were felt in early December 2006 when two sizeable subprime lenders, Ownit Mortgage Solutions and Sebring Capital, failed. The Wall Street Journal described the closing of these firms as ‘sending shock waves’ through the mortgage-bond market. … By late February 2007 when the number of subprime lenders shuttering their doors had reached 22, one of the first headlines announcing the onset of a ‘mortgage crisis’ appeared in the Daily Telegraph of London.” 1017 During the first half of 2007, despite the news of failing subprime lenders and increasing subprime mortgage defaults, Moody’s and S&P continued to issue AAA credit ratings for a large number of RMBS and CDO securities. In the first week of July 2007 alone, S&P issued over 1,500 new RMBS ratings, a number that almost equaled the average number of RMBS ratings it issued in each of the preceding three months. 1018 From July 5 to July 11, 2007, Moody’s issued approximately 675 new RMBS ratings, nearly double its weekly average in the prior month. 1019 The timing of this surge of new ratings on the eve of the mass downgrades is troubling, and raises serious questions about whether S&P and Moody’s quickly pushed these ratings through to avoid losing revenues before the mass downgrades began. 1016 1/25/2010 “60 Day+Delinquency and Foreclosure,” chart prepared by Paulson & Co. Inc., PSI-Paulson&Co-02- 0001-21, at 15. Subcommittee interview of Sihan Shu (2/24/2010). 1017 3/2009 U.S. Department of Housing and Urban Development Interim Report to Congress, “Root Causes of the Foreclosure Crisis,” at 2 [citations omitted]. 1018 6/24/2010 supplemental response from S&P to the Subcommittee, at 12, Hearing Exhibit 4/23-108. 1019 Data compiled by the Subcommittee using 6/14/2007 “Structured Finance New Ratings: May 28, 2007 through June 13, 2007,” Moody’s; 6/28/2007 “Structured Finance New Ratings: June 11, 2007 through June 27, 2007,” Moody’s; 7/5/2007 “Structured Finance New Ratings: June 18, 2007 through July 4, 2007,” Moody’s; and 7/12/2007 “Structured Finance New Ratings: June 25, 2007 through July 11, 2007,” Moody’s. CHRG-110hhrg46593--232 Mr. Manzullo," Do you like that question? Ms. Blankenship. I will take that question. Of the 8,000 community banks, the banks that are on Main Street and in the agricultural and rural communities that represent 22,000 communities across the Nation, by and large they are well capitalized and they do have money to lend. Our own bank actually has increased in lending--our net lending since this time last year. The market confidence was a huge factor. When there were comments that thousands of banks would fail, you know, we had--that is where you saw your customers pulling in. It wasn't the fact that the banks didn't have money to lend. The consumer confidence just went to the tank. And so we had to restore that. And coupled with that was the deposit insurance question and, you know, does your bank save? And the confusion over money market guarantees where the mutual funds got unlimited and our banks had $100,000 still. So it is hard to compete. And yet those customers know us. They know us by name, as you said. And the confidence--we were able to rebuild that confidence. But it was a campaign. We do have money to lend, and we would be glad to lend it. " fcic_final_report_full--232 In , the respective average delinquency rates for the non-GSE and GSE loans were . and .. These patterns are most likely driven by differences in under- writing standards as well as by some differences not captured in these mortgages.  For instance, in the GSE pool, borrowers tended to make bigger down payments. The FCIC’s data show that  of GSE loans with FICO scores below  had an original loan-to-value ratio below , indicating that the borrower made a down payment of at least  of the sales price. This relatively large down payment would help offset the effect of the lower FICO score. In contrast, only  of loans with FICO scores below  in non-GSE subprime securitizations had an LTV under . The data il- lustrate that non-agency securitized loans were much more likely to have more than one risk factor and thereby exhibit so-called risk layering, such as low FICO scores on top of small down payments. GSE mortgages with Alt-A characteristics also performed significantly better than mortgages packaged into non-GSE Alt-A securities. For example, in  among loans with an LTV above , the GSE pools have an average rate of serious delin- quency of ., versus a rate of . for loans in private Alt-A securities.  These results are also, in large part, driven by differences in risk layering. Others frame the situation differently. According to Ed Pinto, a mortgage finance industry consultant who was the chief credit officer at Fannie Mae in the s, GSEs dominated the market for risky loans. In written analyses reviewed by the FCIC staff and sent to Commissioners as well as in a number of interviews, Pinto has argued that the GSE loans that had FICO scores below , a combined loan-to-value ratio greater than , or other mortgage characteristics such as interest-only payments were essentially equivalent to those mortgages in securitizations labeled subprime and Alt-A by issuers. Using strict cutoffs on FICO score and loan-to-value ratios that ignore risk layer- ing and thus are only partly related to mortgage performance (as well as relying on a number of other assumptions), Pinto estimates that as of June , ,  of all mortgages in the country—. million of them—were risky mortgages that he de- fines as subprime or Alt-A. Of these, Pinto counts . million, or , that were purchased or guaranteed by the GSEs.  In contrast, the GSEs categorize fewer than  million of their loans as subprime or Alt-A.  Importantly, as the FCIC review shows, the GSE loans classified as subprime or Alt-A in Pinto’s analysis did not perform nearly as poorly as loans in non-agency sub- prime or Alt-A securities. These differences suggest that grouping all of these loans together is misleading. In direct contrast to Pinto’s claim, GSE mortgages with some riskier characteristics such as high loan-to-value ratios are not at all equivalent to those mortgages in securitizations labeled subprime and Alt-A by issuers. The per- formance data assembled and analyzed by the FCIC show that non-GSE securitized loans experienced much higher rates of delinquency than did the GSE loans with similar characteristics. In addition to examining loans owned and guaranteed by the GSEs, Pinto also com- mented on the role of the Community Reinvestment Act (CRA) in causing the crisis, declaring, “The pain and hardship that CRA has likely spawned are immeasurable.”  CHRG-111shrg57320--323 Mr. Corston," It suggests the inability to repay the loan out of their payment capacity, which moves the reliance to the underlying collateral. And I think we have seen the results. Senator Levin. Now, several OTS officials told our Subcommittee that single-family residential lending, compared to other types of lending, was historically very safe, so that is how they judged WaMu's lending. Is that a fair comparison, given that WaMu's lending practices departed radically from historically safe products and practices? Either one of you. Mr. Doerr, why don't you start? " CHRG-111shrg57322--809 Mr. Broderick," I don't think that it implies that it was excluded from the memo. He just is referencing the fact that his comments may be too late for inclusion in the memo, but it doesn't actually say whether it was in the memo or not. Senator Coburn. OK, but the point is the desk was no longer buying subprime, and you knew that. " FinancialCrisisInquiry--446 GRAHAM: Mr. Bass, I understand that at one point you were sufficiently concerned about the impact of the subprime mortgages that you talked to—maybe it was Bear Stearns and also to the Federal Reserve. Could you summarize what message you delivered to those two audiences and what response you got? January 13, 2010 FOMC20070628meeting--97 95,MR. KROSZNER.," In exhibit 9, the average initial rate on the stock of mortgages that you are looking at for resetting over the next couple of years is about 7⅓ percent. What is roughly the current rate for subprime fixed-rate loans?" CHRG-111shrg57322--315 Mr. Birnbaum," My sentiment that I expressed in my opening statement was that there was a market in residential mortgage-backed securities in subprime that I thought was overvalued. Senator Tester. OK. So it was based on the housing bubble, and its decline or collapse, however you want to put--however I want to put it. " CHRG-110hhrg44901--223 Mr. Bernanke," Well, my understanding is that Congress has addressed that to some extent by allowing direct lending or backup lending. " CHRG-110hhrg34673--228 Mr. Perlmutter," Speaking of the subprime market, last week the bottom kind of fell out of that market, or there was a tremendous drop in that market. Has that leveled off? I haven't read anything since Friday, but it seems there was a tremendous loss of value in that market. " CHRG-111hhrg54872--120 Mr. Calhoun," I think you have to balance all of them. And there has been discussion of the role of banks. I think it is important to remember they did the lion's share of the so-called Alt-A loans which would have larger defaults at greater taxpayer cost than even the subprime loans. " CHRG-111shrg57322--321 Mr. Birnbaum," I believe housing started to decline in the beginning or to the middle of 2006. It depends on how you track these things. Senator Tester. OK. Middle or end of 2006. And you base that--and I do not want to put words in your mouth--on the subprime market? " fcic_final_report_full--107 FEDERAL RULES: “INTENDED TO CURB UNFAIR OR ABUSIVE LENDING ” As Citigroup was buying Associates First in , the Federal Reserve revisited the rules protecting borrowers from predatory conduct. It conducted its second round of hearings on the Home Ownership and Equity Protection Act (HOEPA), and subse- quently the staff offered two reform proposals. The first would have effectively barred lenders from granting any mortgage—not just the limited set of high-cost loans defined by HOEPA—solely on the value of the collateral and without regard to the borrower’s ability to repay. For high-cost loans, the lender would have to verify and document the borrower’s income and debt; for other loans, the documentation standard was weaker, as the lender could rely on the borrower’s payment history and the like. The staff memo explained this would mainly “affect lenders who make no-documentation loans.” The second proposal addressed practices such as deceptive advertisements, misrepresenting loan terms, and having consumers sign blank documents—acts that involve fraud, de- ception, or misrepresentations.  Despite evidence of predatory tactics from their own hearings and from the re- cently released HUD-Treasury report, Fed officials remained divided on how aggres- sively to strengthen borrower protections. They grappled with the same trade-off that the HUD-Treasury report had recently noted. “We want to encourage the growth in the subprime lending market,” Fed Governor Edward Gramlich remarked at the Fi- nancial Services Roundtable in early . “But we also don’t want to encourage the abuses; indeed, we want to do what we can to stop these abuses.”  Fed General Coun- sel Scott Alvarez told the FCIC, “There was concern that if you put out a broad rule, you would stop things that were not unfair and deceptive because you were trying to get at the bad practices and you just couldn’t think of all of the details you would need. And if you did think of all of the details, you’d end up writing a rule that people could get around very easily.”  Greenspan, too, later said that to prohibit certain products might be harmful. “These and other kinds of loan products, when made to borrowers meeting appro- priate underwriting standards, should not necessarily be regarded as improper,” he said, “and on the contrary facilitated the national policy of making homeownership more broadly available.”  Instead, at least for certain violations of consumer protec- tion laws, he suggested another approach: “If there is egregious fraud, if there is egre- gious practice, one doesn’t need supervision and regulation, what one needs is law enforcement.”  But the Federal Reserve would not use the legal system to rein in predatory lenders. From  to the end of Greenspan’s tenure in , the Fed re- ferred to the Justice Department only three institutions for fair lending violations re- lated to mortgages: First American Bank, in Carpentersville, Illinois; Desert Community Bank, in Victorville, California; and the New York branch of Société Générale, a large French bank. FinancialCrisisReport--185 In June 2007, for example, OTS examiners completed a review critical of WaMu procedures to oversee the loans it purchased from third party mortgage brokers. 678 From 2003 to 2007, 48 to 70% of WaMu’s loans were purchased from third parties. 679 An OTS memorandum noted that Washington Mutual had only 14 full-time employees overseeing more than 34,000 third party brokers submitting loans to the bank for approval. OTS also criticized the scorecard used to rate those brokers which, among other problems, did not include the rate at which significant lending or documentation deficiencies were attributed to the broker, the rate at which its loans were denied or produced unsaleable loans, or an indication of whether the broker was included in industry watchlists for misconduct. After describing these and other problems, rather than lower WaMu’s safety and soundness scores for its poor oversight, however, the OTS memorandum made only the following observation: “Given the . . . increase in fraud, early payment defaults, first payment defaults, subprime delinquencies, etc., management should re- assess the adequacy of staffing.” 680 WaMu management agreed with the finding, but provided no corrective action plan, stating only that “[s]taffing needs are evaluated continually and adjusted as necessary.” 681 In the September 2007 annual ROE, OTS wrote: “Risk management practices in the HLG (Home Loans Group) during most of the review period were inadequate …. We believe that there were sufficient negative credit trends that should have elicited more aggressive action by management with respect to limiting credit exposure. In particular, as previously noted, the risk misrepresentation in stated income loans has been generally reported for some time. This information should have led management to better assess the prudence of stated income lending and curtail riskier products well before we indicated during this examination that we would limit the Bank’s ability to continue such lending.” 682 The ROE also faulted management and Board inaction: “Board oversight and management’s performance was less than satisfactory. … Contributing factors should have been more proactively managed by the Board and management. The most significant of these factors include Matters Requiring Board 678 6/7/2007 OTS Asset Quality Memo 11, “Broker Credit Administration,” Hedger_Ann-00027930_001, Hearing Exhibit 4/16-10. 679 Prepared statement of Treasury IG Thorson, April 16, 2010 Subcommittee Hearing, at 5. 680 6/7/2007 OTS Asset Quality Memo 11, “Broker Credit Administration,” Hedger_Ann-00027930_001, Hearing Exhibit 4/16-10. 681 Id. at 011. 682 9/18/2007 OTS Report of Examination, at OTSWMEF-0000046681, Hearing Exhibit 4/16-94 [Sealed Exhibit]. FinancialCrisisReport--20 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 financial crisis. 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 CHRG-110hhrg41184--3 Mr. Bachus," I thank the chairman. Chairman Frank, I appreciate you holding this hearing on monetary policy and the state of the economy. And I thank you, Chairman Bernanke, for being here today and for your service to the country. You testified last July concerning the state of the economy and monetary policy. At that time we had a problem in one segment of our economy, and that was subprime lending. And as we all know, since that time, because of what we sometimes refer as interconnectedness of the markets, it has mushroomed into a full-blown credit crisis. We have unemployment inching up, although it is still at historic lows. It is still very good. We have factory orders and durable goods showing weaknesses, some weaknesses in retail sales, and obviously we are concerned about our credit card and auto lending markets because of the credit crunch. While economic activity and growth have clearly slowed, and while any threats to our economy should not be minimized, I don't believe anything has transpired over the past 7 months that distracts from the competitive strength of U.S. businesses and their innovativeness, and the productivity of American workers still remains very high. I think our workers are unrivaled in the world as far as their abilities and their productivity. Moreover, productive steps by the Federal Reserve and other regulators, combined with responses from the private sector and the natural operations of the business cycle, I believe will help ensure that the current economic downturn is limited in both duration and severity. I believe your aggressive cuts in the Fed funds rates and the recently enacted stimulus package will help. Although I believe it may not have the effect that many claim, I do believe that it does serve as a tax cut for millions of hardworking Americans, and it, too, will help. And all of those should begin to have a positive effect on our economy, I believe, by this summer--and I would be interested in your views--laying the groundwork for a much stronger second half of 2008 and sustainable growth in 2009. At that point, I believe the Fed's primary challenge, and we saw it, I think last week and this week, with the CPI and the PPI numbers, your challenge will shift from avoiding a significant economic downturn to containing inflationary pressures in our economy. Particularly when I go home, people talk to me about the hardship of high gas prices. That's something that I'm not sure any of us have much control over, short term. Long term, there are obviously things, including nuclear power that I have said many times we need to take full advantage of. One lesson we have learned from the subprime contagion is just how highly interconnected our financial markets are. The chairman in his opening statement mentioned a lack of regulation. We have a system of functional regulation where different regulators function in different parts of the market. I'm not sure that part of our problem is not that this sometimes almost causes overregulation, but there may be gaps in the regulation. And I wonder if that is in fact the case, there may be areas where the regulation needs to be strengthened or regulation needs to be coordinated better between different regulators, both State and Federal. As painful as the process and the challenges we have, I think it is pretty evident that we have faced our problems and that we are solving them. I think what we have done is far preferable to the kind of decay and denial that mark the Japanese response to their financial turmoil in the 1990's. And it's the reason I continue to have great confidence in the resilience of the American economy. Chairman Bernanke, in closing, let me say there is perhaps no other public figure in America who has been subjected to as much Monday morning quarterbacking as you have over the last 7 months. But I believe on balance, any objective evaluation of your record would conclude that you have dealt with an exceedingly difficult set of economic circumstances with a steady hand and sound judgment. With that, Mr. Chairman, I yield back the balance of my time. " fcic_final_report_full--214 CDS protection on subprime mortgage–backed securities. In an email to Cassano on February , Park wrote: Joe, Below summarizes the message we plan on delivering to dealers later this week with regard to our approach to the CDO of ABS super senior business going forward. We feel that the CDO of ABS market has in- creasingly become less diverse over the last year or so and is currently at a state where deals are almost totally reliant on subprime/non prime residential mortgage collateral. Given current trends in the housing market, our perception of deteriorating underwriting standards, and the potential for higher rates we are no longer as comfortable taking such concentrated exposure to certain parts of the non prime mortgage securitizations. On the deals that we participate on we would like to see significant change in the composition of these deals going forward—i.e. more diversification into the non-correlated asset classes. As a result of our ongoing due diligence we are not as comfortable with the mezzanine layers (namely BBB and single A tranches) of this asset class. . . . We realize that this is likely to take us out of the CDO of ABS market for the time being given the arbitrage in subprime collat- eral. However, we remain committed to working with underwriters and managers in developing the CDO of ABS market to hopefully become more diversified from a collateral perspective. With that in mind, we will be open to including new asset classes to these structures or in- creasing allocations to others such as [collateralized loan obligations] and [emerging market] CDOs .  AIG’s counterparties responded with indifference. “The day that you [AIG] drop out, we’re going to have  other people who are going to replace you,” Park says he was told by an investment banker at another firm.  In any event, counterparties had some time to find new takers, because AIG Financial Products continued to write the credit default swaps. While the bearish executives were researching the issue from the summer of  onward, the team continued to work on deals that were in the pipeline, even after February . Overall, they completed  deals between Sep- tember  and July —one of them on a CDO backed by  subprime assets.  By June , AIG had written swaps on  billion in multisector CDOs, five times the  billion held at the end of .  Park asserted that neither he nor most others at AIG knew at the time that the swaps entailed collateral calls on AIG if the market value of the referenced securities declined.  Park said their concern was sim- ply that AIG would be on the hook if subprime and Alt-A borrowers defaulted in large numbers. Cassano, however, told the FCIC that he did know about the possible calls,  but AIG’s SEC filings to investors for  mentioned the risk of collateral calls only if AIG were downgraded. FinancialCrisisReport--56 The Treasury and the FDIC IG report examining the failure of WaMu found that, from 2003 to 2007, the bulk of its residential loans – from 48% to 70% – came from third party lenders and brokers. 112 That report also determined that, in 2007, WaMu had 14 full-time employees overseeing 34,000 third party brokers doing business with the bank nationwide, and criticized the Bank’s oversight and staffing effort. 113 (3) Long Beach WaMu had traditionally originated mortgages to well qualified prime borrowers. But in 1999, WaMu bought Long Beach Mortgage Company, 114 which was exclusively a subprime lender to borrowers whose credit histories did not support their getting a traditional mortgage. 115 Long Beach was located in Anaheim, California, had a network of loan centers across the country, and at its height had as many as 1,000 employees. Long Beach made loans for the express purpose of securitizing them and profiting from the gain on sale; it did not hold loans for its own investment. It had no loan officers of its own, but relied entirely on third party mortgage brokers bringing proposed subprime loans to its doors. In 2000, the year after it was purchased by WaMu, Long Beach made and securitized approximately $2.5 billion in home loans. By 2006, its loan operations had increased more than tenfold, and Long Beach securitized nearly $30 billion in subprime home loans and sold the securities to investors. 116 Long Beach’s most common subprime loans were short term, hybrid adjustable rate mortgages, known as “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 rate after two years for the 2/28, three years for the 3/27, or five years for the 5/25. 117 Long Beach typically qualified borrowers according to whether they could afford to pay the initial, low interest rate rather than the later, 111 See 6/11/2007 chart entitled, “Capital Markets Division Growth,” JPM_WM03409858, Hearing Exhibit 4/13- 47c. 112 See prepared statement of Treasury IG Eric Thorson, “Wall Street and the Financial Crisis: Role of the Regulators,” before the U.S. Senate Permanent Subcommittee on Investigations, S.Hrg. 111-672 (April 16, 2010) (hereinafter “April 16, 2010 Subcommittee Hearing”), at 5. 113 See 4/2010 IG Report, at 11, Hearing Exhibit 4/16-82. 114 Washington Mutual Inc. actually purchased Long Beach Financial Corporation, the parent of Long Beach Mortgage Corporation, for about $350 million. 115 12/21/2005 OTS internal memorandum from OTS examiners to Darrel Dochow, OTSWMS06-007 0001009, Hearing Exhibit 4/16-31 (“LBMC was acquired … as a vehicle for WMI to access the subprime loan market. LBMC’s core business is the origination of subprime mortgage loans through a nationwide network of mortgage brokers.”). 116 “Securitizations of Washington Mutual Subprime Home Loans,” chart prepared by the Subcommittee, Hearing Exhibit 4/13-1c. 117 For more information about these types of loans, see Chapter II. higher interest rate. 118 For “interest-only” loans, monthly loan payments were calculated to cover only the interest due on the loan and not any principal. After the fixed interest rate period expired, the monthly payment was typically recalculated to pay off the entire remaining loan within the remaining loan period at the higher floating rate. Unless borrowers could refinance, the suddenly increased monthly payments caused some borrowers to experience “payment shock” and default on their loans. FinancialCrisisReport--52 Washington Mutual was far from the only lender that sold poor quality mortgages and mortgage backed securities that undermined U.S. financial markets. The Subcommittee investigation indicates that Washington Mutual was emblematic of a host of financial institutions that knowingly originated, sold, and securitized billions of dollars in high risk, poor quality home loans. These lenders were not the victims of the financial crisis; the high risk loans they issued became the fuel that ignited the financial crisis. A. Subcommittee Investigation and Findings of Fact As part of its investigation into high risk lending and the Washington Mutual case study, the Subcommittee collected millions of pages of documents from Washington Mutual, JPMorgan Chase, OTS, the FDIC, eAppraiseIT, Lenders Service Inc., Moody’s, Standard & Poor’s, various investment banks, Fannie Mae, Freddie Mac, and others. The documents included email, correspondence, internal memoranda, reports, legal pleadings, financial analysis, prospectuses, and more. The Subcommittee also conducted more than 30 interviews with former WaMu employees and regulatory officials. The Subcommittee also spoke with personnel from the Offices of the Inspector General at the Department of Treasury and the FDIC, who were engaged in a joint review of WaMu’s regulatory oversight and the events leading to its demise. In addition, the Subcommittee spoke with nearly a dozen experts on a variety of banking, accounting, regulatory, and legal issues. On April 13, 2010, the Subcommittee held a hearing which took testimony from former WaMu officials and released 86 exhibits. 106 In connection with the hearing, the Subcommittee released a joint memorandum from Chairman Carl Levin and Ranking Member Tom Coburn summarizing the investigation to date into Washington Mutual and the role of high risk home loans in the financial crisis. The memorandum contained the following findings of fact, which this Report reaffirms. 1. High Risk Lending Strategy. Washington Mutual (WaMu) executives embarked upon a High Risk Lending Strategy and increased sales of high risk home loans to Wall Street, because they projected that high risk home loans, which generally charged higher rates of interest, would be more profitable for the bank than low risk home loans. 2. Shoddy Lending Practices. WaMu and its affiliate, Long Beach Mortgage Company (Long Beach), used shoddy lending practices riddled with credit, compliance, and operational deficiencies to make tens of thousands of high risk home loans that too often contained excessive risk, fraudulent information, or errors. 106 “Wall Street and the Financial Crisis: The Role of High Risk Loans,” before the U.S. Senate Permanent Subcommittee on Investigations, S.Hrg. 111-67 (April 13, 2010) (hereinafter “April 13, 2010 Subcommittee Hearing”). 3. Steering Borrowers to High Risk Loans. WaMu and Long Beach too often steered borrowers into home loans they could not afford, allowing and encouraging them to make low initial payments that would be followed by much higher payments, and presumed that rising home prices would enable those borrowers to refinance their loans or sell their homes before the payments shot up. 4. Polluting the Financial System. WaMu and Long Beach securitized over $77 billion in subprime home loans and billions more in other high risk home loans, used Wall Street firms to sell the securities to investors worldwide, and polluted the financial system with mortgage backed securities which later incurred high rates of delinquency and loss. 5. Securitizing Delinquency-Prone and Fraudulent Loans. At times, WaMu selected and securitized loans that it had identified as likely to go delinquent, without disclosing its analysis to investors who bought the securities, and also securitized loans tainted by fraudulent information, without notifying purchasers of the fraud that was discovered. 6. Destructive Compensation. WaMu’s compensation system rewarded loan officers and loan processors for originating large volumes of high risk loans, paid extra to loan officers who overcharged borrowers or added stiff prepayment penalties, and gave executives millions of dollars even when their High Risk Lending Strategy placed the bank in financial jeopardy. FinancialCrisisReport--118 E. Polluting the Financial System Washington Mutual, as the nation’s largest thrift, was a leading issuer of home loans. When many of those loans began to go bad, they caused significant damage to the financial system. Washington Mutual originated or acquired billions of dollars of home loans through multiple channels, including loans originated by its own loan officers, loans brought to the bank by third party mortgage brokers, and loans purchased in bulk from other lenders or firms. Its subprime lender, Long Beach, originated billions of dollars in home loans brought to it by third party mortgage brokers across the country. According to a 2007 WaMu presentation, by 2006, Washington Mutual was the second largest nonagency issuer of mortgage backed securities in the United States, behind Countrywide. 416 Washington Mutual and Long Beach sold or securitized the vast majority of their subprime home loans. Initially, Washington Mutual kept most of its Option ARMs in its proprietary investment portfolio, but eventually began selling or securitizing those loans as well. With respect to other loans, such as fixed rate 30-year, Alt A, home equity, and jumbo loans, WaMu kept a portion for its own investment portfolio, and sold the rest either to Wall Street investors, usually after securitizing them, or to Fannie Mae or Freddie Mac. By securitizing billions of dollars in poor quality loans, WaMu and Long Beach were able to decrease their risk exposure while passing along risk to others in the financial system. They polluted the financial system with mortgage backed securities which later incurred high rates of delinquency and loss. At times, WaMu securitized loans that it had identified as likely to go delinquent, without disclosing its analysis to investors to whom it sold the securities, and also securitized loans tainted by fraudulent information, without notifying purchasers of the fraud that was discovered and known to the bank. (1) WaMu and Long Beach Securitizations From 2000 to 2007, Washington Mutual and Long Beach securitized at least $77 billion in subprime and home equity loans. 417 WaMu also sold or securitized at least $115 billion in Option ARM loans. 418 Between 2000 and 2008, Washington Mutual sold over $500 billion in loans to Fannie Mae and Freddie Mac, accounting for more than a quarter of every dollar in loans WaMu originated. 419 416 See 6/11/2007 chart entitled, “Rate of Growth Exceeds the Industry,” JPM_WM03409860, Hearing Exhibit 4/13- 47c. 417 6/2008 “WaMu Wholesale Specialty Lending Securitization Performance Summary,” JPM_WM02678980, Hearing Exhibit 4/13-45. 418 10/17/2006 “Option ARM” draft presentation to the WaMu Board of Directors, JPM_WM02549027, Hearing Exhibit 4/13-38 ( see chart at 2). See also 8/2006 “Option ARM Credit Risk,” WaMu presentation, at JPM_WM00212644, Hearing Exhibit 4/13-37 (see chart at 5). 419 See chart in section E(4), below, using loan data from Inside Mortgage Finance . FinancialCrisisInquiry--653 CHAIRMAN ANGELIDES: All right. Thank you very much. And, last question here, before we move on, which is that—do you have data on—and maybe, again, it’s contained. I’ve read a lot, but at 56, I don’t retain all. And that is, do you have data on the extent to which community banks engaged in subprime origination? CHRG-110shrg46629--29 Chairman Bernanke," Well, it is going down because the credit losses associated with subprime have come to light and they are fairly significant. Some estimates are on the order of between $50 billion and $100 billion of losses associated with subprime credit products. The credit rating agencies have begun to try to make sure they account for those losses and they have downgraded some of these products. I should say that the investors, many of them, recognize even before the downgrades occurred that there were risks associated with these products including not only credit risks but also liquidity and interest rate and other types of risks. And so the spreads they were charging on these products were not necessarily the same as would be implied by the credit rating agency. Senator, if I could just say one word about Basel, I would be very grateful. It is simply not the case that Basel II is about lowering credit standards. It is about making the banking system safer, not less safe. Senator Shelby. I did not say credit standards. We are about capital. " CHRG-110shrg46629--35 Chairman Bernanke," That is another issue that we heard a lot about in our hearings in June. It also is covered in the subprime guidance and is also one of the things we are looking at very carefully for our rulemaking. Senator Brown. How are you approaching the determining of borrowers ability to repay a loan? You emphasize the importance. Are we setting standards on that level, also? " CHRG-110hhrg46593--234 Mr. Yingling," Just a few numbers that I think would surprise most people. Consumer and industrial loans for banks are up 15 percent this year. Home equity loans, admittedly from a low base, are up 21 percent. Asset-backed securities lending--not mortgage but other asset backs--down 79 percent. We have a chart on page 10 of our testimony that shows consumer and industrial business lending, and consumer lending is actually up for banks. " FinancialCrisisReport--439 On August 21, 2007, Mr. Birnbaum presented the Mortgage Department’s plan to buy up to $10 billion in AAA rated RMBS securities. 1815 The plan had dual objectives, to profit from the intrinsic financial value of the proposed assets and to use those assets to preserve, rather than cover, the Department’s existing $3.5 billion BBB/BBB- net short: “– The mortgage department thinks there is currently an extraordinary opportunity for those with dry powder to add AAA subprime risk in either cash or synthetic form. – We would like to be opportunistic buyers of up to $10Bln subprime AAAs in either cash or synthetic (ABX) form and run that long against our $3.5Bln in mezzanine subprime shorts. – Mortgage dept VAR would be reduced by $75mm and Firmwide VAR would be reduced by $25mm. – At current dollar prices, the implied losses at the AAA level are 2.5x higher than the implied losses at the BBB level where we have our shorts (the ratio is even cheaper for cash due to technicals). If AAAs were priced consistent with BBB implied loss levels, they would be trading 5-10pts higher in synthetics and 10-15 points higher in cash. ... – On the demand side, we plan to share this trade quietly with selected risk partners. We began doing so yesterday when we sold 1/3 of the AAAs purchased off the [seller] list to [customer] and 100% of the AAAs from [seller] to [customer] and [customer].” 1816 Mr. Montag responded that he wanted to discuss the concept further. 1817 Mr. McMahon wrote: “What are we holding against the 3.5b mezz shorts right now? Why don’t we just cover the shorts?” 1818 Co-President Gary Cohn emailed Messrs. Mullen, Winkelried, and Montag: “I do like the idea but you[r] call.” 1819 Before any further discussion took place, however, events overtook the debate. [M cMahon]. W e aren ’t going crazy with it, just being opportunistic. Before we get large, we are going to lay out a strategy for the four of you. ”). 1815 8/21/2007 email from Joshua Birnbaum, “Potential large subprime trade and impact on firmwide VAR,” GS MBS-E-016359332, Hearing Exhibit 4/27-34; 8/21/2007 email from Joshua Birnbaum, “For 2 p.m. meeting,” GS MBS-E-010608145 (graphs in support of plan to go long up to $10 billion in AAA ABX index). 1816 1817 Id. See 8/21/2007 email from Mr. Montag to Mr. Birnbaum, GS MBS-E-010682736 ( “FYI. I think it would be much better for all concerned that we all discuss this and any strategy and have agreem[e]nt before we go to the presidents and cfo .... Secondly, I think we should be reducing our basis trades to reduce var as is .... Let ’s sit down ”). 1818 8/21/2007 email from Bill McMahon, “Potential large subprime trade and impact on Firmwide VAR, ” GS MBS- E-012606879. 1819 8/21/2007 email from Joshua Birnbaum, “Potential large subprime trade and impact on firmwide VAR,” GS MBS-E-016359332, Hearing Exhibit 4/27-34 (e) “Get Down Now ” fcic_final_report_full--277 Committee meeting and brought up to the full board. A presentation concluded that “total sub-prime exposure in [the investment bank] was bn with an additional bn in Direct Super Senior and bn in Liquidity and Par Puts.”  Citigroup’s total subprime exposure was  billion, nearly half of its capital. The calculation was straightforward, but during an analysts’ conference call that day Crittenden omitted any mention of the super-senior- and liquidity-put-related exposure as he told par- ticipants that Citigroup had under  billion in subprime exposure.  A week later, on Saturday, October , Prince learned from Crittenden that the company would have to report subprime-related losses of  to  billion; on Mon- day he tendered his resignation to the board. He later reflected, “When I drove home and Gary called me and told me it wasn’t going to be two or  million but it was go- ing to be eight billion—I will never forget that call. I continued driving, and I got home, I walked in the door, I told my wife, I said here’s what I just heard and if this turns out to be true, I am resigning.”  On November , Citigroup revealed the accurate subprime exposure—now esti- mated at  billion—and it disclosed the subprime-related losses. Though Prince had resigned, he remained on Citigroup’s payroll until the end of the year, and the board of directors gave him a generous parting compensation package: . million in cash and  million in stock, bringing his total compensation to  million from  to .  The SEC later sued Citigroup for its delayed disclosures. To resolve the charges, the bank paid  million. The New York Fed would later conclude, “There was little communications on the extensive level of subprime exposure posed by Super Senior CDO. . . . Senior management, as well as the independent Risk Man- agement function charged with monitoring responsibilities, did not properly identify and analyze these risks in a timely fashion.”  Prince’s replacements as chairman and CEO—Richard Parsons and Vikram Pan- dit—were announced in December. Rubin would stay until January , having been paid more than  million from  to   during his tenure at the com- pany, including his role as chairman of the Executive Committee, a position that car- ried “no operational responsibilities,” Rubin told the FCIC. “My agreement with Citi provided that I’d have no management of personnel or operations.”  John Reed, former co-CEO of Citigroup, attributed the firm’s failures in part to a culture change that occurred when the bank took on Salomon Brothers as part of the  Travelers merger. He said that Salomon executives “were used to taking big risks” and “had a history . . . [of] making a lot of money . . . but then getting into trouble.”  AIG’S DISPUTE WITH GOLDMAN: “THERE COULD NEVER BE LOSSES ” Beginning on July , , when Goldman’s Davilman sent the email that disrupted the vacation of AIG’s Alan Frost, the dispute between Goldman and AIG over the need for collateral to back credit default swaps captured the attention of the senior manage- ment of both companies. For  months, Goldman pressed its case and sent AIG a for- mal demand letter every single business day. It would pursue AIG relentlessly with demands for collateral based on marks that were initially well below those of other firms—while AIG and its management struggled to come to grips with the burgeoning crisis. FOMC20070810confcall--43 41,VICE CHAIRMAN GEITHNER.," Well, you’ve already seen one significant intervention by the German authorities last week to guarantee the liabilities of a relatively small institution with some mortgage exposure, and the liquidity pressures that the ECB responded to yesterday indicate that there are broader concerns about exposure to losses into those institutions because of their subprime exposure. You’re just seeing that in commercial paper now, rather than elsewhere. So we have no indications from our supervisory counterparts that any major institution in Europe is facing a significant solvency problem now, but that doesn’t mean there isn’t one. We just haven’t heard that from them yet. I think there is a general sense that a lot of this subprime stuff ended up, as it has in the past, in institutions in Europe. So I assume that we have the risk that, as the tide recedes further, you will see more distress there. But, again, we have no indication from any of our counterparts yet that any major institutions face a significant funding or solvency issue." fcic_final_report_full--242 Im p aired Se cu rities Impairment of 2005-2007 vintage mortgage-backed securities (MBS) and CDOs as of year-end 2009, by initial rating. A security is impaired when it is downgraded to C or Ca, or when it suffers a principal loss. IN BILLIONS OF DOLLARS $1,000 N ot impaired 800 600 400 200 0 Impaired A aa A a thru B A aa A a thru B A aa A a thru B A lt- A M BS Su b prime M BS C D Os SOURCE: M oody’s Investors Service, “Special Comment: D efault & Loss Rates of Structured Finance Securities: 1993-2009”; M oody’s SF D RS. Figure . minent or had already been suffered—by the end of  (see figure .). For the lower-rated Baa tranches, . of Alt-A and . of subprime securities were im- paired. In all, by the end of ,  billion worth of subprime and Alt-A tranches had been materially impaired—including . billion originally rated triple-A. The outcome would be far worse for CDO investors, whose fate largely depended on the performance of lower-rated mortgage-backed securities. More than  of Baa CDO bonds and . of Aaa CDO bonds were ultimately impaired.  The housing bust would not be the end of the story. As Chairman Bernanke testi- fied to the FCIC: “What I did not recognize was the extent to which the system had flaws and weaknesses in it that were going to amplify the initial shock from subprime and make it into a much bigger crisis.”  CHRG-110hhrg44900--149 Mr. Bernanke," There is not monetization. This is a sterilized operation; there is no effect on the money supply. And in addition, I would add that our lending, not only to Bear Stearns but more generally to the banks and so on, is not only collateralized with good hair cuts, it is also a recourse to the banks themselves. We have not lost a penny on any of this lending, and it is just lending, we are not purchasing any of it, it goes back to the bank when the term of the loan is over. " CHRG-109hhrg23738--102 Mr. Sherman," Thank God she does not. I have got so many questions I will basically be submitting them for the record. We are heading eventually for a realignment of currency values such that our trade deficit is ameliorated, perhaps reversed. It is deferrable. But this realignment is not avoidable. It will have benefits. It will also have enormous harms, even if it is done smoothly. But if it is not smoothly, it could be a disaster. I will be asking in writing how we can work with other countries to assure that there is a smooth currency realignment and not a crash of the dollar. I will be submitting questions about the importance of subprime lending to our economy, particularly when those loans are not made by depository institutions that are insured by the federal government but do not pose those risks because they are made by private uninsured lenders; andd I will also be asking about the importance of the private auditing function to our capital markets. A recent op-ed in the American Banker notes that our committee and the House passed this--well, our committee passed this GSE reform bill, and we reported it out by an overwhelming vote, that it would establish a better regulator for the GSEs; and I will be asking whether you would concur in this assessment or whether you would agree that stronger capital and prompt corrective action authority as provided in the bill makes sense and just how important it is that Congress pass GSE reform legislation this year. One issue I have asked you about before is the issue of the regulations issued by the Treasury Department and the Federal Reserve Board allowing national banks to engage in real estate brokerage and real estate management. As you know, these regulations have been blocked by congressional action on an annual basis, which is hardly an efficient way to provide for a national system to regulate who can and cannot, and under what circumstances, engage in real estate brokerage activity. Now, you have consistently opposed mixing banking and commerce, and a commercial activity is a commercial activity even if it involves financing. For many of my working-class-family constituents, they are not even aspiring to buy a home, they are aspiring to buy a car, and the lending function who will make the loan is the most important part of selecting an automobile dealer. Wheat and steel, even this shirt, can be financed on a credit card, so just because something is financed does not mean it is not commerce. So I hope you would explain: Why is buying and selling of real estate a financial activity if buying and selling cars, steel, et cetera, is not? Perhaps you could respond orally to that question. " FOMC20071211meeting--115 113,MR. KROSZNER.," Thank you. At the last meeting I expected a somewhat rougher patch, particularly in housing, than the last Greenbook scenario—a sort of slow-burn scenario, or something that Dave made reference to. But over just the past three weeks or so, the heat of that fire has become a lot greater than I had expected in terms of the burn that I’m seeing in the financial markets as well as in the real markets, particularly with respect to consumption, as many people have mentioned, and then more broadly just the reclosing of markets that had opened up. I described some of the markets and the turmoil, saying that things were in sort of a brittle circumstance. Unfortunately, I think in certain parts we’re starting to see some cracks show. I want to focus on thinking about banks’ balance sheets and how that addresses some of the issues that we’ve talked about. For commercial and industrial lending, as many people said, there still seems to be reasonable robustness in the investment-grade corporate sector. Those guys haven’t yet seen a lot of pressures in terms of increased cost of funding—not a reduced cost of funding but also not an increased cost of funding—just a slight increase in terms; but it’s no problem for them to deal with those kinds of terms. They have the markets open to them both for long-term debt issuance and for intermediate-term debt issuance. They have bank funding that is available. Most of the banks, the large banks as well as smaller banks, are suggesting that, although they may be tightening standards somewhat, there is still a reasonable amount of credit demand and that most boards and executives are saying “continue to make those loans.” Firms’ balance sheets are still quite strong. Firms have built up a lot of cash or liquid assets on their balance sheets over the past few years of profitability, so that part hasn’t seen that much of a challenge. Some of the increases that we’ve seen and measured on the books of banks in terms of their C&I portfolios are the taking on board of some leveraged loans on which they had made commitments a number of months ago; those commitments are now being drawn down, and so they’re increasing their portfolios. So some of the increase in C&I lending is really just commitments that have come in earlier. The leveraged-lending market, which had opened up for syndication, has quite affirmatively closed once again. That’s clearly a negative development. With respect to SIVs, asset-backed commercial paper conduits, it seems that many of the banks are going it alone without waiting for the M-LEC. Virtually all major banks have announced programs for bringing asset-backed commercial paper or SIVs onto their balance sheets. So this is still orderly, but it’s beginning to show some stress on the balance sheets with the leveraged lending and all of the SIVs coming on board, and this underscores the importance that a number of people mentioned about capital-raising efforts and ensuring that capital will be available, not just above the regulatory minimums but enough to make the market certifiers, the rating agencies, and others continue to feel comfortable. A number of people have also mentioned that the flattening, and in some cases the downturn, in commercial real estate and the tightening of terms are of particular concern at the midsized and smaller banks. As you know, we had issued some guidelines a little more than a year ago on commercial real estate concentration and concerns about that because we had looked back to what happened during the savings and loan crisis and saw that we were starting to get banks into the same levels of concentration that we had seen back then that were associated with troubles. Although we had a lot of negative pushback at that time, I think that was not an unreasonable thing to do, but there are still a lot of challenges at those institutions. Consumer lending is probably the area in which I’ve seen the greatest change, and it has raised my concerns the most. I’ll hold off on mortgages for a moment. First, I talked with a very large provider of credit cards and other consumer products, HELOCs, mortgages, et cetera, who said that, since the report that I received just before the last FOMC meeting, when things were reasonably stable, they had seen significant deterioration. As some people have said, even though it has gone up sharply, the numbers are still reasonable, but it’s the delta that concerns me, the very sharp deterioration that they’re seeing. They’re seeing this nationwide. The sharpest deterioration is, as a number of people have said, in the areas that have seen the greatest housing-price stress— California, Nevada, and Florida—but it’s not limited to those. I won’t go through all the details of what they told me on delinquency rates on different types of products, but nationwide they are seeing doubling, tripling, or quadrupling in those areas, and this is over a period of just six to eight weeks. So that’s really quite significant and concerns me in combination with some of the lower numbers that we’re seeing with respect to consumption. Also, one of the phrases that they use is that they’re now seeing “contagion in their book.” So it’s not just in one particular area but through a series of consumer products, and it’s not just for subprime borrowers. They noted that one-third of the charge-offs had a credit score of over 700 at the origination of the mortgage. So it’s far beyond just the subprime area. Obviously, as a number of people have said, the mortgage markets have really not reopened. There had been some hope around the last meeting that the jumbo market would reopen. We’re seeing no evidence of that. The subprime market is not really open. The ABX indexes and other indexes are suggesting that markets are anticipating extremely high loss rates, even beyond what Bill was suggesting with the 15 percent loss. Now, I don’t know whether those are reflecting just loss rates or whether other issues with respect to a lack of liquidity in the markets, or hedging that is going on, but still it’s a concern. As I mentioned last time, the Case-Shiller S&P index, although extremely thinly traded when you go out a year or two, is still suggesting potentially a 20 percent decline on average in the ten cities that they look at. So nothing has improved there, and given the tightness in the markets, given that we know that there will be more resets coming, given the continuing pressures, there’s probably going to be a lot more downside potential for housing prices, and that, of course, could again feed into lower consumer spending. So that’s the concern on the real side. The concern on the financial side is that, obviously, all these things put a lot of pressure on bank balance sheets. Gathering capital is very important, but basically what we’re seeing is a very, very slow revival of the markets, and I agree with many of the others who have said that it’s going to take a while. A lot more information, model building, and hiring of people who can analyze these things will be needed. Something that was disheartening to me is that the Mortgage Bankers Association said that they hope by early next year to be able to provide sufficient information to the market so that people can really assess on a loan-by-loan basis what’s in their CDOs, and that’s a real concern. The information is simply not out there. So it’s not just confidence or concerns. People are now looking carefully and saying, “I just don’t have the information to be able to make an assessment.” That’s, of course, on top of the macroeconomic risk and uncertainty about housing prices in general. So I do think it’s going to take a while for these markets to revive. As the Vice Chairman—actually both Vice Chairmen—and others mentioned, if you look into the forward markets for the OIS spread and other things, this is going to persist. This is not just an end-of-the- year problem. People are looking to the banks for re-intermediation and for taking a lot of things on the balance sheets. That’s going to continue to put a lot of pressure on the capital that they have, and I think there will be continuing uncertainty for both U.S. institutions and international institutions that things have to keep coming on their books and they won’t be able to get other things off their books. So that is a real challenge going forward. Just a moment on inflation. I certainly am heartened, as many other people have said, that as expectations about our policy moves have changed, we haven’t seen a significant uptick in inflation expectations, although by some survey measures we have seen some upticks. But real inflationary pressures are out there, and each incremental step we take with respect to policy easing potentially has higher and higher costs with respect to inflation. There are no free lunches here, but we do have to be mindful of the downside risk, particularly with respect to the banking and the financial system. Thank you." FinancialCrisisReport--405 Mortgage Department to “get closer to home,” he meant that it should assume a more neutral risk position. 1645 One way to “get closer to home” was for the Department to sell its long assets. Another way to achieve a more neutral risk position was for the Department to take new short positions to offset its existing long positions. 1646 Internal documents indicate that the directions given to the Mortgage Department in the December meeting were more detailed than the general instruction to “get closer to home.” In an email sent on the same day by Mr. Sparks to Goldman executives Messrs. Montag and Ruzika entitled, “Subprime risk meeting with Viniar/McMahon Summary,” Mr. Sparks wrote: “Followups: 1. Reduce exposure, sell more ABX index outright, basis trade of index vs. CDS too large. 2. Distribute as much as possible on bonds created from new loan securitizations and clean previous positions. 3. Sell some more resid[ual]s 4. Mark [the value of assets in] the CDO warehouse more regularly ... 5. Stay focused on the credit of the originators we buy loans from and lend to 6. Stay focused and aggressive on MLN [Mortgage Lending Network] (warehouse customer and originator we have EPDs [early payment defaults] to that is likely to fail) 7. Be ready for the good opportunities that are coming (keep powder dry and look around the market hard).” 1647 The next day, December 15, 2006, Mr. Montag forwarded Mr. Sparks’ email to Mr. Viniar asking: “is this a fair summary?” 1648 Mr. Viniar replied: “Yes.” Mr. Viniar noted: “On ABX, the position is reasonably sensible but is just too big. Might have to spend a little to size it appropriately. On everything else my basic message was let’s be aggressive distributing things because there will be very good opportunities as the markets [go] into 1644 1645 1646 Subcommittee interview of David Viniar (4/13/2010) . Id. Id. In terms of risk reduction, taking on offsetting short positions to reduce long positions does not necessarily offer the same degree of certainty of risk protection as simply selling off the long assets. In many cases, the offsets may not perfectly match, leaving some degree of risk exposure known as “basis risk. ” See, e.g., 2/12/2007 email from Mr. Sobel to Mr. Cohn, “Post today, ” GS MBS-E-009763506 ( “Risk that concerns me is basis between ABX and single names.”); 2/11/2007 email from Tom Montag, GS M BS-E-009688192 (discussing ABX offsets: “There is no est[imated] loss in the basis risk. Big wildcard. They [the traders] think they have correlation right and moves either way should be ok but obviously index assumptions have been wrong starting last may or june when positions were being put on and the gains seduced us to do more.”). 1647 12/14/2006 email from Daniel Sparks, “Subprime risk meeting with Viniar/McMahon Summary,” GS MBS-E- 009726498, Hearing Exhibit 4/27-3. “Residuals ” refers to the equity positions that Goldman had retained from the RMBS and CDO securitizations it originated. 1648 12/14/2006 email from Tom Montag to David Viniar, GS MBS-E-009726498, Hearing Exhibit 4/27-3. what is likely to be even greater distress and we want to be in a position to take advantage of them.” 1649 CHRG-111shrg57320--132 Mr. Reich," I was not. Senator Levin. All right. Well, let me read them to you. I am going to again read the somewhat longer context that these are from, Exhibits 1d and 1e. In Exhibit 1d,\2\ ``2004 Underwriting of these SFR loans remains less than satisfactory.''--------------------------------------------------------------------------- \2\ See Exhibit No. 1d, which appears in the Appendix on page 200.--------------------------------------------------------------------------- ``The level of SFR underwriting exceptions in our samples has been an ongoing examination issue''--that means OTS was unhappy with them--``for several years and one that management has found difficult to address. . . .'' Next, still 2004, this is what your folks found: ``[Residential Quality Assurance]'s review of 2003 originations disclosed critical error rates as high as 57 percent of certain loan samples. . . .'' In 2005, ``SFR [Single Family Residential] Loan Underwriting . . . has been an area of concern for several exams.'' That means several years. ``[Securitizations] prior to 2003 have horrible performance.'' Continuing reading down under 2005, ``. . . concerns regarding the number of underwriting exceptions and with issues that evidence lack of compliance with bank policy.'' Next, still 2005, ``[W]e remain concerned with the number of underwriting exceptions and with issues that evidence lack of compliance with bank policy. . . . [T]he level of deficiencies, if left unchecked, could erode the credit quality of the portfolio. Our concerns are increased when the risk profile of the portfolio is considered''--and it was risky--``including concentrations in Option ARM loans to higher-risk borrowers, in low and limited documentation loans, and loans with subprime or higher-risk characteristics.'' In 2006, the next page, ``[U]nderwriting errors continue to require management's attention.'' ``Overall, we concluded that the number and severity of underwriting errors noted remain at higher than acceptable levels.'' In 2007, ``Underwriting policies, procedures, and practices were in need of improvement, particularly with respect to stated income lending.'' Your people are finding all this stuff. ``Based on our review of 75 subprime loans originated by [Long Beach], we concluded that subprime underwriting practices remain less than satisfactory.'' How is that for an understatement? ``Given that this is a repeat concern . . . we informed management that underwriting must be promptly corrected''--``promptly corrected''--``or heightened supervisory action would be taken.'' No, it would not. Year after year after year, it was not taken. Why should they believe it was going to be taken now? In 2008, ``High [Single Family Residential] losses due in part to downturn in real estate market but exacerbated by: geographic concentrations, risk layering, liberal underwriting policy, poor underwriting.'' That is 2008, July. Then in Exhibit 1e,\1\ 2006, ``Within [Enterprise Risk Management], fraud risk management at the enterprise level is in the early stage of development.'' Heck, they are just beginning to manage the fraud risk in 2006.--------------------------------------------------------------------------- \1\ See Exhibit No. 1e, which appears in the Appendix on page 202.--------------------------------------------------------------------------- In 2007, ``Risk management practices in the . . . Home Loans Group during most of the review period were inadequate. . . . We believe that there were sufficient negative credit trends that should have elicited more aggressive action by management''--how about more aggressive management by your . . . agency? ``In particular, as previously noted, the risk misrepresentation''--here you go. Now you are talking fraud. ``. . . the risk misrepresentation in stated income loans has been generally reported for some time.'' For some time it has been going on. On and on, year after year. So what do you do about it? What does OTS do about it? Not one single formal enforcement action against WaMu from 2004 until 2008. " CHRG-110shrg50417--18 RESPONSIBLE LENDING " CHRG-110shrg50415--28 RESPONSIBLE LENDING " fcic_final_report_full--229 Mortgage D elinq u en c ies b y R egion Arizona, California, Florida, and Nevada—the “sand states”—had the most problem loans. IN PERCENT, BY REGION 16% 12 8 4 0 13.6% Sa n d states 8.7% U . S . tota l 7.0% Non - sand states 1998 2000 2002 2004 2006 2008 2010 N OTE: Se ri o u s de li nq u en ci es i n clu de m o r tgages 90 da y s o r m o r e p ast d u e and those i n f o r e cl os ur e . S O U RCE: Mo r tgage Banke r s Asso ci at i on Nat i ona l De li nq u en cy S urv e y Figure . Serious delinquency also varied by type of loan (see figure .). Subprime ad- justable-rate mortgages began to show increases in serious delinquency in early , even as house prices were peaking; the rate rose rapidly to  in . By late , the delinquency rate for subprime ARMs was . Prime ARMs did not weaken un- til , at about the same time as subprime fixed-rate mortgages. Prime fixed-rate mortgages, which have historically been the least risky, showed a slow increase in se- rious delinquency that coincided with the increasing severity of the recession and of unemployment in . The FCIC undertook an extensive examination of the relative performance of mortgages purchased or guaranteed by the GSEs, those securitized in the private market, and those insured by the Federal Housing Administration or Veterans Ad- ministration (see figure .). The analysis was conducted using roughly  million mortgages outstanding at the end of each year from  through .  The data contained mortgages in four groups—loans that were sold into private label securiti- zations labeled subprime by issuers (labeled SUB), loans sold into private label Alt-A securitizations (ALT), loans either purchased or guaranteed by the GSEs (GSE), and loans guaranteed by the Federal Housing Administration or Veterans Administration (FHA).  The GSE group, in addition to the more traditional conforming GSE loans, CHRG-111hhrg53248--58 Mr. Hensarling," On your time, yes; on my time, no. Let's continue on with our GSE history lesson if we can. Beginning in 1990, Fannie and Freddie's investment portfolios grew tenfold. In 1995, HUD first authorized Fannie and Freddie to purchase the subprime securities, including loans to low-income borrowers. In 2004 alone, Fannie and Freddie purchased $175 billion in subprime mortgages, accounting for 44 percent of the market. From 2005 to 2007, Fannie and Freddie purchased approximately $1 trillion, a number that is all too common in this Congress, $1 trillion in subprime and Alt-A loans, and the list goes on. That is the history. Where do we find ours today? We know that Fannie and Freddie's share of the origination market has now increased from roughly half to 75 percent. At last look, the taxpayers have paid out, I believe, $85 billion that none of us expect to get back. They are on the hook for an additional $315 billion, principally for helping securitize loans to people who couldn't afford to pay them back in the first place. Now, Mr. Secretary, you have said in, I believe in rolling out the White Paper before the Senate Banking Committee on June 18th, ``we wanted to make sure we were focusing on central issues of this crisis.'' I know you are concerned about Fannie and Freddie, but as a logical conclusion, since there is not a proposal beyond a study of the GSEs in the Administration's proposal, that the Administration has concluded that Fannie and Freddie were not a central cause of the crisis. " CHRG-111shrg51290--40 Mr. Bartlett," Senator, first of all, I believe firmly that that is what financial institutions do because that is their goal in life, is to help their customers and to keep their healthy customers. We got away from that during the subprime market, or many companies did, and those companies have taken action---- Senator Shelby. Then there is no loyalty to your bank that way, is there? " FinancialCrisisReport--119 According to a 2007 WaMu presentation at a securities investor meeting in New York, in 2004, WaMu issued $37.2 billion in RMBS securitizations and was the sixth largest RMBS issuer in the United States. 420 In 2005, it doubled its production, issuing $73.8 billion in securitizations, and became the third largest issuer. In 2006, it issued $72.8 billion and was the second largest issuer, behind Countrywide. 421 WaMu and Long Beach’s securitizations produced only RMBS securities. Although WaMu considered issuing CDO securities as well, it never did so. 422 From 2004 to 2006, WaMu and Long Beach securitized dozens of pools of prime, subprime, Alt A, second lien, home equity, and Option ARM loans. 423 WaMu and Long Beach also sold “scratch and dent” pools of nonperforming loans, including nonperforming primary mortgages, second lien, and Option ARMs. 424 At first, Washington Mutual worked with Wall Street firms to securitize its home loans, but later built up its own securitization arm, Washington Mutual Capital Corporation (WCC), which gradually took over the securitization of both WaMu and Long Beach loans. WCC was a private Washington State corporation that WaMu acquired from another bank in 2001, and renamed. 425 WCC became a wholly owned subsidiary of Washington Mutual Bank. In July 2002, WaMu announced that WCC would act as an institutional broker-dealer handling RMBS securities and would work with Wall Street investment banks to market and sell WaMu and Long Beach RMBS securities. 426 WCC was initially based in Seattle, and by 2003, had between 30 and 40 employees. 427 In 2004, due to increasing securitizations, WaMu decided to move the headquarters of WCC to Manhattan. 428 In 2004, for the first time, WCC acted as the lead manager of a WaMu securitization. That same year, WCC initiated a “conduit program” to buy Alt A and subprime loans in bulk for securitization. 429 WCC issued its first Alt A securitization in 2005, and its first subprime securitization in 2006. 430 It also conducted whole loan sales and credit card 420 See 6/11/2007 chart entitled, “Rate of Growth Exceeds the Industry,” JPM_WM03409860, Hearing Exhibit 4/13- 47c. 421 Id. WaMu attributed its rapid rise in the issuer rankings over the three-year period to its establishment of a Conduit Program, which began buying loans in bulk in 2004. Id. 422 See 12/15/2006 Enterprise Risk Management Committee, JPM_WM02656967. See also 10/25/2006 Asset- Liability Management Committee Meeting Agenda, JPM_WM02406624. 423 See 6/2008 “WaMu Wholesale Specialty Lending Securitization Performance Summary,” JPM_WM02678980, Hearing Exhibits 4/13-45 and 46; 6/11/2007 chart entitled, “WaMu Capital Corp Sole/Lead Underwriter,” JPM_WM03409861, Hearing Exhibit 4/13-47c. 424 See, e.g., undated “List of WaMu-Goldman Loans Sales and Securitizations,” Hearing Exhibit 4/13-47b; 2/2007 internal WaMu email chain, JPM_WM00652762. 425 See 6/11/2007 chart entitled, “Capital Markets Division Growth,” JPM_WM03409858, Hearing Exhibit 4/13- 47c. 426 Id. 427 Subcommittee interview of David Beck (3/2/2010). 428 Id. 429 See 6/11/2007 chart entitled, “Capital Markets Division Growth,” JPM_WM03409858, Hearing Exhibit 4/13- 47c. 430 Id. securitizations. 431 At its peak, right before the collapse of the subprime securitization market, CHRG-111hhrg51585--9 Mr. Royce," Thank you, Mr. Chairman. I would like to welcome Mr. Street from Orange County, California, who is going to be testifying on the second panel. By all accounts, I think Lehman Brothers was and is today a failed institution. The firm was very highly leveraged. It had significant exposure to the mortgage market, including the subprime sector. It had over $6 billion in subprime. It even owned a subprime mortgage originator, and institutions ignored those risks. I am afraid we are moving away from personal and institutional responsibility on a massive scale. I voted against TARP because of this, and I have opposed other government bailouts because I am becoming increasingly concerned with the Federal Government's new role as savior of all things failed. The Federal Government must get out of the business of picking winners and losers. There have been other municipalities that took significant losses on failed investments over the years without receiving government assistance. Orange County, California, took a hit in the 1990's, and a lesson was learned that it was a dangerous endeavor for county treasurers to use taxpayer funds to invest in products local governments do not understand. I am afraid our incessant desire to reward those poor investment decisions will inevitably weaken, if not erase, market discipline. The strength of your ties to the Federal Government should not be more important than counterparty due diligence in your ability to make prudent investments. Unfortunately, Congress has repeatedly signaled the opposite in recent months. I yield back the balance of my time, Mr. Chairman. " CHRG-109hhrg31539--58 Mrs. Maloney," Many New Yorkers are some of the most vulnerable homeowners. They are the people who made purchases with very little money down and obtained mortgages in a subprime market. Is there a danger of a wave of foreclosures and people losing their homes if interest rates keep rising? " CHRG-110hhrg45625--218 Mr. Meeks," I wish I had more time. But let me just get my last fear because I really wanted to get under that piece because I think the diversity needs to be done. But my last fear is this: What if the Treasury buys the loans off the banks' books and the banks hold on to the reserve requirements and work towards replacing lost shareholder value rather than lend it out again? You know, then, right now most of the banks have frozen all of their lending and those that are lending have these stringent requirements. So therefore my big fear is if that is the case, then again we will be back in a few months with the same lack of consumer confidence and lending confidence and there would be no movement in the credit market, and therefore we would be back to the same place again and would be having to put more money into this thing. We don't have any guarantees that the banks won't do that. " CHRG-111hhrg48867--242 Mr. Ellison," Well, let me ask you this question then. Mortgage originators, who were largely unregulated--as you know, most of the mortgages, the what we call subprime, predatory mortgages were not originated by banks but by unregulated mortgage originators. Do you agree that they contributed significantly to the problem and were unregulated? Do you agree with that? " CHRG-111hhrg74090--159 Mr. Calkins," Thank you. Chairman Rush, Ranking Member Radanovich, members of the subcommittee, thank you for inviting me here to testify about this important matter. The proposed legislation would effect sweeping changes in the Federal Trade Commission. The key to the bill is in the definitions and they are written extremely broadly. Applying those definitions and working your way through the bill, you find that the bill would transfer out of the Federal Trade Commission much of the work that the Federal Trade Commission now does, giving those responsibilities to the new agency and giving it the exclusive authority to prescribe role and issue guidance with respect to much of what the Bureau of Consumer Protection does. If you take the FTC's most recent annual report for 2009 and turn to consumer protection and start reading what they have done, subprime credit, mortgage servicing, foreclosure rescue, fair lending, mortgage advertising, debt collection, payday lending, Operation Clean Sweep, Operation Telephony, the Sumtasia marketing case, payment systems, the Naovi case, Nationwide Connections case, global marketing case and so on and so forth, prepaid phone calls, on matter after matter after matter of what they have been doing, I read the bill as saying that all of that would be transferred to the new agency. In short, we would have major change. Indeed, if you read the bill carefully you would find that even some of the antitrust responsibility of the Commission would be transferred. I assume that is a mistake but that is how it is currently written. Now, why have this sweeping change in what the Federal Trade Commission does? It might make sense if the Federal Trade Commission was a bad agency that was doing bad work, but as you all have spoken so eloquently this morning, the Federal Trade Commission is a good agency that has been doing good work. It has a unique bipartisan structure. It combines consumer protection and competition to bring the best from both perspectives to bear on problems and it has been doing important work for consumers including in the world of credit for a very, very long time. Transferring responsibility from the Federal Trade Commission to another agency obviously creates some pretty significant risks, and my recommendation to you is to proceed with great caution, to weigh those risks to decide whether they are really worth running and certainly if they are to work very hard to try to minimize those risks because the bill as written would make major changes and you need to be very careful to make sure that all of this makes sense. Thanks very much, and I am happy to answer questions when the time comes. [The prepared statement of Mr. Calkins follows:] " FinancialCrisisReport--177 During the five-year period reviewed by the Subcommittee, from 2004 through 2008, OTS examiners identified over 500 serious deficiencies in Washington Mutual’s lending, risk management, and appraisal practices. 647 OTS examiners also criticized the poor quality loans and mortgage backed securities issued by Long Beach, and received FDIC warnings regarding the bank’s high risk activities. When WaMu failed in 2008, it was not a case of hidden problems coming to light; the bank’s examiners were well aware of and had documented the bank’s high risk, poor quality loans and deficient lending practices. (a) Deficiencies in Lending Standards From 2004 to 2008, OTS Findings Memoranda and annual Reports of Examination (ROE) repeatedly identified deficiencies in WaMu’s lending standards and practices. Lending standards, also called “underwriting” standards, determine the types of loans that a loan officer may offer or purchase from a third party mortgage broker. These standards determine, for example, whether the loan officer may issue a “stated income” loan without verifying the borrower’s professed income, issue a loan to a borrower with a low FICO score, or issue a loan providing 90% or even 100% of the appraised value of the property being purchased. When regulators criticize a bank’s lending or “underwriting” standards as weak or unsatisfactory, they are expressing concern that the bank is setting its standards too low, issuing risky loans that may not be repaid, and opening up the bank to later losses that could endanger its safety and soundness. When they criticize a bank for excessively high lending or underwriting “errors,” regulators are expressing concern that the bank’s loan officers are failing to comply with the bank’s standards, such as by issuing a loan that finances 90% of a property’s appraised value when the bank’s lending standards prohibit issuing loans that finance more than 80% of the appraised value. In addition to errors, regulators may express concern about the extent to which a bank allows its loan officers to make “exceptions” to its lending standards and issue a loan that does not comply with some aspects of its lending standards. Exceptions that are routinely approved can undermine the effectiveness of a bank’s formal lending standards. Another common problem is inadequate loan documentation indicating whether or not a particular loan complies with the bank’s lending standards, such as loan files that do not include a property’s appraised value, the source of the borrower’s income, or key analytics such as the loan-to-value or debt-to- income ratios. In the case of Washington Mutual, from 2004 to 2008, OTS examiners routinely found all four sets of problems: weak standards, high error and exception rates, and poor loan documentation. 2004 Lending Deficiencies. In 2004, OTS examiners identified a variety of problems with WaMu’s lending standards. In May of that year, an OTS Findings Memorandum stated: 647 See IG Report at 28. “Several of our recent examinations concluded that the Bank’s single family loan underwriting was less than satisfactory due to excessive errors in the underwriting process, loan document preparation, and in associated activities.” 648 CHRG-111hhrg53238--199 Mr. Zywicki," Right. With respect to the story that I told, I get one or two e-mails a week from borrowers in California and Arizona who say, ``Professor Zywicki, I bought a house 2 years ago. I am $100,000 underwater. I saw an article that said I can walk away from my mortgage. Should I do it?'' Right. People are out there. So it is not a cartoon. People are making that decision. Do people understand their mortgages? No, nobody does. I mean, that is one of the problems with this, is it sets up this aspirational standard where every person can understand every mortgage. And according to a study done by the Federal Trade Commission 2 years ago, what they found was that nobody understands their mortgages, whether they are prime or subprime borrowers. It is not a subprime versus prime sort of issue. What they also recommended, which I think--to go to what else we should do--is they went through and they gave very clear instructions on how we could construct better disclosures so that people could shop in a better sort of way. That would solve a lot of the problems if we solved the disclosure problem. The disclosures are not good. " CHRG-111hhrg53241--66 Mr. Plunkett," Well, I think the idea is that, first and foremost, it will do research. It will be focused solely on consumer protection, and rules should follow good empirical knowledge of the marketplace. If we had had that on subprime loans, for example, we might have seen some rulemaking earlier on. " fcic_final_report_full--118 As the United States ran a large current account deficit, flows into the country were unprecedented. Over six years from  to , U.S. Treasury debt held by foreign official public entities rose from . trillion to . trillion; as a percentage of U.S. debt held by the public, these holdings increased from . to .. For- eigners also bought securities backed by Fannie and Freddie, which, with their im- plicit government guarantee, seemed nearly as safe as Treasuries. As the Asian financial crisis ended in , foreign holdings of GSE securities held steady at the level of almost  years earlier, about  billion. By —just two years later— foreigners owned  billion in GSE securities; by ,  billion. “You had a huge inflow of liquidity. A very unique kind of situation where poor countries like China were shipping money to advanced countries because their financial systems were so weak that they [were] better off shipping [money] to countries like the United States rather than keeping it in their own countries,” former Fed governor Frederic Mishkin told the FCIC. “The system was awash with liquidity, which helped lower long-term interest rates.”  Foreign investors sought other high-grade debt almost as safe as Treasuries and GSE securities but with a slightly higher return. They found the triple-A assets pour- ing from the Wall Street mortgage securitization machine. As overseas demand drove up prices for securitized debt, it “created an irresistible profit opportunity for the U.S. financial system: to engineer ‘quasi’ safe debt instruments by bundling riskier assets and selling the senior tranches,” Pierre-Olivier Gourinchas, an economist at the Uni- versity of California, Berkeley, told the FCIC.  Paul Krugman, an economist at Princeton University, told the FCIC, “It’s hard to envisage us having had this crisis without considering international monetary capital movements. The U.S. housing bubble was financed by large capital inflows. So were Spanish and Irish and Baltic bubbles. It’s a combination of, in the narrow sense, of a less regulated financial system and a world that was increasingly wide open for big international capital movements.”  It was an ocean of money. MORTGAGES: “A GOOD LOAN ” The refinancing boom was over, but originators still needed mortgages to sell to the Street. They needed new products that, as prices kept rising, could make expensive homes more affordable to still-eager borrowers. The solution was riskier, more ag- gressive, mortgage products that brought higher yields for investors but correspond- ingly greater risks for borrowers. “Holding a subprime loan has become something of a high-stakes wager,” the Center for Responsible Lending warned in .  Subprime mortgages rose from  of mortgage originations in  to  in .  About  of subprime borrowers used hybrid adjustable-rate mortgages (ARMs) such as /s and /s—mortgages whose low “teaser” rate lasts for the first two or three years, and then adjusts periodically thereafter.  Prime borrowers also used more alternative mortgages. The dollar volume of Alt-A securitization rose almost  from  to .  In general, these loans made borrowers’ monthly mortgage payments on ever more expensive homes affordable—at least initially. Pop- ular Alt-A products included interest-only mortgages and payment-option ARMs. Option ARMs let borrowers pick their payment each month, including payments that actually increased the principal—any shortfall on the interest payment was added to the principal, something called negative amortization. If the balance got large enough, the loan would convert to a fixed-rate mortgage, increasing the monthly payment—perhaps dramatically. Option ARMs rose from  of mortgages in  to  in .  CHRG-111hhrg53241--90 Mr. Plunkett," It is not rocket science. There was evidence 10 years ago that subprime mortgages were defaulting at a higher rate than regular mortgages. If those agencies had bothered to look, do research that was available in the public realm, if it was a priority, they could have done it. That is why we need an agency focused just on consumer protection. " fcic_final_report_full--561 McMurray, and Bartlett). 109. Angelo Mozilo, email to David Sambol, April 17, 2006, subject: re: Sub-prime seconds (cc Kur- land, McMurray, and Bartlett). 110. Sabeth Siddique, interview by FCIC, September 9, 2010. 111. “Survey of Nontraditional Mortgages” (actual title redacted), confidential Federal Reserve docu- ment obtained by FCIC, produced November 1, 2005, pp. 2, 3. 112. Susan Bies, interview by FDIC, October 11, 2010. 113. John Dugan, testimony before the FCIC, Hearing on Subprime Lending and Securitization and Government-Sponsored Enterprises (GSEs), day 2, session 2: Office of the Comptroller of the Currency, April 8, 2010, transcript, 114. Sabeth Siddique, interviews by FCIC, September 9, 2010, and October 25, 2010. 115. Bies, interview. 116. Mortgage Insurance Companies of America, quoted in Kirstin Downey, “Insurers Want Action on Risky Mortgages; Firms Want More Loan Restrictions,” Washington Post , August 19, 2006. 117. William A. Sampson, Mortgage Insurance Companies of America, “MICA Testimony on Non- Traditional Mortgages,” before the Senate Subcommittee on Housing and Transportation and the Sub- committee on Economic Policy, 109th Cong., 2nd sess., September 20, 2006. 118. Siddique, interviews, October 25, 2010, and September 9, 2010. 119. Consumer Advisory Council Meeting, March 30, 2006, transcript. 120. Consumer Advisory Council Meeting, June 22, 2006, transcript. 121. Siddique, interview, October 25, 2010; Bies, interview. 122. There is no central clearinghouse to calculate structured finance assets. The FCIC’s estimate is based on the amount of structured finance assets rated by Moody’s along with unrated agency RMBS, along with an estimate for structured finance assets not rated by Moody’s, using as sources Fannie Mae and Freddie Mac, Bloomberg, American CoreLogic Loan Performance, Fitch Ratings, Moody’s, S&P, Thomson Reuters, and SIFMA. 123. Alan Greenspan, testimony before the FCIC, Hearing on Subprime Lending and Securitization and Government-Sponsored Enterprises (GSEs), day 1, session 1: The Federal Reserve, April 7, 2010, transcript, p. 29. 124. Mortgage Bankers Association, “National Delinquency Survey.” 125. CoreLogic, Inc., August 26, 2010, news release, second quarter, 2010. Second-quarter figures were an improvement from 11.2 million residential properties (24%) in negative equity in the first quar- ter of 2010. 126. Mark Zandi, written testimony for the FCIC, First Public Hearing of the FCIC, day 1, panel 3: Financial Crisis Impacts on the Economy, January 13, 2010, pp. 14, 15. 127. Dean Baker, interview by FCIC, August 18, 2010. 128. Warren Peterson, testimony before the FCIC, Hearing on the Impact of the Financial Crisis— Greater Bakersfield, session 3: Residential and Community Real Estate, September 7, 2010, transcript, pp. 106–7, 119–20, 107–8; Warren Peterson, interview by FCIC, August 24, 2010. fcic_final_report_full--116 THE MORTGAGE MACHINE CONTENTS Foreign investors: “An irresistible profit opportunity” ........................................  Mortgages: “A good loan” ..................................................................................  Federal regulators: “Immunity from many state laws is a significant benefit” .... Mortgage securities players: “Wall Street was very hungry for our product” ...... Moody’s: “Given a blank check” .........................................................................  Fannie Mae and Freddie Mac: “Less competitive in the marketplace” ...............  In , commercial banks, thrifts, and investment banks caught up with Fannie Mae and Freddie Mac in securitizing home loans. By , they had taken the lead. The two government-sponsored enterprises maintained their monopoly on securitiz- ing prime mortgages below their loan limits, but the wave of home refinancing by prime borrowers spurred by very low, steady interest rates petered out. Meanwhile, Wall Street focused on the higher-yield loans that the GSEs could not purchase and securitize—loans too large, called jumbo loans, and nonprime loans that didn’t meet the GSEs’ standards. The nonprime loans soon became the biggest part of the mar- ket—“subprime” loans for borrowers with weak credit and “Alt-A” loans, with charac- teristics riskier than prime loans, to borrowers with strong credit.  By  and , Wall Street was securitizing one-third more loans than Fannie and Freddie. In just two years, private-label mortgage-backed securities had grown more than , reaching . trillion in ;  were subprime or Alt-A.  Many investors preferred securities highly rated by the rating agencies—or were encouraged or restricted by regulations to buy them. And with yields low on other highly rated assets, investors hungered for Wall Street mortgage securities backed by higher-yield mortgages—those loans made to subprime borrowers, those with non- traditional features, those with limited or no documentation (“no-doc loans”), or those that failed in some other way to meet strong underwriting standards. “Securitization could be seen as a factory line,” former Citigroup CEO Charles Prince told the FCIC. “As more and more and more of these subprime mortgages were created as raw material for the securitization process, not surprisingly in hind- sight, more and more of it was of lower and lower quality. And at the end of that  process, the raw material going into it was actually bad quality, it was toxic quality, and that is what ended up coming out the other end of the pipeline. Wall Street obvi- ously participated in that flow of activity.”  CHRG-111hhrg55811--327 Mr. Holmes," Yes. Certainly our major concern through the credit crisis was the health of our counterparties. And it certainly didn't appear that any of the interest rate swaps in which end-users were participants or foreign exchange transactions were the things that created financial difficulties for our counterparties. It was the subprime market, as you indicated. " fcic_final_report_full--185 In the spring of , the FOMC would again discuss risks in the housing and mortgage markets and express nervousness about the growing “ingenuity” of the mortgage sector. One participant noted that negative amortization loans had the per- nicious effect of stripping equity and wealth from homeowners and raised concerns about nontraditional lending practices that seemed based on the presumption of continued increases in home prices. John Snow, then treasury secretary, told the FCIC that he called a meeting in late  or early  to urge regulators to address the proliferation of poor lending practices. He said he was struck that regulators tended not to see a problem at their own institutions. “Nobody had a full -degree view. The basic reaction from finan- cial regulators was, ‘Well, there may be a problem. But it’s not in my field of view,’” Snow told the FCIC. Regulators responded to Snow’s questions by saying, “Our de- fault rates are very low. Our institutions are very well capitalized. Our institutions [have] very low delinquencies. So we don’t see any real big problem.”  In May , the banking agencies did issue guidance on the risks of home equity lines of credit and home equity loans. It cautioned financial institutions about credit risk management practices, pointing to interest-only features, low- or no-documentation loans, high loan-to-value and debt-to-income ratios, lower credit scores, greater use of automated valuation models, and the increase in transactions generated through a loan broker or other third party. While this guidance identified many of the problematic lending practices engaged in by bank lenders, it was limited to home equity loans. It did not apply to first mortgages.  In , examiners from the Fed and other agencies conducted a confidential “peer group” study of mortgage practices at six companies that together had origi- nated . trillion in mortgages in , almost half the national total. In the group were five banks whose holding companies were under the Fed’s supervisory purview—Bank of America, Citigroup, Countrywide, National City, and Wells Fargo—as well as the largest thrift, Washington Mutual.  The study “showed a very rapid increase in the volume of these irresponsible loans, very risky loans,” Sabeth Siddique, then head of credit risk at the Federal Reserve Board’s Division of Banking Supervision and Regulation, told the FCIC.  A large percentage of their loans issued were subprime and Alt-A mortgages, and the underwriting standards for these prod- ucts had deteriorated.  Once the Fed and other supervisors had identified the mortgage problems, they agreed to express those concerns to the industry in the form of nonbinding guidance. “There was among the Board of Governors folks, you know, some who felt that if we just put out guidance, the banks would get the message,” Bies said.  The federal agencies therefore drafted guidance on nontraditional mortgages such as option ARMs, issuing it for public comment in late . The draft guidance directed lenders to consider a borrower’s ability to make the loan payment when rates adjusted, rather than just the lower starting rate. It warned lenders that low- documentation loans should be “used with caution.”  FinancialCrisisReport--448 The Subcommittee’s net short chart is generally consistent with a Goldman chart that Mr. Birnbaum asked one of the Mortgage Department’s analysts to prepare for him in August 2007, which can be seen on the following page. [SEE CHART NEXT PAGE: RMBS Subprime Notional History , prepared by Goldman Sachs.] 1864 The “zero” line in the middle of the chart represents a neutral trading position that is neither net long nor net short. To use Mr. Viniar’s description, the zero line represents “home.” The area below the zero line represents net short positions; the area above the line represents net long positions. The chart shows that the Goldman Mortgage Department was net short throughout 2007, with a total net short position that reached $13.9 billion in July. 1864 8/17/2007 Goldman internal chart, “RMBS Subprime Notional History (Mtg Dept - ‘Mtg NYC SPG Portfolio ’),” GS MBS-E-012928391, Hearing Exhibit 4/27-56a. The title of the Goldman chart, “NYC SPG Trading ” is confusing, as Mr. Birnbaum asked the analyst, Kevin Kao, for a chart of all synthetic positions across the entire Mortgage Department (including areas other than SPG Trading). In an email to M r. Birnbaum, Mr. Kao confirmed that despite the title, the chart actually included all synthetic positions across the entire Mortgage Department, and not just the SPG Trading Desk positions. 8/17/2007 email from Mr. Kao to Mr. Birnbaum, GS MBS-E-012929469. Mr. Kao explained that his chart did not include cash positions, meaning long positions in mortgage loans or RMBS from any remaining warehouse inventory. Id. That omission was not significant, however, since Goldman had rapidly sold off the vast bulk of its cash inventory starting in November 2006. 4/2010 “Goldman Sachs Long Cash Subprime Mortgage Exposure, Investments in Subprime Mortgage Loans, and Investments in Subprime Mortgage Backed Securities November 24, 2006 vs. August 31, 2007 - in $ Billions,” chart prepared by the Subcommittee, Hearing Exhibit 4/27-163. In any event, the Subcommittee ’s net short chart includes the Department’s cash positions and demonstrates that any long cash positions were insufficient to offset the shorts, as the Mortgage Department was massively net short throughout most of 2007. See PSI Net Short Chart. In his Supplemental Responses to Questions for the Record from the Subcommittee, Mr. Birnbaum conceded that the Subcommittee ’s net short chart includes cash positions and therefore fixed the problem of being limited to synthetics as was the case with Goldman ’s own net short chart. See 8/17/2007 Goldman internal chart, “RM BS Subprime Notional History (Mtg Dept - Mtg NYC SPG Portfolio),” GS M BS-E-012928391, Hearing Exhibit 4/27-56a; Birnbaum responses to Subcommittee QFRs at PSI_QFR_GS0509. Mr. Birnbaum maintained his objection that the Subcommittee ’s net short chart improperly summed the notional amounts of different asset classes. Id. However, as noted in the text, the Mortgage Department’s Top Sheet actually converted the notional amounts of each asset class into their market values, making it fair to sum across all asset classes.  451 FinancialCrisisInquiry--162 All right. Thank you. I’m going move on now. Mr. Wallison? WALLISON: Thanks very much, Mr. Chairman. Mr. Mayo, as an analyst at banks, how many subprime mortgages did you think were outstanding in our economy, and many of them held by banks, in 2008? What percentage of the total number of mortgages were subprime or Alt A? In other words, non-prime in some way? MAYO: I thought that was like a trillion out of 11 trillion. Is that... WALLISON: So you thought it was about 10 percent? MAYO: Yes. WALLISON: If I told you it was half, would it have differed—would that have caused your view of what the problems might be to change the order of the various causes of the financial crisis that you describe? MAYO: That would be a little bit of a different conclusion, yes. WALLISON: OK. I thought it might. The other question I was puzzling about is your description of capitalism. And you said that capitalism has to involve bankruptcy. No one should be too big to fail. Everyone should be allowed to fail. But then you said but under prudent oversight. What is the purpose of oversight if it isn’t supposed to be keeping people from failing? CHRG-111shrg57319--312 Mr. Schneider," Yes, Senator. For our subprime servicing, we put them in a higher-risk servicing protocol, which meant we called them earlier and more often and worked more closely with those borrowers. Senator Kaufman. What is the concept of a skinny file? Are you familiar with the term ``skinny file'' with regard to FICO? " CHRG-111hhrg49968--78 Mr. Campbell," Last quick question. TARP money was originally intended to stabilize the markets, but also to give banks capital from which to do more lending. As they want to give it back in order to avoid the restrictions being placed on them, isn't that, in effect, going to reverse part of the original intent, which was to provide them more capital from which to lend, and therefore reduce potential lending in the marketplace? Thank you. " CHRG-111shrg50814--95 Mr. Bernanke," Senator, the direct impact of the TARP dollars is to expand the capital bases of these companies which allows them to do all the activities they do, including lending---- Senator Tester. But the lending hasn't freed up, from everybody I have talked to. " FinancialCrisisReport--34 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 fees. lien subprime deals originated in 2006 as well as … 91.8 percent of 2nd-lien deals originated in 2006 have been downgraded.”). 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. CHRG-111hhrg53241--39 The Chairman," Our final witness is Nancy Zirkin, on behalf of the Leadership Conference on Civil Rights.STATEMENT OF NANCY ZIRKIN, EXECUTIVE VICE PRESIDENT, LEADERSHIP CONFERENCE ON CIVIL RIGHTS (LCCR) Ms. Zirkin. Thank you, Mr. Chairman, and members of the committee. I am Nancy Zirkin, executive vice president of the Leadership Conference on Civil Rights (LCCR), the oldest and largest human and civil rights organization in this country comprised of 200 national organizations. We are also a part of the Americans for Financial Reform. LCCR supports a Consumer Financial Protection Agency because it is the key to protecting the civil rights of the communities that LCCR represents. Our interest ties into what has always been one of the key goals of the civil rights movement, homeownership, which is how most people build wealth and improve communities. LCCR and our member organizations have always worked to expand fair housing and also the credit that most people need to buy housing. Despite the progress since the Fair Housing Act, predatory lending has been the latest obstacle standing in the way, and, of course, it is very much the root of the crisis that we find ourselves in today. For years, LCCR and our allies argued that the modern lending system was working against us. Just to be clear, responsible subprime lending is a good thing. The problem is that the industry basically threw the responsible out of the window by giving countless numbers of people loans that weren't realistic or responsible. Even worse, many lenders were steering racial and ethnic minorities into these loans, even when they could have qualified for conventional loans. So, for years, civil rights and consumer advocates have tried to get help from Federal banking regulators, but they ignored us and maintained the status quo. Seemingly, they were more persuaded by the industry's platitudes about access to credit than the growing evidence of what the credit was actually doing. Since 1994, for example, the Fed has been able to ban predatory loans but waited until a year ago to actually start doing so, after most predatory lenders had already skipped down and left taxpayers holding the bag. The OTS and OCC were no better, even when it came to enforcing civil rights laws like the Equal Credit Opportunity Act. During the housing bubble years, neither regulator referred cases to the Department of Justice. In one instance, DOJ had to go after an OTS thrift on its own, Mid-America Bank. I have attached a new brief by the Center for Responsible Lending to my written statement which will be added to the record. The brief contains a lot of compelling horror stories about the lack of financial enforcement. And we all know about the Treasury Inspector General's report on IndyMac, which certainly shows what OTS did--or didn't do, I should say. The problem with relying on Federal bank regulators to protect our communities is simple. Its structure is inherently designed to fail consumers. When regulators are financially dependent on the institutions that they police, consumer interest will always be squeezed out. CFPA will break this pattern. In the same way that our Founders realized that sometimes you have to deliberately pick interests against each other in order to create a stable government, the interest of consumers and civil rights on the one hand and bank profitability on the other need to be pitted against each other. It is obvious that the current system didn't serve either interest. That is why LCCR thinks your legislation, Mr. Chairman, is so important. Speaking of details, my written testimony includes recommendations to the bill that we think are essential, and also LCCR's Fair Housing Task Force has a series of recommendations that we will be sharing. Again, thank you for inviting LCCR here today; and I will be happy to answer any questions you might have. Thank you. [The prepared statement of Ms. Zirkin can be found on page 170 of the appendix.] " CHRG-111hhrg51698--123 Mr. Cota," Congressman, first with regard to your comments on the CFTC in that they didn't have enough information in order to determine whether or not there was speculation having an impact, that is because they don't have jurisdiction over large chunks of the market through various--closing the Enron bill does take part of that, but those administrative rules are not in place yet, and it still exempts the lending loophole in all of those. So until you start counting the whole pie, it doesn't make any sense. The case of Amaranth, which was a hedge fund that went bad, they only got caught because they did some of their trades upon a regulated exchange, a subsidiary of the Chicago Merc, the New York Mercantile Exchange, where they were cornering--it was perceived that their positions were too large for the February contract. In retrospect, after an investigation, it turned out that they had 80 percent of the U.S. total natural gas production for the February contract, just for their position. So until you see what these aggregate position limits are of these large entities, and you keep track of it, that is the only time you can bring it to the light of day. I like to have exchanges do most of this, because you put all of the players together in the same room, and they know what is going on. When they see somebody is going to put them at risk, they are going to be much more diligent and make sure that person doesn't. As to what started the whole process, we started when the subprime market went bad, so people needed to put their money as they sold out of that. The banks that lost money on that initially lost because they had loaned money to people to buy these subprimes, and then they decided it went as high as possible, so I had better short it. So they shorted it. People they loaned money to went bad. People needed to move money out quickly. Any pyramid collapses faster than it went up, and then they went into their remaining items. The remaining investments were equities at that point, so in 2007 you saw a bump in equities. As that started to come apart, it moved into currencies and commodities. It was the only thing that was cash. As people became afraid of everything else, a stock may go to zero, Lehman may go to zero, a commodity will never go to zero. It may go to 2 cents on the dollar, but it won't go to zero. So the investing world was so afraid of any sort of investment. The banks didn't trust one another so that they went into the few things that they thought were left. That, to me, underscores the issue that you need to have sensible regulation. The world looks to the United States to have the most coherent regulation of financial markets in an open and free market--so that you can trust your money is going to be worth something. The other markets around the world don't have that. I am a kind of a contrarian to some of the conversations here--if you do have a well-regulated market in the United States, the money will flood back in because they can trust this market. They may not be able to trust the others. That is my analysis of what occurred. " CHRG-110hhrg45625--155 Mr. Feeney," I want to thank both of you for being here. I know these are difficult times. I actually liked Mr. Ackerman's analogy. But for all too many Americans, this looks like it turns the play on its head. It is Little Orphan Annie who is being taxed to prop up Big Daddy Warbucks. And the average American out there believes very much that is what they are being forced to participate in as part of this proposal. But I want to look at a bigger picture. We have some huge expertise here, and I am going to mention two dirty words, the Great Depression. Virtually every major market crisis in 100-some years in America has been caused by easy credit, a bubble bursting, and then a credit tightening crisis. That is exactly what we are facing now. There were the Roaring Twenties with easy money. And for the last 6 or 8 years, we have had not only very easy money, there is plenty of blame to go around. It has been the United States Congress that passed the Community Reinvestment Act and browbeat every lender they could into making risky loans and then turned around and accused the lenders of being greedy. It is almost amazing, but that is what we do here, unfortunately, almost all too often. Congress also refused to reform Fannie and Freddie, despite the urging of many of us, and Secretary Paulson, for example, you have huge expertise in what happened after the October 29th stock market crash. In this case, we had a subprime lending bubble that started the crisis. But in 1929, the reaction to that was very real, and it wasn't just a failure to provide liquidity. Credit tightened by some 33 percent. The money supply shrank in America. And I know we are trying to fight that. I don't necessarily agree with your proposal. I know what you are trying to do. But simultaneously, Herbert Hoover raised marginal tax rates from 25 percent to 63 percent. This Congress just passed an impending largest tax increase in history. Hoover signed into law the largest anti-free trade act in history, Smoot-Hawley. This Congress has sat on free trade bills, sending a horrible message to our trading partners. There were huge regulatory increases that started in the aftermath of the 1929 market bubble that, in my view, contributed to taking a short-term, 18-month, 2-year recession, and turned it into a 15-year depression before the stock market fully recovered. I believe that the failure to pass an energy bill here is huge. So I would ask you gentlemen, in addition to dealing with the liquidity crisis, as we turn over these enormous regulatory powers and socialize much of the lending industry, even though we have already socialized Fannie and Freddie for all intents and purposes, how do you intend on these other huge issues, tax increases, huge new spending increases which accompanied the aftermath of the 1929 market crash, how do you in the name of fighting demagoguery explain to the average American that what really needs to be done here? This was not, in my view, a huge failure of the marketplace. This was bad policy by the Fed, easy credit, and Congress browbeating people into making terrible loans. Just like investors speculated with other peoples' money in the 1929 market crash, and bet on margin, it is exactly what happened in our subprime crisis. And so my view is that it was horrible government policy, anti-capitalist policy, that largely led to this crisis. I would like you to address as historians and economists, how we can avoid all of these other things, big tax increases, fighting free trade, huge regulatory burdens, socializing much of the market. Back then, it was utilities and other areas. Today, of course, it is the AIG, it is the banking lenders. And I would like you to address the broader picture. How do we avoid taking an 18-month market recession and turning it into a 15-year Great Depression? " CHRG-111hhrg55811--324 Mr. Manzullo," Thank you. Let me ask probably the most simple question. I ask the same question just as Mr. Sherman asks the same question every time we have somebody talking about these instruments. If the subprime market had not gone sour, would there have been any problems with the derivative markets? I know you are all anxious to jump into that one. " fcic_final_report_full--261 Committee members discussed the “considerable financial turbulence” in the sub- prime mortgage market and that some firms, including Countrywide, were showing some strain. They noted that the data did not indicate a collapse of the housing mar- ket was imminent and that, if the more optimistic scenarios proved to be accurate, they might look back and be surprised that the financial events did not have a stronger impact on the real economy. But the FOMC members also expressed con- cern that the effects of subprime developments could spread to other sectors and noted that they had been repeatedly surprised by the depth and duration of the dete- rioration of these markets. One participant, in a paraphrase of a quote he attributed to Winston Churchill, said that no amount of rewriting of history would exonerate those present if they did not prepare for the more dire scenarios discussed in the staff presentations.  Several days later, on August , Countrywide released its July  operational results, reporting that foreclosures and delinquencies were up and that loan produc- tion had fallen by  during the preceding month. A company spokesman said lay- offs would be considered. On the same day, Fed staff, who had supervised Countrywide’s holding company until the bank switched to a thrift charter in March , sent a confidential memo to the Fed’s Board of Governors warning about the company’s condition: The company is heavily reliant on an originate-to-distribute model, and, given current market conditions, the firm is unable to securitize or sell any of its non-conforming mortgages. . . . Countrywide’s short-term funding strategy relied heavily on commercial paper (CP) and, espe- cially, on ABCP. In current market conditions, the viability of that strat- egy is questionable. . . . The ability of the company to use [mortgage] securities as collateral in [repo transactions] is consequently uncertain in the current market environment. . . . As a result, it could face severe liquidity pressures. Those liquidity pressures conceivably could lead eventually to possible insolvency.  Countrywide asked its regulator, the Office of Thrift Supervision, if the Fed could provide assistance, perhaps by waiving a Fed rule and allowing Countrywide’s thrift subsidiary to support its holding company by raising money from insured deposi- tors, or perhaps through discount-window lending, which would require the Fed to accept risky mortgage-backed securities as collateral, something it never had done and would not do—until the following spring. The Fed did not intervene: “Substan- tial statutory requirements would have to be met before the Board could authorize lending to the holding company or mortgage subsidiary,” staff wrote. “The Federal Reserve had not lent to a nonbank in many decades; and . . . such lending in the cur- rent circumstances seemed highly improbable.”  The following day, lacking any other funding, Mozilo recommended to his board that the company notify lenders of its intention to draw down . billion on backup lines of credit.  Mozilo and his team knew that the decision could lead to ratings downgrades. “The only option we had was to pull down those lines,” he told the FCIC. “We had a pipeline of loans and we either had to say to the borrowers, the cus- tomers, ‘we’re out of business, we’re not going to fund’—and there’s great risk to that, litigation risk, we had committed to fund. . . . When it’s between your ass and your image, you hold on to your ass.”  CHRG-111shrg57319--440 Mr. Beck," Yes. Senator Levin. OK. Do you have anything else? Senator Kaufman. Yes. Mr. Beck, you said that at this point most people knew that the subprime mortgage market was in pretty bad shape. What was the psychology of the people buying mortgage-backed securities at that point if they knew that this was a pretty bad situation? Which I think by then they did. " CHRG-111hhrg46820--101 Mr. Merski," Chairwoman Velazquez, Ranking Member Graves, and members of the committee, I am pleased to present the ICBA's views on the small business economy and on recommendations to promote an economic recovery. ICBA represents 5,000 community banks throughout our country, and community banks are independently owned and specialize in small business relationship banking. Notably half of all small business loans under $100,000 are made by community banks. Forty-eight percent of small businesses get their financing from community banks with 1 billion and under in assets. Today our small businesses are facing the most difficult economic conditions in decades and accessing credit is getting more problematic due to the turmoil in the credit markets. The National Federation of Independent Business Index of Small Business Optimism has dropped to its lowest level since it began in 1986. Additionally, the free fall in SBA lending is cause for alarm and immediate action. Therefore, fiscal policies focused on restoring consumer confidence, broad credit availability, a robust housing market and job growth are all vital to an economic recovery. We all know that many of our Nation's largest lenders and money center banks tripped up on subprime lending, toxic investments and now they are the ones pulling in their lending, writing down losses, and rebuilding their capital. However, there is another story out there. Thousands of community banks represent that other side of the financial story. Community banks rely on relationships in their communities, not on relationships with investment banks or hedge funds. Community bankers actually live and work in their communities that they serve and they certainly do not put their customers in loan products that they cannot possibly repay. While community banks did not cause the current turmoil, they are very well-positioned and willing to help get our economy back on track. To complement the aggressive monetary policy easing, ICBA recommends additional fiscal incentives, including individual and small business tax relief, enhanced home buyer tax credit, expanding SBA programs and Subchapter S tax reforms. Additionally, we really need to address our fair value accounting system and improve community banks' access to the TARP and TALF programs that this committee has worked hard on. SBA lending programs are vital. SBA lending should serve as a counterbalance during these challenging credit times for small businesses. Unfortunately, what we see is a dramatic drop in the dollar amount and number of small business loans being made. While the typical commercial small business loan has a maturity of 1 to 3 years, SBA 7(a) loans typically average 12 or more years in maturity. This lowers the entrepreneur's monthly loan payments and frees up needed cash flow to start or grow the small business. ICBA recommends immediately offering a super SBA loan program for 1 year as an economic stimulus to help small businesses access the capital they need. This could be an expedited 7(a) loan program with a 95 percent guarantee for small business loans up to 500,000. The vicious downward cycle in the housing sector must also be broken. Extending the $7,500 first-time home buyer tax credit and removing the repayment provision will help jump-start home sales, stabilize home prices, and address foreclosures. ICBA also recommends an immediate increase in the annual limit on tax-exempt municipal bonds from 10 million to 50 million. This would create greater low cost funding for local projects such as school construction, water treatment plants and other municipality projects. Chairwoman Velazquez, ICBA greatly appreciates your efforts to work with the Treasury and the Federal Reserve in successfully launching the TALF program. By providing liquidity to issuers of consumer asset backed paper, the Federal Reserve facility will enable more institutions to increase their lending. ICBA also appreciates the Small Business Committee's attention to the TARP capital purchase program. Community banks are very concerned that 3,000 financial institutions still do not have access to the capital purchase program. In conclusion, community banks did not cause this financial crisis, but we certainly will be there to help ensure our Nation's small businesses will have the access to credit that they need. I appreciate the opportunity to testify. Thank you. [The statement of Mr. Merski is included in the appendix at page 100.] " CHRG-111shrg56262--69 Chairman Reed," Thank you. Professor McCoy, you have suggested that borrowers be given an affirmative claim against assignees, a violation of Federal lending standards. Can you elaborate on that? Then I would ask others to comment on that proposal. Ms. McCoy. Yes, I would be glad to. We are in a situation right now where in the majority of States, if a borrower's loan is sold, generally through securitization, they lose, without their consent, their defenses to collection and their ability to sue the holder of the loan for consumer protection violations and fraud. And where the rubber really hits the road is when that borrower is sued for foreclosure. If the loan has been securitized, let us say the borrower was defrauded originally, the loan later goes into foreclosure, under State law the borrower cannot raise the fraud as a defense to foreclosure. They lost that, and they lost that through a process over which they had no say. In addition, because the borrowers can really only sue their lender, or their mortgage broker, it means that we do not have the threat of making the borrower whole that investment banks have to care about; that investors have to care about when they think about will we do due diligence or just rely on the rating agency. And I feel in order to bring rationality and consistency to the entire mortgage process, we need to allow borrowers to bring claims of fraud and consumer protection violations against whoever holds their loan. Now, there are ways you can structure this liability that rating agencies can rate and that securitization can function with. Economists and I and other coauthors studied the effect of similar laws in nine States, and what we found is in six of those States, access to subprime credit actually increased, holding everyone else constant, despite assignee liability. In three of the States, depending on the indicator, the results were mixed, but in no State was there an affirmative drop in access to credit. " CHRG-111hhrg56241--183 The Chairman," If the gentleman would yield, if they can make enough money doing everything but lending that may be a contributing factor to not lending. We will have an all-day hearing on Friday, February 5th, with borrowers and regulators and lenders, and we want to get into this question about why more loans aren't being made. It is a bipartisan concern. And I do think it is legitimate to inquire to the extent to which other opportunities to make a lot of money displace lending, either directly or indirectly. Let me just now-- " FinancialCrisisReport--309 In April 2007, a managing director at S&P in the Structured Finance Group wrote an email confirming the staffing shortages in the RMBS Surveillance Group: “We have worked together with Ernestine Warner (EW) to produce a staffing model for RMBS Surveillance (R-Surv). It is intended to measure the staffing needed for detailed surveillance of the 2006 vintage and also everything issued prior to that. This model shows that the R-Surv staff is short by 7 FTE [Full Time Employees] - about 3 Directors, 2 AD’s, and 2 Associates. The model suggests that the current staff may have been right sized if we excluded coverage of the 2006 vintage, but was under titled lacking sufficient seniority, skill, and experience.” 1199 The global head of the S&P Structured Finance Surveillance Group, Peter D’Erchia, told the Subcommittee that, in late 2006, he expressed concerns to senior management about surveillance resources and the need to downgrade subprime in more significant numbers in light of the deteriorating subprime market. 1200 According to Mr. D’Erchia, the executive managing director of the Global Structured Finance Ratings Group, Joanne Rose, disagreed with him about the need to issue significantly more downgrades in subprime RMBS and this disagreement continued into the next year. He also told the Subcommittee that after this disagreement with her, he received a disappointing 2007 performance evaluation. He wrote the following in the employee comment section of his evaluation: “Even more offensive – and flatly wrong – is the statement that I am not working for a good outcome for S&P. That is all I am working towards and have been for 26 years. It is hard to respond to such comments, which I think reflect Joanne’s [Rose] personal feelings arising from our disagreement over subprime debt deterioration, not professional assessment. … Such comments, and others like it, suggest to me that this year-end appraisal, in contrast to the mid-year appraisal, has more to do with our differences over subprime deterioration than an objective assessment of my overall performance.” 1201 In 2008, Mr. D’Erchia was removed from his surveillance position, where he oversaw more than 314 employees, as part of a reduction in force. He was subsequently rehired as a managing director in U.S. Public Finance at S&P, a position without staff to supervise. 1198 2/3/2007 email from Ernestine Warner to Peter D’Erchia, Hearing Exhibit 4/23-86 [emphasis in original]. 1199 4/24/2007 email from Abe Losice to Susan Barnes, “Staffing for RMBS Surveillance,” Hearing Exhibit 4/23-88. 1200 Subcommittee interview of Peter D’Erchia (4/13/2010). 1201 2007 Performance Evaluation for Peter D’Erchia, S&P SEN-PSI 0007442; See also April 23, 2010 Subcommittee Hearing at 74-75. FinancialCrisisReport--218 At another point, the same Examiner-in-Charge wrote a long email discussing issues related to a decision by WaMu to qualify borrowers for adjustable rate mortgages using an interest rate that was less than the highest rate that could be charged under the loan. He complained that it was difficult to force WaMu to comply with the OTS “policy of underwriting at or near the fully indexed rate,” when “in terms of policy, I am not sure we have ever had a really hard rule that institutions MUST underwrite to the fully indexed rate.” 823 He also noted that OTS sometimes made an exception to that rule for loans held for sale. NTM Guidance. While some OTS examiners were complaining about the agency’s weak standards, other OTS officials worked to ensure that new standards being developed for high risk mortgages would not restrain WaMu’s lending practices. The effort began in 2006 with an aim to address concerns about lax lending standards and the risks posed by subprime, negatively amortizing, and other exotic home loans. The federal banking agencies convened a joint effort to reduce the risk associated with those mortgages by issuing interagency guidance for “nontraditional mortgage” products (NTM Guidance). Washington Mutual filed public comments on the proposed NTM Guidance and argued that Option ARM and Interest-Only loans were “considered more safe and sound for portfolio lenders than many fixed rate mortgages,” so regulators should “not discourage lenders from offering these products.” 824 It also stated that calculating a potential borrower’s “DTI [debt-to-income ratio] based on the potential payment shock from negative amortization would be highly speculative” and “inappropriate to use in lending decisions.” 825 During subsequent negotiations to finalize that guidance, OTS argued for less stringent lending standards than other regulators were advocating and bolstered its points using data supplied by Washington Mutual. 826 In one July 2006 email, for example, an OTS official expressed the view that early versions of the new guidance focused too much on negative amortization loans, which were popular with several thrifts and at WaMu in particular, and failed to also look closely at other high risk lending products more common elsewhere. 827 He also wrote that OTS needed to address this issue and “should consider going on the offensive, rather than defensive to refute the OCC’s positions” on negatively amortizing loans, defending the loans using WaMu Option ARM loan data. 828 In August, several OTS officials discussed over email how to prevent the 822 Id. 823 9/15/2005 email from OTS Examiner-in-Charge Lawrence Carter to OTS Western Region Deputy Director Darrel Dochow, OTSWMS05-002 0000535, Hearing Exhibit 4/16-6. 824 3/29/2006 letter from Washington Mutual Home Loans President David C. Schneider to OTS Chief Counsel, Proposed Guidance – Interagency Guidance on Nontraditional Mortgage Products 70 Fed. Reg. 77249, JPM_WM04473292. 825 Id. at JPM_WM04473298. 826 Subcommittee interviews of Sheila Bair (4/5/2010) and George Doerr (3/30/2010). The Subcommittee was told that OTS was the “most sympathetic to industry” concerns of the participating agencies and was especially protective of Option ARMs. 827 7/27/2006 email from Steven Gregovich to Grovetta Gardineer and others, “NTM Open Issues,” OSWMS06-008 0001491-495, Hearing Exhibit 4/16-71. 828 Id. proposed restrictions on negatively amortizing loans from going farther than they believed necessary, noting in part the “profitable secondary market” for Option ARMs and the fact that “hybrid IO [interest only] ARMs are a huge product for Wamu.” One OTS official wrote: “We have dealt with this product [negatively amortizing loans] longer than any other regulator and have a strong understanding of best practices. I just don’t see us taking a back seat on guidance that is so innate to the thrift industry.” 829 FinancialCrisisInquiry--198 ZANDI: No, now, the CDOing that was going on—CDO would be like the best example of the wildest euphoria, meaning we were bundling up securities and putting them—putting them into one big security, that CDOing was going on with every single security out there at the height of the—at the height of the hubris. CHAIRMAN ANGELIDES: OK. Mr. Rosen, you were talking about the development of bad products, bad underwriting and fraud in the marketplace. And obviously it was—went all the way up the chain. And in terms of those products then moving throughout the system. I guess my question is, to what extent were those products available historically as predatory loan products? In a sense, to what extent did what used to be considered predatory loans, focused perhaps on certain neighborhoods, essentially get transported to the larger economy? Because there were lenders who offered some of these products on a narrow basis, correct? ROSEN: They were, and many of these practices have been around for a long time, very successfully done, not the risk element—we heard that earlier—but narrowly based. It’s when they became—layered the risk. So if you underwrote a subprime mortgage but underwrote the person’s income, gave them counseling, did all the right things, you didn’t have this issue. Defaults were always higher, but not dramatically higher. Same thing with option ARMs. What happened is we layered the risk. We decided to give a person a subprime mortgage, not verify their income, give them no down payment. And I have charts in the paper which I sent to you guys that—it was hard to believe they were doing it; it’s layering all the risks. And it is because the owner of these mortgages was distant from the origination process. I think that’s why it happened. So the proliferation of products that were sound for certain categories of people with the right underwriting, became—underwriting just disappeared, and it proliferated throughout the system, so we ended up writing, instead of 5 percent subprime mortgages, all of a sudden, it was 20 percent. CHRG-111shrg57322--818 Mr. Broderick," And they will bring them to someone else. Senator Coburn. Understand. I have no criticism for that and I am not making any judgment on it. What happened, in your opinion, in the March time frame for your company to make the determination to no longer buy subprime? You are a risk manager. You are involved in that thought and decision making and research. What happened? " fcic_final_report_full--124 At the same time, the piggybacks added risks. A borrower with a higher com- bined LTV had less equity in the home. In a rising market, should payments become unmanageable, the borrower could always sell the home and come out ahead. How- ever, should the payments become unmanageable in a falling market, the borrower might owe more than the home was worth. Piggyback loans—which often required nothing down—guaranteed that many borrowers would end up with negative equity if house prices fell, especially if the appraisal had overstated the initial value. But piggyback lending helped address a significant challenge for companies like New Century, which were big players in the market for mortgages. Meeting investor demand required finding new borrowers, and homebuyers without down payments were a relatively untapped source. Yet among borrowers with mortgages originated in , by September  those with piggybacks were four times as likely as other mortgage holders to be  or more days delinquent. When senior management at New Century heard these numbers, the head of the Secondary Marketing Depart- ment asked for “thoughts on what to do with this . . . pretty compelling” information. Nonetheless, New Century increased mortgages with piggybacks to  of loan pro- duction by the end of , up from only  in .  They were not alone. Across securitized subprime mortgages, the average combined LTV rose from  to  between  and .  Another way to get people into mortgages—and quickly—was to require less in- formation of the borrower. “Stated income” or “low-documentation” (or sometimes “no-documentation”) loans had emerged years earlier for people with fluctuating or hard-to-verify incomes, such as the self-employed, or to serve longtime customers with strong credit. Or lenders might waive information requirements if the loan looked safe in other respects. “If I’m making a , ,  loan-to-value, I’m not going to get all of the documentation,” Sandler of Golden West told the FCIC. The process was too cumbersome and unnecessary. He already had a good idea how much money teachers, accountants, and engineers made—and if he didn’t, he could easily find out. All he needed was to verify that his borrowers worked where they said they did. If he guessed wrong, the loan-to-value ratio still protected his investment.  Around , however, low- and no-documentation loans took on an entirely dif- ferent character. Nonprime lenders now boasted they could offer borrowers the con- venience of quicker decisions and not having to provide tons of paperwork. In return, they charged a higher interest rate. The idea caught on: from  to , low- and no-doc loans skyrocketed from less than  to roughly  of all outstand- ing loans.  Among Alt-A securitizations,  of loans issued in  had limited or no documentation.  As William Black, a former banking regulator, testified before the FCIC, the mortgage industry’s own fraud specialists described stated income loans as “an open ‘invitation to fraud’ that justified the industry term ‘liar’s loans.’”  Speaking of lending up to  at Citigroup, Richard Bowen, a veteran banker in the consumer lending group, told the FCIC, “A decision was made that ‘We’re going to have to hold our nose and start buying the stated product if we want to stay in busi- ness.’”  Jamie Dimon, the CEO of JP Morgan, told the Commission, “In mortgage underwriting, somehow we just missed, you know, that home prices don’t go up for- ever and that it’s not sufficient to have stated income.”  fcic_final_report_full--298 On Wednesday, January , , Treasurer Upton reported an internal accounting error that showed Bear Stearns to have less than  billion in liquidity—triggering a report to the SEC. While the company identified the error, the SEC reinstituted daily reporting by the company of its liquidity.  Lenders and customers were more and more reluctant to do business with the company. On February , Bear Stearns had . billion in mortgages, mortgage- backed securities, and asset-backed securities on its balance sheet, down almost  billion from November. Nearly  billion were subprime or Alt-A mortgage–backed securities and CDOs. The hedge funds that were clients of Bear’s prime brokerage services were particu- larly concerned that Bear would be unable to return their cash and securities. Lou Lebedin, the head of Bear’s prime brokerage, told the FCIC that hedge fund clients occasionally inquired about the bank’s financial condition in the latter half of , but that such inquiries picked up at the beginning of , particularly as the cost in- creased of purchasing credit default swap protection on Bear. The inquiries became withdrawals—hedge funds started taking their business elsewhere. “They felt there were too many concerns about us and felt that this was a short-term move,” Lebedin said. “Often they would tell us they’d be happy to bring the business back, but that they had the duty to protect their investors.” Renaissance Technologies, one of Bear’s biggest prime brokerage clients, pulled out all of its business. By April, Lebedin’s prime brokerage operation would be holding  billion in assets under manage- ment, down more than  from  billion in January.  Nonetheless, during the week of March , when SEC staff inspected Bear’s liquid- ity pool, they identified “no significant issues.” The SEC found Bear’s liquidity pool ranged from  billion to  billion.  Bear opened for business on Monday, March , with approximately  billion in cash reserves. The same day, Moody’s downgraded  mortgage-backed securities issued by Bear Stearns Alt-A Trust, a special purpose entity. News reports on the downgrades carried abbreviated headlines stating, “Moody’s Downgrades Bear Stearns,” Upton said.  Rumors flew and counterparties panicked.  Bear’s liquidity pool began to dry up, and the SEC was now concerned that Bear was being squeezed from all directions.  While “everything rolled” during the day—that is, Bear’s repo lenders renewed their commitments—SEC officials worried that this would “proba- bly not continue.”  On Tuesday, the Fed announced it would lend to investment banks and other “primary dealers.” The Term Securities Lending Facility (TSLF) would make avail- able up to  billion in Treasury securities, accepting as collateral GSE mortgage– backed securities and non-GSE mortgage–backed securities rated triple-A. The hope was that lenders would lend to investment banks if the collateral was Treasuries rather than other highly rated but now suspect assets such as mortgage-backed secu- rities. The Fed also announced it would extend loans from overnight to  days, giv- ing investment banks an added breather from the relentless need to unwind repos every morning. CHRG-111shrg51290--8 Chairman Dodd," Thank you very much, as well, Senator. I appreciate your opening comments. Let me just introduce our witnesses so we can get to them. As I said at the outset, I was very impressed with your testimony. It is very thorough and, in fact, my constituent is extremely thorough. His testimony was 28 pages. We are going to try and limit you this morning. I am going to challenge my colleagues to read all of it, but we will try and keep it down to about somewhere between five and 8 minutes or so, so that we can get to some questions with you. Our first witness is truth in advertising. He is a good friend of mine, Steve Bartlett. Steve is CEO of the Financial Services Roundtable, previously served as the Mayor of Dallas, a former Member of the Congress. In fact, he served on the Financial Services Committee when he served in the House, and so he has a familiarity with these issues as a chief executive of a city, as a Member of the Congress serving on the counterpart Committee to this Committee, and, of course, as the CEO of the Financial Services Roundtable. Steve, we thank you immensely for joining us today and being with us. Ellen Seidman is the former Director of the Office of Thrift Supervision and currently Senior Fellow of the New America Foundation and Executive Vice President on National Policy and Partnership Development at ShoreBank Corporation. We thank you very much once again for being before the Committee. And I am proud to introduce Professor Patricia McCoy, a nationally recognized authority on consumer finance law and subprime lending. She is the George J. and Helen M. England Professor of Law at the University of Connecticut. She was a partner of Mayer, Brown, Rowe and Maw in Washington, D.C., where she specialized in complex securities banking and commercial constitutional litigation. It is a pleasure to have you. I hope you are enjoying your tenure in Connecticut. Ms. McCoy. Very much so, Senator. " FinancialCrisisReport--342 In the fall of 2005, Mr. Lippmann said that he approached his supervisor Richard D’Albert, Global Head of the Structured Products Group, for permission to enter into CDS agreements to short RMBS securities totaling $1 billion. 1300 He said that he explained at the time that a cost benefit analysis favored a short RMBS position, because the bank would pay a relatively small amount of CDS premiums per year in exchange for a potentially huge payout. Mr. Lippmann said that he estimated at the time that, when the costs were compared to the potential payout if the BBB securities defaulted, the proposed short position offered a potential payout ratio of 8 to 1. Mr. Lippmann also developed a presentation supporting his position entitled, “Shorting Home Equity Mezzanine Tranches.” It made the following points: • “Over 50% of outstanding subprime mortgages are located in MSAs [metropolitan statistical areas] with double digit 5 year average of annual home price growth rates. • There is a strong negative correlation between home price appreciation and loss severity. • Default of subprime mortgages are also strongly negatively correlated with home price growth rates. 1296 Subcommittee interview of Greg Lippmann (10/18/2010). When asked if the position was a proprietary investment by the bank, Mr. Lippmann told the Subcommittee that it was. Id. Deutsche Bank acknowledges in a 20-F filing with the U.S. Securities and Exchange Commission that it conducts proprietary trading, in addition to trading activity that facilitates customer business. Deutsche Bank stated that it trades for its own account (i.e., uses its capital) to exploit market opportunities. See Deutsche Bank Aktiengesellschaft’s Form 20-F filed with the Securities and Exchange Commission on March 26, 2008, at 24. 1297 Subcommittee interview of Greg Lippmann (10/18/2010). 1298 Id. 1299 Id. 1300 Id. • Nearly $440 billion subprime mortgages will experience payment shocks in the next 3 years. • Products that may be riskier than traditional home equity/subprime mortgages have become popular.” 1301 FinancialCrisisReport--172 Even before it received formal Board approval, Washington Mutual had begun shifting its loan originations toward higher risk loans. By 2007, rising defaults and the collapse of the subprime secondary market prevented WaMu from fully implementing its plans, but it did have time to shift the composition of the loans it originated and purchased, increasing the percentage of higher risk home loans from at least 19% in 2003, to over 47% in 2007. 616 Home Equity 7% Subprime 2003 2007 Option ARM 7% 5% Home Equity 24% Fixed 23% Other ARM 17% Fixed 64% Subprime 5% Option ARM 18% Other ARM 30% Over the course of nearly three years, from 2005 to 2007, WaMu issued and securitized hundreds of billions of high risk loans, including $49 billion in subprime loans 617 and $59 billion in Option ARMs. 618 Data compiled by the Treasury and the FDIC Inspectors General showed that, by the end of 2007, Option ARMs constituted about 47% of all home loans on WaMu’s balance sheet, of which about 56% of the borrowers were making the minimum payment amounts. 619 The data also showed that 84% of the total value of the Option ARMs was negatively amortizing, meaning that the borrowers were going into deeper debt rather than paying off their loan balances. 620 In addition, by the end of 2007, stated income loans – loans in which the bank had not verified the borrower’s income – represented 73% of WaMu’s Option 616 “WaMu Product Originations and Purchases by Percentage – 2003-2007,” chart prepared by the Subcommittee, Hearing Exhibit 4/13-1i. 617 “Securitizations of Washington Mutual and Long Beach Subprime Home Loans,” chart prepared by the Subcommittee, Hearing Exhibit 4/13-1c. 618 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 (hereinafter “Treasury and FDIC IG Report”), at 9, Hearing Exhibit 4/16-82. 619 Id. An August 2006 WaMu internal presentation indicated that over 95% of its Option ARM borrowers were making minimum payments. See 8/2006 chart, “Borrower-Selected Payment Behavior,” in WaMu internal presentation entitled, “Option ARM Credit Risk,” JPM_WM00212646, Hearing Exhibit 4/13-37. 620 See Treasury and FDIC IG Report, at 9, Hearing Exhibit 4/16-82. CHRG-111shrg53085--144 Mr. Attridge," We haven't changed our underwriting criteria. What has changed is the economic environment we are lending in. Senator Schumer. So if a credit union would want to lend to this small business and the local community banker for whatever reason wouldn't, why not let them? Mr. Whalen. " CHRG-111shrg57322--108 Mr. Sparks," WaMu, Long Beach is and was a client of Goldman Sachs. Senator Kaufman. And in May 2006, Goldman Sachs acted as co-lead underwriter with WaMu to securitize $532 million in subprime second-lien, fixed-rate mortgages originated at Long Beach? Does that sound reasonable to you? " fcic_final_report_full--135 When the initial quantitative analysis was complete, the lead analyst on the deal convened a rating committee of other analysts and managers to assess it and deter- mine the overall ratings for the securities.  Siegel told the FCIC that qualitative analysis was also integral: “One common misperception is that Moody’s credit rat- ings are derived solely from the application of a mathematical process or model. This is not the case. . . . The credit rating process involves much more—most importantly, the exercise of independent judgment by members of the rating committee. Ulti- mately, ratings are subjective opinions that reflect the majority view of the commit- tee’s members.”  As Roger Stein, a Moody’s managing director, noted, “Overall, the model has to contemplate events for which there is no data.”  After rating subprime deals with the  model for years, in  Moody’s intro- duced a parallel model for rating subprime mortgage–backed securities. Like M Prime, the subprime model ran the mortgages through , scenarios.  Moody’s officials told the FCIC they recognized that stress scenarios were not sufficiently se- vere, so they applied additional weight to the most stressful scenario, which reduced the portion of each deal rated triple-A. Stein, who helped develop the subprime model, said the output was manually “calibrated” to be more conservative to ensure predicted losses were consistent with analysts’ “expert views.” Stein also noted Moody’s concern about a suitably negative stress scenario; for example, as one step, analysts took the “single worst case” from the M Subprime model simulations and multiplied it by a factor in order to add deterioration.  Moody’s did not, however, sufficiently account for the deteriorating quality of the loans being securitized. Fons described this problem to the FCIC: “I sat on this high- level Structured Credit committee, which you’d think would be dealing with such is- sues [of declining mortgage-underwriting standards], and never once was it raised to this group or put on our agenda that the decline in quality that was going into pools, the impact possibly on ratings, other things. . . . We talked about everything but, you know, the elephant sitting on the table.”  To rate CMLTI -NC, our sample deal, Moody’s first used its model to simu- late losses in the mortgage pool. Those estimates, in turn, determined how big the jun- ior tranches of the deal would have to be in order to protect the senior tranches from losses. In analyzing the deal, the lead analyst noted it was similar to another Citigroup deal of New Century loans that Moody’s had rated earlier and recommended the same amount.  Then the deal was tweaked to account for certain riskier types of loans, in- cluding interest-only mortgages.  For its efforts, Moody’s was paid an estimated ,.  (S&P also rated this deal and received ,.)  As we will describe later, three tranches of this deal would be downgraded less than a year after issuance—part of Moody’s mass downgrade on July , , when housing prices had declined by only . In October , the M–M tranches were downgraded and by , all the tranches had been downgraded. Of all mort- gage-backed securities it had rated triple-A in , Moody’s downgraded  to junk.  The consequences would reverberate throughout the financial system. CHRG-111hhrg67816--180 Mr. Rush," I have less than 1 minute, and I just want to ask another question on pay-day lending. I believe that pay-day lenders have a role in our economy but there are far too many abuses. Does the FTC have authority to crack down on pay-day lending practices such as rollover fees and the specific statutory language leading to direct the Commission to adequately deal with certain abusive pay-day lending features? " CHRG-111hhrg54872--100 Mr. Shelton," I have an opinion. My opinion is very well that payday lending is absolutely necessary which is why the demand is so high. However, payday lending is extremely unfair in that the APR if you factor throughout most States ends up being astronomical. " CHRG-110hhrg46596--76 Mr. Bachus," I understand. Is there leverage under the law, or under the lending regulations, to require them to lend it, as opposed to, say, they pay the amount of dividend or to make acquisitions? I will ask Mr. Kashkari or either one of you gentlemen. " CHRG-110shrg46629--5 STATEMENT OF SENATOR SHERROD BROWN Senator Brown. Thank you, Mr. Chairman. And Chairman Bernanke, thank you very much for joining us this morning. I am particularly pleased that your testimony describes Congress as prescient in the trend toward transparency. It is not often you see the words Congress and prescient in the same sentence. Thank you for that. Of course, you are referring to an action 30 years ago, but we will take what we can get. As you know, we need to encourage transparency in both central banking and in financial services and particularly in the mortgage business. I appreciate your devoting much of your testimony in the work of the Federal Reserve in promoting better disclosure for mortgage borrowers and hope you and your colleagues will approach this task with great urgency. As you know, the loans of close to 2 million subprime borrowers will reset in the next 2 years. Every day of inaction means another 2,000 to 3,000 mortgages will reset without sufficient protections. If they are lucky, many of these families will be able to take out another lousy mortgage. If they are unlucky, they may lose their life savings. The Federal Reserve must act and must act quickly both to mitigate the damage that has already been done and to prevent a continuation of the abusive practices and products that have characterized too much of the mortgage industry over the past few years. I understand why a lender needs to price for risk but I do not understand why the structure of mortgage products is so different in the prime and subprime markets. Most of the people in this room do not have a prepayment penalty on their mortgage. Most of us have our property taxes and our hazardous insurance escrowed. By contrast, the loans in the subprime sector, like the 228s, seem almost designed to deceive. They are sold to borrowers with teaser rates and with dangerous features and with the smooth pitch that there is no need to worry about the reset because good things might happen in your life, a better job, a better loan, even winning the lottery. But betting on the outcome is not a sound banking practice. It is possible that I will play like Grady Sizemore in next year's Congressional baseball game but the Indians would be well advised not to put him on waivers. Sadly, it is not very likely I will climb the fence to rob somebody of a home run next summer because Republicans just do not have that kind of power. You obviously need to take a broad view in your position. But the very dispersion of risk that makes the subprime problem less of a worry from an economic standpoint makes it a greater problem for homeowners trying to work out an unaffordable loan. We all know it makes economic sense for a lender to mitigate losses but just try getting the right person on the phone in a timely fashion, especially if the owner of the loan sits in Shanghai. One man's junk is another man's treasure. What may look like BBB debt to an investor on Wall Street is really the hopes and dreams of thousands of families in Slavic Village in Cleveland and across the country. Those hopes and dreams diminish with every day that we delay. So, I would urge you to take action quickly and comprehensively. You need to bring an end to the deceptive practices in the subprime sector, not just for banks and their affiliates but for all mortgage brokers and all types of lenders. Thank you. I look forward to your testimony. " FOMC20070509meeting--86 84,MR. KROSZNER.," Thank you very much. The last time we met, one theme was the greater uncertainty, and Governor Kohn mentioned that he is feeling greater uncertainty now than he ever had. I am not sure that greater uncertainty has been the tenor of the comments here today, but I think it has been greater uncertainty with downside risk. So the key issue from last time that I think is still with us is that we certainly saw evidence of the slowdown and, as President Stern mentioned, that sometimes we have to acknowledge reality, and we did have much slower growth than many people had been expecting in the two previous meetings. The Greenbook suggests that the slowdown is unlikely to persist—and I broadly agree with that view, as do many people around the table—but I want to review five key uncertainties that we talked about last time and to discuss how they developed and where they are likely to go. The first uncertainty is investment, and of course, a lot of us have spoken about that. I would rate the level of uncertainty as still elevated there. I am not going to use color coding to rate that uncertainty, but I would say it is still elevated. We have recently gotten some more-solid numbers, but those are just recent; and I think it is still more a glimmer of hope than something we can bank on that we are going to get a turnaround in investment. That we have seen some better numbers in ISM, durable goods, and so forth says that the direction is perhaps a little more positive than we were thinking six weeks ago. But there is still a reasonable amount of uncertainty about whether the pickup in business investment will help offset any slowdown in consumption to make sure that we continue to grow in the 2 percent range going forward. The second uncertainty is productivity and potential output. Obviously that is still at an elevated level. As far as I am concerned, it is one of the biggest challenges for us to think about in the intermediate run. In particular, a downside scenario that concerns me is that, if we do not have a pickup in investment, we are unlikely to see a sustained rise in productivity growth. If perhaps one reason for the lower investment is that there are concerns about productivity growth or returns from that investment, we could have a fairly negative scenario in which we get much lower potential output. Offsetting that concern is that we are seeing some glimmers of hope on investment. With respect to potential, I think it is appropriate that the Greenbook has raised participation rates a bit, given that older people seem to be healthier than previous cohorts were and seem to be more willing to work. However, I think the big question mark is, exactly as David said, that not until August will we get a better feel for which way the data revision will go because the difference between the two sides of the balance sheet is fairly big. Broadly, I share Gary Stern’s optimism that it is not a good bet to bet against the U.S. economy and against ultimately good productivity growth. But I have the concern that I do not fully understand the slowness of the investment recovery and some of the productivity slowdown. There is potentially a worrying downside scenario there. Third is the uncertainty about the housing market and subprime. Well, obviously, uncertainty on subprime was highly elevated then, and it has come down quite a bit. We have seen some tightening of lending standards, particularly at the lower end. The survey of senior loan officers asked for a differentiation between subprime and prime lending standards. It showed a very dramatic increase in subprime standards, which is exactly what we would expect in this kind of market, certainly potentially reducing demand at least in the lower end of the housing market. About the housing market in and of itself, the uncertainty is still there. We still have a lot of uncertainty about whether the numbers are telling us about weather or about the actual strength of the market. As I think I have mentioned to a number of you before, we need to have, besides Dave, a meteorologist on the staff to forecast the weather because every number we hear on the housing market is not a number in which we can put any stock; it all has to do with heat or cold or rain or snow or whatever other thing that Mother Nature may throw at us. So I still think there is a pretty mixed picture there. As I said, we have seen very little evidence of spillovers from the subprime market. The main concern, and this is a variation of what Governor Warsh said, is that something we or the Congress might do might cut off this market. We have to be mindful of any actions that we may be taking with respect to guidance, as well as of any actions that the Congress may be taking, that could reduce this market more than otherwise. The yield curve is favorable for a lot of the variable-rate subprime borrowers to move into fixed-rate products, with payment shock of perhaps no more than 50 basis points. The delinquencies we have been seeing have not been due to resets or to payment shock. They have been due primarily to the so-called juvenile delinquents—the early defaulters going bad. That means that we do not know what is coming down the line because we have not really seen the experience of the resets. Now, with the recently benign yield curve, that situation could reasonably be worked out. The key is whether any equity is left. If no equity is left and the resets come, these guys are likely to walk. If they have been doing risk layering—putting really no money down—and the prices go down, that will be a problem. So I think that may be a bit of a slow burn. Coupled with the broader misalignment that we are seeing now of a little increase in housing starts, which in some ways we would see as a positive, is a sort of negative given that housing sales seem to be declining so much. Thus there seems to be a disconnect between supply and demand, and I think the Greenbook is now quite wisely saying that we will likely have a longer transition in the housing market. A fourth area of uncertainty that we talked about last time was the financial markets—the dramatic spike up in volatility. That volatility spike has come down, but we, being good economists, can never be satisfied with either high volatility or low volatility. Low volatility is of concern to us, and I very much share the concerns that Tim, Cathy, Kevin, and others have mentioned. Not only in the United States, but also in the rest of the world, are some of those spreads a bit narrower than they otherwise would be. In particular, there are concerns about banks chasing private equity deals going covenant-free. In many of my discussions with private equity folks, instead of saying, well, bring us on more capital, those contacts are the ones saying that the banks are pushing them to take greater leverage than they otherwise would want. Now, if that isn’t the fox guarding the henhouse, I do not know what is. You want the banks to be the disciplinary force, and that they would potentially be taking on very large risks is a real concern. The fifth area of uncertainty was consumption. We have seen a bit of a step-down in consumption growth, but there is still a lot of uncertainty, and I share the exact concerns that Governor Kohn articulated; given that there are likely to be some wealth effects, even though we have some offsetting effects in the stock market, I do not want to bet on those offsetting effects in the stock market being there for the next three quarters. Housing wealth seems to be flattening, if not coming down, with the Case-Shiller index on average for those ten markets down 3 to 5 percent. If people’s thinking about their consumption pattern is based on some increase in housing wealth, the saving rate should at least gradually increase. At some point, that reality may be biting and leading to some concern. On the inflation front, once again, we will have continuing uncertainty about what drives short-term to intermediate-term inflation. As I mentioned last time, we get very, very mild effects from the traditional things that we think that make a difference. Oil, energy, commodity prices, and resource utilization don’t seem to have that much force, but in both the short and intermediate terms I think they are leaning on the positive side rather than on the negative side. We still have the owners’ equivalent rent issue that is coming in with the transition in the housing market and is still to some extent temporarily pushing up our measured inflation rates. Inflation expectations continue to seem to be quite well contained, and that, I think, is key because, given that these other forces do not seem to be important in the short to intermediate run, inflation expectations are very important. So my bottom line is that, although I see some downside risks on growth, I think the Greenbook scenario is a reasonable central tendency one, and I see some important upside risks on inflation." CHRG-111shrg53085--142 Mr. Attridge," Well, Senator, I guess from the community banks' point of view, at least the community banks in Connecticut and I know there are some in other parts of the country that are more stressed out because of the real estate issues in the area they are in, but we are well capitalized. We have the money to lend. We are lending and we are looking for loans and there is competition out there for good loans. The problem is on the other side. The small businesses are not looking for---- Senator Schumer. Let me tell you a story I heard, and this is a Connecticut story. It is about a gentleman who applied for a job with me, OK. His father owns a small home heating oil delivery business. It has, I don't know, about 50 employees, ten trucks, I don't know how many. It had a $4 million line of credit with one of the larger banks, not a community bank, probably one of--I am certain it is one of Mr. Patterson's members. They pulled the line of credit. He has gone everywhere under the sun to try to find a substitute line of credit. This business is profitable. People are still buying home heating oil in Southwestern Connecticut. He can't find it. So you tell me your people are lending. Mr. Patterson tells me his people are lending. Every one of us at the table has had businesses calling us and saying they can't find the lending. " CHRG-111hhrg54872--181 Mr. Calhoun," Congressman Scott, I would like to express concerns about creating these exemptions because of the difficulties that has created in the past. One of the biggest examples was, just a few years ago, in fact even when we were looking at the predatory mortgage bill hear this committee, there were efforts to exclude FHA with the argument that FHA loans are a very small part of the market. They were about 2 percent a few years ago, and they were the generally safer loans. However, in the last year, we have seen the very subprime lenders invade FHA. You can go on the Web sites and see ads for, here is how you transfer your business. And there are subprime lenders who have literally converted into FHA lenders. One of the beauties of and I think real core strengths of this bill is it looks at products, not the label that is put on the product or the label that is put on the financial services provider, because that has created a lot of problems. In this specific limited exception, it may be okay. But these exceptions have created a lot of dangers in the past. " CHRG-111shrg56415--37 Mr. Tarullo," Senator, I think leverage on the expectation of rising asset prices was at the heart of the subprime problem, and indeed, it is at the heart of some of the other problems that we see, to some degree, in commercial real estate, as well. So, I would try to reinforce any instinct you have to push people toward better underwriting standards, and we, as the Chairman noted, are trying to do that ourselves. " CHRG-111hhrg52397--299 Mr. Manzullo," Thank you, Mr. Chairman. Let me ask a very basic question. I believe that we would not be in this crisis that we are today if the subprime market had not gone sour and thus tainted the basis of the investments, which grew, the investments grow obviously exponentially through derivatives. Does that statement make sense or am I missing something on it? " CHRG-111hhrg52406--125 Mr. Gutierrez," Sure. Mr. Miller of California. I want to make myself clear so you don't misunderstand me. I think that the problem we faced in recent years was we failed to define predatory versus subprime. And lenders went out and acted, and some individuals acted as if there were no underwriting standards necessary that should apply to a loan. " CHRG-111shrg54675--92 RESPONSE TO WRITTEN QUESTIONS OF SENATOR KOHL FROM FRANK MICHAELQ.1. I have heard from many small businesses struggling to find lines of credit and keep their doors open. How has the member business lending cap affected the ability of credit unions to make small business loans to their members? Does your organization have any data showing that more small businesses would be served if the member business lending cap was increased by loan size and volume? In the current credit crisis, do you believe that credit unions are able to provide more loans to small businesses and should the cap be raised?A.1. The member business lending cap has affected the ability of credit unions to make small business loans to their members in two ways. First, many of the roughly one quarter of credit unions that offer business loans are getting sufficiently close to the cap for it to affect their behavior. Long before a credit union actually reaches the arbitrary 12.25 percent cap it must begin to moderate its business lending in order to stay below the cap. Considering the vast majority of credit unions that were not originally grandfathered from the cap, fully 38 percent of credit union business loans outstanding are in credit unions with more than 10 percent of assets in business loans. That means that almost 40 percent of the market is essentially frozen. Another 21 percent of the business loans outstanding in credit unions that are not grandfathered is in credit unions with business loans between 7.5 percent and 10 percent of assets. These credit unions are approaching the territory at which they will need to moderate business lending growth. A total of almost 60 percent of nongrandfathered credit union business loans is in credit unions at or near the cap. Second, the cap not only restricts the credit unions that are engaging in business lending and approaching their limit, but also discourages credit unions who would like to enter the business lending market. The cap effectively limits entry into the business lending arena on the part of small- and medium-sized credit unions--the vast majority of all credit unions--because the startup costs and requirements, including the need to hire and retain staff with business lending experience, exceed the ability of many credit unions with small portfolios to cover these costs. Today, only one in four credit unions have MBL programs and aggregate credit union member business loans represent only a fraction of the commercial loan market. Eliminating or expanding the limit on credit union member business lending would allow more credit unions to generate the level of income needed to support compliance with NCUA's regulatory requirements and would expand business lending access to many credit union members, thus helping local communities and the economy. CUNA has produced an estimate of how much additional business lending could be provided by credit unions if the cap were raised to 25 percent of assets. We assume that all current business lending credit unions will hold business loans in the same proportion to the new cap that they currently do to the existing cap, and that they will use one half of the new authority in the first year. Further, we assume that on average credit unions that currently make no business loans will as a group add business loans equal to 1 percent of their assets. Applying these assumptions to second quarter NCUA Call Report data indicates an additional $12.5 billion in business loans for America's small businesses. Based on this analysis, we conservatively project that credit unions could provide up to an additional $10 billion of business loans in the first year after the raising of the cap. ------ fcic_final_report_full--104 The starting point for many mortgages was a mortgage broker. These independ- ent brokers, with access to a variety of lenders, worked with borrowers to complete the application process. Using brokers allowed more rapid expansion, with no need to build branches; lowered costs, with no need for full-time salespeople; and ex- tended geographic reach. For brokers, compensation generally came as up-front fees—from the borrower, from the lender, or both—so the loan’s performance mattered little. These fees were often paid without the borrower’s knowledge. Indeed, many borrowers mistakenly be- lieved the mortgage brokers acted in borrowers’ best interest.  One common fee paid by the lender to the broker was the “yield spread premium”: on higher-interest loans, the lending bank would pay the broker a higher premium, giving the incentive to sign the borrower to the highest possible rate. “If the broker decides he’s going to try and make more money on the loan, then he’s going to raise the rate,” said Jay Jeffries, a for- mer sales manager for Fremont Investment & Loan, to the Commission. “We’ve got a higher rate loan, we’re paying the broker for that yield spread premium.”  In theory, borrowers are the first defense against abusive lending. By shopping around, they should realize, for example, if a broker is trying to sell them a higher- priced loan or to place them in a subprime loan when they would qualify for a less- expensive prime loan. But many borrowers do not understand the most basic aspects of their mortgage. A study by two Federal Reserve economists estimated at least  of borrowers with adjustable-rate mortgages did not understand how much their in- terest rates could reset at one time, and more than half underestimated how high their rates could reach over the years.  The same lack of awareness extended to other terms of the loan—for example, the level of documentation provided to the lender. “Most borrowers didn’t even realize that they were getting a no-doc loan,” said Michael Calhoun, president of the Center for Responsible Lending. “They’d come in with their W- and end up with a no-doc loan simply because the broker was getting paid more and the lender was getting paid more and there was extra yield left over for Wall Street because the loan carried a higher interest rate.”  And borrowers with less access to credit are particularly ill equipped to challenge the more experienced person across the desk. “While many [consumers] believe they are pretty good at dealing with day-to-day financial matters, in actuality they engage in financial behaviors that generate expenses and fees: overdrawing checking ac- counts, making late credit card payments, or exceeding limits on credit card charges,” Annamaria Lusardi, a professor of economics at Dartmouth College, told the FCIC. “Comparing terms of financial contracts and shopping around before making finan- cial decisions are not at all common among the population.”  Recall our case study securitization deal discussed earlier—in which New Cen- tury sold , mortgages to Citigroup, which then sold them to the securitization trust, which then bundled them into  tranches for sale to investors. Out of those , mortgages, brokers originated , on behalf of New Century. For each, the brokers received an average fee from the borrowers of ,, or . of the loan amount. On top of that, the brokers also received yield spread premiums from New Century for , of these loans, averaging , each. In total, the brokers received more than . million in fees for the , loans.  CHRG-111shrg51303--53 Mr. Dinallo," No, I don't actually disagree with that. I agree with it. The only difference is causation. As I said, the 25 other domestic life insurance companies that we have examined have not had a problem with their securities lending. The causation of AIG's problem with its securities lending business was essentially the run on the entire company caused by its exposure from Financial Products division. Senator Shelby. Could you briefly walk us through the balance sheets for the life insurance companies under your jurisdiction? What was their capital at the start of 2008 and what were their losses in securities lending in that year? If you would take just a second. I know my time is up, but I think that is important. " CHRG-111shrg54675--97 RESPONSE TO WRITTEN QUESTIONS OF SENATOR KOHL FROM ED TEMPLETONQ.1. I have heard from many small businesses struggling to find lines of credit and keep their doors open. How has the member business lending cap affected the ability of credit unions to make small business loans to their members? Does your organization have any data showing that more small businesses would be served if the member business lending cap was increased by loan size and volume? In the current credit crisis, do you believe that credit unions are able to provide more loans to small businesses and should the cap be raised?A.1. When Congress passed the Credit Union Membership Access Act (CUMAA) (P.L. 105-219) in 1998, they put in place restrictions on the ability of credit unions to offer member business loans. Congress codified the definition of a member business loan and limited a credit union's member business lending to the lesser of either 1.75 times the net worth or 12.25 percent of total assets. Also pursuant to section 203 of CUMAA Congress mandated that the Treasury Department study the issue of credit unions and member business lending. In January 2001, the Treasury Department released the study, ``Credit Union Member Business Lending'' that found, among other things: Overall, credit unions are not a threat to the viability and profitability of other insured depository institutions. In certain instances, however, credit unions that engage in member business lending may be an important source of competition for small banks and thrifts operation in the same geographic areas. Congress has not revisited this issue since the study came out. The arbitrary member business lending cap placed on credit unions is a detriment to credit unions ability to serve their members and America's small businesses. A number of credit unions are at or near the MBL cap, and a significant number shy away from business lending programs altogether because of the arbitrary cap and the restrictions it places on the ability to operate a business loan program. Additionally, the definition of a member business loan has not been updated for inflation in over a decade, meaning the $50,000 minimum level set in 1998 needs to be updated. Credit union economists have estimated that removing the member business lending cap could help credit unions provide $10 billion in new small business loans in the first year alone. Removing the credit union member business lending cap would help provide economic stimulus without costing the taxpayer a dime. Senator Schumer has indicated his interest in introducing legislation to remove this cap and we would urge the Committee to support him in these efforts. ------ CHRG-111hhrg52397--188 Mr. Foster," And if I go to the next smaller slice is credit default swaps at 7 percent. And a general question, would have forcing all of the OTC derivatives on to clearing or an exchange have prevented AIG financial products, at least the part that was not related to the mortgage lending or their securities lending business? " CHRG-110hhrg38392--11 Mr. Bernanke," I will do my opening statement. Thank you. Chairman Frank, Ranking Member Bachus, and members of the committee, I am pleased to present the Federal Reserve's Monetary Policy Report to the Congress. As you know, this occasion marks the 30th year of semiannual testimony on the economy and monetary policy for the Federal Reserve. In establishing these hearings--Mr. Hawkins and Mr. Humphrey were mentioned--the Congress proved prescient in anticipating the worldwide trend toward greater transparency and accountability of central banks in making monetary policy. Over the years, these testimonies and the associated reports have proved an invaluable vehicle for the Federal Reserve's communication with the public about monetary policy, even as they have served to enhance the Federal Reserve's accountability for achieving the dual objectives of maximum employment and price stability set forth by the Congress. I take this opportunity to reiterate the Federal Reserve's strong support of the dual mandate. In pursuing maximum employment and price stability, monetary policy makes its greatest possible contribution to the general economic welfare. Let me now review the current economic situation and the outlook beginning with developments in the real economy and the situation regarding inflation before turning to monetary policy. I will conclude with comments on issues related to lending to households and consumer protection, topics not normally addressed in monetary policy testimony, but in light of recent developments deserving of our attention today. After having run at an above-trend rate earlier in the current economic recovery, U.S. economic growth has proceeded during the past year at a pace more consistent with sustainable expansion. Despite the downshift in growth, the demand for labor has remained solid with more than 850,000 jobs being added to payrolls thus far in 2007 and the unemployment rate having remained at 4\1/2\ percent. The combination of moderate gains in output and solid advances in employment implies that recent increases in labor productivity have been modest by the standards of the last decade. The cooling of productivity growth in recent quarters is likely the result of cyclical or other temporary factors, but the underlying pace of productivity gains may also have slowed somewhat. To a considerable degree, the slower pace of economic growth in recent quarters reflects the ongoing adjustment in the housing sector. Over the past year, home sales in construction have slowed substantially and house prices have decelerated. Although a leveling off of home sales in the second half of 2006 suggested some tentative stabilization of housing demand, sales have softened further this year, leading the number of unsold new homes in builders' inventories to rise further relative to the pace of new home sales. Accordingly, construction of new homes has sunk further, with starts of new single family houses thus far this year running 10 percent below the pace in the second half of last year. The pace of home sales seems likely to remain sluggish for a time, partly as a result of some tightening and lending standards and the recent increase in mortgage interest rates. Sales should ultimately be supported by growth in income and employment, as well as by mortgage rates that--despite the recent increase--remain fairly low relative to historical norms. However, even if demand stabilizes as we expect, the pace of construction will probably fall somewhat further as builders work down the stocks of unsold new homes. Thus, declines in residential construction will likely continue to weigh on economic growth over coming quarters, although the magnitude of the drag on growth should diminish over time. Real consumption expenditures appear to have slowed last quarter following two quarters of rapid expansion. Consumption outlays are likely to continue growing at a moderate pace, aided by a strong labor market. Employment should continue to expand, though possibly at a somewhat slower pace than in recent years as a result of the recent moderation in the growth of output and ongoing demographic shifts that are expected to lead to a gradual decline in labor force participation. Real compensation appears to have risen over the past year, and barring further sharp increases in consumer energy costs, it should rise further as labor demand remains strong and productivity increases. In the business sector, investment in equipment and software showed a modest gain in the first quarter. A similar outcome is likely for the second quarter, as weakness in the volatile transportation equipment category appears to have been offset by solid gains in other categories. Investment in nonresidential structures, after slowing sharply late last year, seems to have grown fairly vigorously in the first half of 2007. Like consumption spending, business fixed investment overall seems poised to rise at a moderate pace, bolstered by gains in sales and generally favorable financial conditions. Late last year and early this year, motor vehicle manufacturers and firms in several other industries found themselves with elevated inventories, which led them to reduce production to better align inventories with sales. Excess inventories now appear to have been substantially eliminated and should not prove a further restraint on growth. The global economy continues to be strong. Supported by solid economic growth abroad, U.S. exports should expand further in coming quarters. Nonetheless our trade deficit, which was about 5\1/4\ percent of nominal gross domestic product in the first quarter, is likely to remain high. For the most part, financial markets have remained supportive of economic growth. However, conditions in the subprime mortgage sector have deteriorated significantly reflecting mounting delinquency rates on adjustment rate loans. In recent weeks, we have also seen increased concerns among investors about credit risk on some other types of financial instruments. Credit spreads on lower quality corporate debt have widened somewhat and terms for some leveraged business loans have tightened. Even after their recent rise, however, credit spreads remain near the low end of their historical ranges and financing activity in the bond and business loan markets has remained fairly brisk. Overall, the U.S. economy appears likely to expand at a moderate pace over the second half of 2007 with growth then strengthening a bit in 2008 to a rate close to the economy's underlying trend. Such an assessment was made around the time of the June meeting of the Federal Market Committee by the members of the Board of Governors and the presidents of the Reserve Banks, all of whom participate in deliberations on monetary policy. The central tendency of the growth forecast, which are conditioned on the assumption of appropriate monetary policy, is for real GDP to expand roughly 2\1/4\ to 2\1/2\ percent this year and 2\1/2\ to 2\3/4\ percent in 2008. The forecasted performance for this year is about \1/4\ percentage point below that projected in February, the difference being largely a result of weaker than expected residential construction activity this year. The unemployment rate is anticipated to edge up between 4\1/2\ and 4\3/4\ percent over the balance of this year and about 4\3/4\ percent in 2008, a trajectory about the same as the one expected in February. I turn now to the inflation situation. Sizable increases in food and energy prices have boosted overall inflation and eroded real incomes in recent months, both unwelcome developments. As measured by changes in the price index for personal consumption expenditures (PCE inflation), inflation ran at an annual rate of 4.4 percent over the first 5 months of this year, a rate that, if maintained, would clearly be inconsistent with the objective of price stability. Because monetary policy works with a lag, however, policymakers must focus on the economic outlook. Food and energy prices tend to be quite volatile, so that, looking forward, core inflation (which excludes food and energy prices) may be a better gauge than overall inflation of underlying inflation trends. Core inflation has moderated slightly over the past few months, with core PCE inflation coming in at an annual rate of about 2 percent so far this year. Although the most recent readings on core inflation have been favorable, month-to-month movements in inflation are subject to considerable noise, and some of the recent improvement could also be the result of transitory influences. However, with long-term inflation expectations contained, futures prices suggesting that investors expect energy and other commodity prices to flatten out, and pressures in both labor and product markets likely to ease modestly, core inflation should edge a bit lower, on net, over the remainder of this year and next year. The central tendency of FOMC participants' forecast for core PCE inflation--2 to 2\1/4\ percent for 2007 and 1\3/4\ to 2 percent in 2008--is unchanged from February. If energy prices level off as currently anticipated, overall inflation should slow to a pace close to that of core inflation in coming quarters. At each of its four meetings so far this year, the FOMC has maintained its target for the Federal funds rate at 5\1/4\ percent, judging that the existing stance of policy was likely to be consistent with growth running near trend and inflation staying on a moderating path. As always, in determining the appropriate stance of policy, we will be alert to the possibility that the economy is not evolving in the way we currently judge to be the most likely. One risk to the outlook is that the ongoing housing correction might prove larger than anticipated with possible spillovers onto consumer spending. Alternatively, consumer spending, which has advanced relatively vigorously, on balance, in recent quarters, might expand more quickly than expected; in that case, economic growth could rebound to a pace above its trend. With the level of resource utilization already elevated, the resulting pressures in labor and product markets could lead to increased inflation over time. Yet another risk is that energy and commodity prices could continue to rise sharply leading to further increases in headline inflation, and if those costs pass through to the prices of nonenergy goods and services, to higher core inflation as well. Moreover, if inflation were to move higher for an extended period and the increase became embedded in longer-term inflation expectations, the reestablishment of price stability would become more difficult and costly to achieve. With the level of resource utilization relatively high and with the sustained moderation in inflation pressures yet to be convincingly demonstrated, the FOMC has consistently stated that upside risks to inflation are its predominant policy concern. In addition to its dual mandate to promote maximum employment and price stability, the Federal Reserve has an important responsibility to help protect consumers in financial services transactions. For nearly 40 years, the Federal Reserve has been active in implementing, interpreting, and enforcing consumer protection laws. I would like to discuss with you this morning some of our recent initiatives and actions, particularly those related to subprime mortgage lending. Promoting access to credit and to home ownership are important objectives, and responsible subprime mortgage lending can help to advance both goals. In designing regulations, policymakers should seek to preserve those benefits. That said, the recent rapid expansion of the subprime market was clearly accompanied by deterioration in underwriting standards, and in some cases, by abusive lending practices and outright fraud. In addition, some households took on mortgage obligations they could not meet, perhaps in some cases because they did not fully understand the terms. Financial losses have subsequently induced lenders to tighten their underwriting standards. Nevertheless, rising delinquencies in foreclosures are creating personal, economic, and social distress for many homeowners and communities, problems that likely will get worse before they get better. The Federal Reserve is responding to these difficulties at both the national and the local levels. In coordination with other Federal supervisory agencies, we are encouraging the financial industry to work with borrowers to arrange prudent loan modifications to avoid unnecessary foreclosures. Federal Reserve banks around the country are cooperating with community and industry groups that work directly with borrowers who are having trouble meeting their mortgage obligations. We continue to work with organizations that provide counseling about mortgage products to current and potential homeowners. We are also meeting with market participants--including lenders, investors, servicers, and community groups--to discuss their concerns and to gain information about market developments. We are conducting a top-to-bottom review of possible actions we might take to help prevent recurrence of these problems. First, we are committed to providing more effective disclosures to help consumers defend against improper lending. Three years ago, the Board began a comprehensive review of Regulation Z, which implements the Truth in Lending Act (TILA). The initial focus of our review was on disclosures related to credit cards and other revolving credit accounts. After conducting extensive consumer testing, we issued a proposal in May that would require credit card issuers to provide clearer and easier-to-understand disclosures to customers. In particular, the new disclosures would highlight applicable rates and fees, particularly penalties that might be imposed. The proposed rules would also require card issuers to provide 45 days' advance notice of a rate increase or any other change in account terms so that consumers will not be surprised by unexpected charges and will have time to explore alternatives. We are now engaged in a similar review of the TILA rules for mortgage loans. We began this review last year by holding four public hearings across the country during which we gathered information on the adequacy of disclosures for mortgages, particularly for nontraditional and adjustable rate products. As we did with credit card lending, we will conduct extensive consumer testing of proposed disclosures. Because the process of designing and testing disclosures involves many trial runs, especially given today's diverse and sometimes complex credit products, it may take some time to complete our review and propose new disclosures. However, some other actions can be implemented more quickly. By the end of this year, we will propose changes to TILA rules to address concerns about mortgage loan advertisements and solicitations that may be incomplete or misleading and to require lenders to provide mortgage disclosures more quickly so that consumers can get the information they need when it is most useful to them. We already have improved a disclosure that creditors must provide to every applicant for an adjustable rate mortgage to explain better the features and risks of these products, such as ``payment shock'' and rising loan balances. We are certainly aware, however, that disclosure alone may not be sufficient to protect consumers. Accordingly, we plan to exercise our authority under the Home Ownership and Equity Protection Act (HOEPA) to address specific practices that are unfair or deceptive. We held a public hearing on June 14th to discuss industry practices, including those pertaining to prepayment penalties, the use of escrow accounts for taxes and insurance, stated income and low documentation lending, and the evaluation of a borrower's ability to repay. The discussion and ideas we heard were extremely useful, and we look forward to receiving additional public comments in coming weeks. Based on the information we are gathering, I expect that the Board will propose additional rules under HOEPA later this year. In coordination with the other Federal supervisory agencies, last year we issued principles-based guidance on nontraditional mortgages, and in June of this year, we issued supervisory guidance on subprime lending. These statements emphasize the fundamental consumer protection principles of sound underwriting and effective disclosures. In addition, we reviewed our policies related to the examination of nonbank subsidiaries of bank and financial holding companies for compliance with consumer protection laws and guidance. As a result of that review, and following discussions with the Office of Thrift Supervision, the Federal Trade Commission, and State regulators, as represented by the Conference of State Bank Supervisors and the American Association of Residential Mortgage Regulators, we are launching a cooperative pilot project aimed at expanding consumer protection compliance reviews at selected nondepository lenders with significant subprime mortgage operation. These reviews will begin in the fourth quarter of this year and will include independent State-licensed mortgage lenders, nondepository mortgage lending subsidiaries of bank and thrift holding companies, and mortgage brokers doing business with or serving as agents of these entities. The agencies will collaborate in determining the lessons learned and in seeking ways to better cooperate in ensuring effective and consistent examinations and improved enforcement for nondepository mortgage lenders. Working together to address jurisdictional issues and to improve information sharing among agencies, we will seek to prevent abusive and fraudulent lending while ensuring that consumers retain access to beneficial credit. I believe that the actions I have described today will help address the current problems. The Federal Reserve looks forward to working with the Congress on these important issues. Thank you, Mr. Chairman. [The prepared statement of Chairman Bernanke can be found on page 65 of the appendix.] " CHRG-111hhrg53240--6 Mr. Bachus," I thank the chairman. I thank you for convening this hearing on consumer protection and the role of the Federal Reserve. And I would like to personally welcome Governor Elizabeth Duke. I guess ``welcome'' is a good word. You are welcome. Obviously, you have a difficult task any time you face a subcommittee. And I am not sure who selected you as the one to come up here, but I think it was a very capable decision. At one point in her distinguished career, she was the head of the community banking for one of our long-based Birmingham banks. And I thank you for being here. As we heard in this morning's hearing, and it is likely to come out in this hearing, proponents of the Administration's proposal to create a Consumer Financial Protection Agency are contending that there was a massive failure in consumer protection on the part of the Federal Reserve, and that failure led to the collapse of the global economy. I think that is an oversimplification and unduly unjust criticism. And there is lots to criticize about the Fed's response to the growth and the collapse of the subprime mortgage market, as well as the agency's handling of the credit crisis and the turmoil in the financial markets. In addition, we all agree that comprehensive reform of our financial regulatory system is needed. But I think it is, or should be, clear to all of us that last September, the challenges that the central bank faced were without precedent and that Chairman Bernanke and the Federal Reserve, in combination with the other regulators, the Administration, and the Congress acted with good intentions, and I believe averted a much more catastrophic economic collapse. I am not sure this Congress and the people we represent fully realize that they did some very good work. Both the Democrats' regulatory reform proposal and a plan we have put forth strips the Federal Reserve of its consumer protection mandate. And it does that although--with both the subprime lending regulations in 2007, and the credit card regulations of the Fed advanced in 2008 were very good. In fact, in a bipartisan way, both the chairman of the full committee and I as ranking member and most of the members complimented you on that work and, I think, had--I think they were very good. The difference in the Republican plan is that it streamlines and consolidates the functions of the four bank regulators, including consumer protection, into a single umbrella agency; and this creates clear lines of accountability and prevents regulatory authorities from passing the buck. In contrast, the Democrats' plan adds a massive new layer of bureaucracy with broad undefined and arbitrary powers to a brand-new agency with absolutely no experience. It is a plan that continues the kind of turf battles that undermine rather than promote effective consumer protection. In closing, let me say that I understand that Governor Duke will be suggesting some other approaches and I think other approaches probably will carry the day, given the Fed's extensive regulatory expertise and their recent successes in this regard, we have a responsibility to carefully consider them and judge them on the merits. Thank you, Mr. Chairman. " CHRG-111hhrg55809--201 Mr. Bernanke," Well, it is first certainly true that we are better off than we were with the system in crisis. It is also true that the banks have not returned to normal lending by any means. I think the low interest rates do have positive effects on the economy, for example, operating through other markets, like the mortgage market or the corporate bond market. But getting the banking system back into a lending mode is very important. We continue to work with the banks to encourage them to raise equity so they have sufficient capital to support their lending. We have provided them with an enormous amount of liquidity so they are able to have the funds to lend. We are encouraging them to lend, in that going back to November, the bank regulators had a joint statement encouraging banks to lend to creditworthy borrowers as being in the interest both of the banks and of the economy. And we continue to try to follow up on all those things. In addition, as you may know, we have some programs, including the Term Asset-Backed Securities Loan Facility, which is trying to open up sources of funding from the capital markets, for example, for consumer loans and small business loans. I would add, I guess, that there are also some efforts taking place from the Treasury to support small-business lending. It is a difficult problem, but we are trying it attack it in a number of fronts. Just to conclude, I would say that it is true that as long as the banks are as reluctant to lend as they are, to some extent, it weakens the effect of our stimulative policies. Mr. Miller of California. You recall last September, we were having a very lengthy debate, and you and I had some conversations requiring the $700 billion to going to buy mortgage-backed securities, which we approved the first $350 billion. But it seems like we went through a tremendous amount of debate to make that decision; yet the Federal Reserve last week decided to buy a trillion and quarter dollars of mortgage-backed securities. And your previous comments, we have talked about the Fed's role in injecting liquidity in the marketplace and being able to fight inflation as needed, but you can't do that with assets you are buying. They are not liquid. Unless you are going to have a barn sale and just get rid of them for liquidity, how can you justify those two? They seem to be-- " CHRG-110shrg46629--144 PREPARED STATEMENT OF BEN S. BERNANKE Chairman, Board of Governors of the Federal Reserve System July 19, 2007 Chairman Dodd, Ranking Member Shelby, and Members of the Committee, I am pleased to present the Federal Reserve's Monetary Policy Report to the Congress. As you know, this occasion marks the 30th year of semiannual testimony on the economy and monetary policy by the Federal Reserve. In establishing these hearings, the Congress proved prescient in anticipating the worldwide trend toward greater transparency and accountability of central banks in the making of monetary policy. Over the years, these testimonies and the associated reports have proved an invaluable vehicle for the Federal Reserve's communication with the public about monetary policy, even as they have served to enhance the Federal Reserve's accountability for achieving the dual objectives of maximum employment and price stability set for it by the Congress. I take this opportunity to reiterate the Federal Reserve's strong support of the dual mandate; in pursuing maximum employment and price stability, monetary policy makes its greatest possible contribution to the general economic welfare. Let me now review the current economic situation and the outlook, beginning with developments in the real economy and the situation regarding inflation before turning to monetary policy. I will conclude with comments on issues related to lending to households and consumer protection--topics not normally addressed in monetary policy testimony but, in light of recent developments, deserving of our attention today. After having run at an above-trend rate earlier in the current economic recovery, U.S. economic growth has proceeded during the past year at a pace more consistent with sustainable expansion. Despite the downshift in growth, the demand for labor has remained solid, with more than 850,000 jobs having been added to payrolls thus far in 2007 and the unemployment rate having remained at 4\1/2\ percent. The combination of moderate gains in output and solid advances in employment implies that recent increases in labor productivity have been modest by the standards of the past decade. The cooling of productivity growth in recent quarters is likely the result of cyclical or other temporary factors, but the underlying pace of productivity gains may also have slowed somewhat. To a considerable degree, the slower pace of economic growth in recent quarters reflects the ongoing adjustment in the housing sector. Over the past year, home sales and construction have slowed substantially and house prices have decelerated. Although a leveling-off of home sales in the second half of 2006 suggested some tentative stabilization of housing demand, sales have softened further this year, leading the number of unsold new homes in builders' inventories to rise further relative to the pace of new home sales. Accordingly, construction of new homes has sunk further, with starts of new single-family houses thus far this year running 10 percent below the pace in the second half of last year. The pace of home sales seems likely to remain sluggish for a time, partly as a result of some tightening in lending standards and the recent increase in mortgage interest rates. Sales should ultimately be supported by growth in income and employment as well as by mortgage rates that--despite the recent increase--remain fairly low relative to historical norms. However, even if demand stabilizes as we expect, the pace of construction will probably fall somewhat further as builders work down stocks of unsold new homes. Thus, declines in residential construction will likely continue to weigh on economic growth over coming quarters, although the magnitude of the drag on growth should diminish over time. Real consumption expenditures appear to have slowed last quarter, following two quarters of rapid expansion. Consumption outlays are likely to continue growing at a moderate pace, aided by a strong labor market. Employment should continue to expand, though possibly at a somewhat slower pace than in recent years as a result of the recent moderation in the growth of output and ongoing demographic shifts that are expected to lead to a gradual decline in labor force participation. Real compensation appears to have risen over the past year, and barring further sharp increases in consumer energy costs, it should rise further as labor demand remains strong and productivity increases. In the business sector, investment in equipment and software showed a modest gain in the first quarter. A similar outcome is likely for the second quarter, as weakness in the volatile transportation equipment category appears to have been offset by solid gains in other categories. Investment in nonresidential structures, after slowing sharply late last year, seems to have grown fairly vigorously in the first half of 2007. Like consumption spending, business fixed investment overall seems poised to rise at a moderate pace, bolstered by gains in sales and generally favorable financial conditions. Late last year and early this year, motor vehicle manufacturers and firms in several other industries found themselves with elevated inventories, which led them to reduce production to better align inventories with sales. Excess inventories now appear to have been substantially eliminated and should not prove a further restraint on growth. The global economy continues to be strong. Supported by solid economic growth abroad, U.S. exports should expand further in coming quarters. Nonetheless, our trade deficit--which was about 5\1/4\ percent of nominal gross domestic product (GDP) in the first quarter--is likely to remain high. For the most part, financial markets have remained supportive of economic growth. However, conditions in the subprime mortgage sector have deteriorated significantly, reflecting mounting delinquency rates on adjustable-rate loans. In recent weeks, we have also seen increased concerns among investors about credit risk on some other types of financial instruments. Credit spreads on lower-quality corporate debt have widened somewhat, and terms for some leveraged business loans have tightened. Even after their recent rise, however, credit spreads remain near the low end of their historical ranges, and financing activity in the bond and business loan markets has remained fairly brisk. Overall, the U.S. economy appears likely to expand at a moderate pace over the second half of 2007, with growth then strengthening a bit in 2008 to a rate close to the economy's underlying trend. Such an assessment was made around the time of the June meeting of the Federal Open Market Committee (FOMC) by the members of the Board of Governors and the presidents of the Reserve Banks, all of whom participate in deliberations on monetary policy. The central tendency of the growth forecasts, which are conditioned on the assumption of appropriate monetary policy, is for real GDP to expand roughly 2\1/4\ to 2\1/2\ percent this year and 2\1/2\ to 2\3/4\ percent in 2008. The forecasted performance for this year is about \1/4\ percentage point below that projected in February, the difference being largely the result of weaker-than-expected residential construction activity this year. The unemployment rate is anticipated to edge up to between 4\1/2\ and 4\3/4\ percent over the balance of this year and about 4\3/4\ percent in 2008, a trajectory about the same as the one expected in February. I turn now to the inflation situation. Sizable increases in food and energy prices have boosted overall inflation and eroded real incomes in recent months--both unwelcome developments. As measured by changes in the price index for personal consumption expenditures (PCE inflation), inflation ran at an annual rate of 4.4 percent over the first 5 months of this year, a rate that, if maintained, would clearly be inconsistent with the objective of price stability.\1\ Because monetary policy works with a lag, however, policymakers must focus on the economic outlook. Food and energy prices tend to be quite volatile, so that, looking forward, core inflation (which excludes food and energy prices) may be a better gauge than overall inflation of underlying inflation trends. Core inflation has moderated slightly over the past few months, with core PCE inflation coming in at an annual rate of about 2 percent so far this year.--------------------------------------------------------------------------- \1\ Despite the recent surge, total PCE inflation is 2.3 percent over the past 12 months.--------------------------------------------------------------------------- Although the most recent readings on core inflation have been favorable, month-to-month movements in inflation are subject to considerable noise, and some of the recent improvement could also be the result of transitory influences. However, with long-term inflation expectations contained, futures prices suggesting that investors expect energy and other commodity prices to flatten out, and pressures in both labor and product markets likely to ease modestly, core inflation should edge a bit lower, on net, over the remainder of this year and next year. The central tendency of FOMC participants' forecasts for core PCE inflation--2 to 2\1/4\ percent for 2007 and 1\3/4\ to 2 percent in 2008--is unchanged from February. If energy prices level off as currently anticipated, overall inflation should slow to a pace close to that of core inflation in coming quarters. At each of its four meetings so far this year, the FOMC maintained its target for the Federal funds rate at 5\1/4\ percent, judging that the existing stance of policy was likely to be consistent with growth running near trend and inflation staying on a moderating path. As always, in determining the appropriate stance of policy, we will be alert to the possibility that the economy is not evolving in the way we currently judge to be the most likely. One risk to the outlook is that the ongoing housing correction might prove larger than anticipated, with possible spillovers onto consumer spending. Alternatively, consumer spending, which has advanced relatively vigorously, on balance, in recent quarters, might expand more quickly than expected; in that case, economic growth could rebound to a pace above its trend. With the level of resource utilization already elevated, the resulting pressures in labor and product markets could lead to increased inflation over time. Yet another risk is that energy and commodity prices could continue to rise sharply, leading to further increases in headline inflation and, if those costs passed through to the prices of nonenergy goods and services, to higher core inflation as well. Moreover, if inflation were to move higher for an extended period and that increase became embedded in longer-term inflation expectations, the reestablishment of price stability would become more difficult and costly to achieve. With the level of resource utilization relatively high and with a sustained moderation in inflation pressures yet to be convincingly demonstrated, the FOMC has consistently stated that upside risks to inflation are its predominant policy concern. In addition to its dual mandate to promote maximum employment and price stability, the Federal Reserve has an important responsibility to help protect consumers in financial services transactions. For nearly 40 years, the Federal Reserve has been active in implementing, interpreting, and enforcing consumer protection laws. I would like to discuss with you this morning some of our recent initiatives and actions, particularly those related to subprime mortgage lending. Promoting access to credit and to homeownership are important objectives, and responsible subprime mortgage lending can help advance both goals. In designing regulations, policymakers should seek to preserve those benefits. That said, the recent rapid expansion of the subprime market was clearly accompanied by deterioration in underwriting standards and, in some cases, by abusive lending practices and outright fraud. In addition, some households took on mortgage obligations they could not meet, perhaps in some cases because they did not fully understand the terms. Financial losses have subsequently induced lenders to tighten their underwriting standards. Nevertheless, rising delinquencies and foreclosures are creating personal, economic, and social distress for many homeowners and communities--problems that likely will get worse before they get better. The Federal Reserve is responding to these difficulties at both the national and the local levels. In coordination with the other Federal supervisory agencies, we are encouraging the financial industry to work with borrowers to arrange prudent loan modifications to avoid unnecessary foreclosures. Federal Reserve Banks around the country are cooperating with community and industry groups that work directly with borrowers having trouble meeting their mortgage obligations. We continue to work with organizations that provide counseling about mortgage products to current and potential homeowners. We are also meeting with market participants--including lenders, investors, servicers, and community groups--to discuss their concerns and to gain information about market developments. We are conducting a top-to-bottom review of possible actions we might take to help prevent recurrence of these problems. First, we are committed to providing more-effective disclosures to help consumers defend against improper lending. Three years ago, the Board began a comprehensive review of Regulation Z, which implements the Truth in Lending Act (TILA). The initial focus of our review was on disclosures related to credit cards and other revolving credit accounts. After conducting extensive consumer testing, we issued a proposal in May that would require credit card issuers to provide clearer and easier-to-understand disclosures to customers. In particular, the new disclosures would highlight applicable rates and fees, particularly penalties that might be imposed. The proposed rules would also require card issuers to provide 45 days' advance notice of a rate increase or any other change in account terms so that consumers will not be surprised by unexpected charges and will have time to explore alternatives. We are now engaged in a similar review of the TILA rules for mortgage loans. We began this review last year by holding four public hearings across the country, during which we gathered information on the adequacy of disclosures for mortgages, particularly for nontraditional and adjustable-rate products. As we did with credit card lending, we will conduct extensive consumer testing of proposed disclosures. Because the process of designing and testing disclosures involves many trial runs, especially given today's diverse and sometimes complex credit products, it may take some time to complete our review and propose new disclosures. However, some other actions can be implemented more quickly. By the end of the year, we will propose changes to TILA rules to address concerns about mortgage loan advertisements and solicitations that may be incomplete or misleading and to require lenders to provide mortgage disclosures more quickly so that consumers can get the information they need when it is most useful to them. We already have improved a disclosure that creditors must provide to every applicant for an adjustable-rate mortgage product to explain better the features and risks of these products, such as ``payment shock'' and rising loan balances. We are certainly aware, however, that disclosure alone may not be sufficient to protect consumers. Accordingly, we plan to exercise our authority under the Home Ownership and Equity Protection Act (HOEPA) to address specific practices that are unfair or deceptive. We held a public hearing on June 14 to discuss industry practices, including those pertaining to prepayment penalties, the use of escrow accounts for taxes and insurance, stated-income and low-documentation lending, and the evaluation of a borrower's ability to repay. The discussion and ideas we heard were extremely useful, and we look forward to receiving additional public comments in coming weeks. Based on the information we are gathering, I expect that the Board will propose additional rules under HOEPA later this year. In coordination with the other Federal supervisory agencies, last year we issued principles-based guidance on nontraditional mortgages, and in June of this year we issued supervisory guidance on subprime lending. These statements emphasize the fundamental consumer protection principles of sound underwriting and effective disclosures. In addition, we reviewed our policies related to the examination of nonbank subsidiaries of bank and financial holding companies for compliance with consumer protection laws and guidance. As a result of that review and following discussions with the Office of Thrift Supervision, the Federal Trade Commission, and State regulators, as represented by the Conference of State Bank Supervisors and the American Association of Residential Mortgage Regulators, we are launching a cooperative pilot project aimed at expanding consumer protection compliance reviews at selected nondepository lenders with significant subprime mortgage operations. The reviews will begin in the fourth quarter of this year and will include independent State-licensed mortgage lenders, nondepository mortgage lending subsidiaries of bank and thrift holding companies, and mortgage brokers doing business with or serving as agents of these entities. The agencies will collaborate in determining the lessons learned and in seeking ways to better cooperate in ensuring effective and consistent examinations of and improved enforcement for nondepository mortgage lenders. Working together to address jurisdictional issues and to improve information-sharing among agencies, we will seek to prevent abusive and fraudulent lending while ensuring that consumers retain access to beneficial credit. I believe that the actions I have described today will help address the current problems. The Federal Reserve looks forward to working with the Congress on these important issues." FOMC20071211meeting--82 80,MS. YELLEN.," Thank you, Mr. Chairman. At the time of our last meeting, I held out hope that the financial turmoil would gradually ebb and the economy might escape without serious damage. Subsequent developments have severely shaken that belief. The bad news since our last meeting has grown steadier and louder, as strains in financial markets have resurfaced and intensified and as the economy has shown clear signs of faltering. In addition, the downside threats to growth that then seemed to be tail events now appear to be much closer to the center of the distribution. I found little to console me in the Greenbook. Like the Board staff, I have significantly marked down my growth forecast. The possibilities of a credit crunch developing and of the economy slipping into a recession seem all too real. Conditions in financial markets have worsened. Rates on a wide array of loans and securities have increased significantly since our last meeting, including those on term commercial paper, term LIBOR, prime jumbo mortgages, and high-yield corporate bonds. CDS spreads from major financial institutions with significant mortgage exposure, including Freddie and Fannie, have risen appreciably. In addition, broad stock indexes are down nearly 5 percent. At the same time, measures of implied volatility in equity, bond, and foreign exchange markets have all moved up, reflecting the greater uncertainty about the economy’s direction. The most recent data on spending have been discouraging as well. Data on house sales, prices, and construction have been downbeat, and foreclosures on subprime loans have moved even higher. Even with efforts such as those facilitated by the Administration to freeze subprime rates, foreclosures look to rise sharply next year, which may dump a large number of houses on a market already swamped with supply. This will exacerbate the downward pressure on house prices and new home construction from already elevated home inventories. Indeed, the ten-city Case-Shiller home-price index has declined more than 5 percent over the past year through September, and futures contracts point to another sizable decline over the next twelve months. I am particularly concerned that we may now be seeing the first signs of spillovers from the housing and financial sectors to the broader economy. Although the job market has remained reasonably healthy so far, real consumer spending in September and October was dead in the water, and households are growing more pessimistic about future prospects. The December reading of consumer sentiment showed another decline, and the cumulative falloff in this measure is becoming alarming. Gains in disposable income have been weakened. With consumer sentiment in the doldrums, house prices on the skids, and energy prices on the rise, consumer spending looks to be quite subdued for some time. This view is echoed by the CEO of a national high-end clothing retailer on our board, who recently emphasized to us that the positive chain store sales data in November were in fact artificially boosted by the Thanksgiving calendar shift and that the underlying trend for his business has worsened notably. My modal forecast foresees the economy barely managing to avoid recession, with growth essentially zero this quarter and about 1 percent next quarter. I expect growth to remain below potential throughout next year, causing the unemployment rate to rise to about 5 percent, much like in the Greenbook. This forecast assumes a 50 basis point decline in the federal funds rate in the near future, placing the real funds rate near the center of the range of estimates of the neutral rate reported in the Bluebook. I should emphasize that I do not place a lot of confidence in this forecast, and, in particular, I fear that we are in danger of sliding into a credit crunch. Such an outcome is illustrated by the credit crunch alternative simulation in the Greenbook. Although I don’t foresee conditions in the banking sector getting as bleak as during the credit crunch of the early 1990s, the parallels to those events are striking. Back then, we saw a large number of bank failures in the contraction of the savings and loan sector. In the current situation, most banks are still in pretty good shape. Instead, it is the shadow banking sector— that is, the set of markets in which a variety of securitized assets are financed by the issuance of commercial paper—that is where the failures have occurred. This sector is all but shut for new business. But bank capital is also an issue. Until the securitization of nonconforming mortgage lending reemerges, financing will depend on the willingness and ability of banks, thrifts, and the GSEs to step in to fill the breach. To the extent they do, that will put further pressure on their capital, which is already under some pressure from write-downs on existing loans and holdings of assets. Banks are showing increasing concern that their capital ratios will become binding and are tightening credit terms and conditions. Several developments suggest to me that this situation could worsen. In addition to the problems plaguing the adjustable-rate subprime mortgages, delinquencies have recently started to move up more broadly—on credit card and auto loans, adjustable-rate prime mortgages, and fixed-rate subprime mortgages. My contacts at large District banks tell me that, because the economy continues to be reasonably healthy and people have jobs, things are still under control. But if house prices and the stock market fall further and the economy appears to be weakening, then they will further tighten the lending conditions and terms on consumer loans to avoid problems down the road, and these fears could be self-fulfilling. If banks only partially replace the collapsed shadow banks or, worse, if they cut back their lending in anticipation of a worsening economy, then the resulting credit crunch could push us into recession. This possibility is presumably increasingly reflected in CDS and low-grade corporate bond spreads. Thus, the risk of recession no longer seems remote, especially since the economy may well already have begun contracting in the current quarter. Indeed, the December Blue Chip consensus puts the odds of a recession at about 40 percent. This estimate is within the range of recession probabilities computed by my staff using models based on the yield curve and other variables. Turning to inflation, data on the core measure continues to be favorable. Wage growth remains moderate, and the recent downward revisions to hourly compensation have relieved some worries there. Inflation expectations remain contained. As I mentioned, I expect some labor market slack to develop, and this should offset any, in my view, modest inflationary pressures from past increases in energy and import prices and help keep core PCE price inflation below 2 percent. Continued increases in energy and import prices pose some upside risk to the inflation outlook, but there are also downside risks to inflation associated with a weakening economy and rising unemployment. To sum up, I believe that the most likely outcome is for the economy to slow significantly in the near term, flirting with recession, and I view the risk to that scenario as being weighted significantly to the downside. In contrast, I expect inflation to remain well contained, and I view those risks as fairly balanced." fcic_final_report_full--156 CDOs in .  The company wouldn’t make the decision to stop writing these con- tracts until .  GOLDMAN SACHS: “MULTIPLIED THE EFFECTS OF THE COLLAPSE IN SUBPRIME ” Henry Paulson, the CEO of Goldman Sachs from  until he became secretary of the Treasury in , testified to the FCIC that by the time he became secretary many bad loans already had been issued—“most of the toothpaste was out of the tube”— and that “there really wasn’t the proper regulatory apparatus to deal with it.”  Paul- son provided examples: “Subprime mortgages went from accounting for  percent of total mortgages in  to  percent by . . . . Securitization separated origina- tors from the risk of the products they originated.” The result, Paulson observed, “was a housing bubble that eventually burst in far more spectacular fashion than most previous bubbles.”  Under Paulson’s leadership, Goldman Sachs had played a central role in the cre- ation and sale of mortgage securities. From  through , the company pro- vided billions of dollars in loans to mortgage lenders; most went to the subprime lenders Ameriquest, Long Beach, Fremont, New Century, and Countrywide through warehouse lines of credit, often in the form of repos.  During the same period, Gold- man acquired  billion of loans from these and other subprime loan originators, which it securitized and sold to investors.  From  to , Goldman issued  mortgage securitizations totaling  billion (about a quarter were subprime), and  CDOs totaling  billion; Goldman also issued  synthetic or hybrid CDOs with a face value of  billion between  and June .  Synthetic CDOs were complex paper transactions involving credit default swaps. Unlike the traditional cash CDO, synthetic CDOs contained no actual tranches of mortgage-backed securities, or even tranches of other CDOs. Instead, they simply referenced these mortgage securities and thus were bets on whether borrowers would pay their mortgages. In the place of real mortgage assets, these CDOs contained credit default swaps and did not finance a single home purchase. Investors in these CDOs included “funded” long investors, who paid cash to purchase actual securities issued by the CDO; “unfunded” long investors, who entered into swaps with the CDO, making money if the reference securities performed; and “short” investors, who bought credit default swaps on the reference securities, making money if the se- curities failed. While funded investors received interest if the reference securities per- formed, they could lose all of their investment if the reference securities defaulted. Unfunded investors, which were highest in the payment waterfall, received pre- mium-like payments from the CDO as long as the reference securities performed but would have to pay if the reference securities deteriorated beyond a certain point and if the CDO did not have sufficient funds to pay the short investors. Short investors, often hedge funds, bought the credit default swaps from the CDOs and paid those premiums. Hybrid CDOs were a combination of traditional and synthetic CDOs. Firms like Goldman found synthetic CDOs cheaper and easier to create than tra- ditional CDOs at the same time as the supply of mortgages was beginning to dry up. Because there were no mortgage assets to collect and finance, creating synthetic CDOs took a fraction of the time. They also were easier to customize, because CDO managers and underwriters could reference any mortgage-backed security—they were not limited to the universe of securities available for them to buy. Figure . provides an example of how such a deal worked. CHRG-111hhrg53248--43 Secretary Geithner," Remember, a dollar of capital is equivalent to between $8 and $12 of lending capacity. So if you are short a dollar of capital, you are going to have to reduce lending by $8 to $12. So on the scale of our financial system, just think of this, so without that initial $250 billion of capital the previous Administration put into the financial system, you would have seen overall lending capacity decline by well over $1 trillion, $1 trillion to $2 trillion. So you did see the benefits of that. " FinancialCrisisInquiry--238 So that’s about 15 million subprime and Alt-A loans. How do you square that with the idea that the subprime and Alt-A loans originated from irresponsible lenders by unregulated mortgage brokers? ROSEN: So I don’t have those numbers on Fannie Mae and Freddie Mac with me, so I can’t—but I do know that Fannie Mae and Freddie Mac got to the party late; that they did not do them early on at all. They came on board in 2006 and ‘07. They did not start this. They were not the buyers of this. The vast majority of them, as you can see I have a chart here if you can take a look, on page nine, the vast majority of them were put in the CDOs which Fannie and Freddie are not involved with. Those were private securities. So I don’t have the numbers in front of me, but I have the paper. Somewhere in the order of 80 percent were done privately, and Fannie and Freddie were certainly at the end, did more. And those are—they shouldn’t have done them. They admit that now. But they did more. But they were certainly not the originators of this whole process. WALLISON: Well, with all respect, it’s very hard to believe that mortgages that were acquired in 2006 and 2007 would have caused them to become insolvent. ROSEN: That is actually—the 2006, ‘07 books were the bad books. WALLISON: Well, yes, they’re terrible. CHRG-111hhrg53248--151 Mr. Scott," We continue to get complaints from some in the banking industry with certain practices. We have the Consumer Protection Agency which we are pushing, which unfortunately some are fighting very hard. And yet they are not doing the basic things that need to be done. They are not lending. What can you do to increase pressure on our banks to lend? " CHRG-111shrg57709--124 Mr. Volcker," Let me try that one. Commercial banking, as I said, is a risky business. Now the question is whether you want to, in effect, provide a subsidy or provide protection when they are lending to small business, when they are lending to medium-size business, when they are lending to homeowners, when they are transferring money around the Country. Those are important continuing functions of a commercial bank, in my view, and I do think it is deserving of some public support. I do not think speculative activity falls in that range. They are not lending to your constituents. They are out making money for themselves and making money with big bonuses. And why do we want to protect that activity? I want to encourage them to go into commercial lending activity. Senator Johanns. But, see, you are assuming something about what I am doing. I do not like the bailouts. I voted against TARP, the second tranche of TARP. Quite honestly, I do not think we should put the taxpayer in that position. But I also likewise think that if your goal is to try to wrestle risk out of the system, you get to a point where quite honestly you do not have a workable system anymore, and that is what worries me about where you are going here--is because you are using this opportunity to put into place something that has some pretty profound consequences, and I am not sure these circumstances justify that step. That is why I ask these questions. " CHRG-110hhrg44901--9 The Chairman," Now, Mr. Chairman, I did want to join the chairman of the subcommittee in thanking you for the action you took on Monday, a very important set of steps with regard to the subprime. With that, let me welcome you again to your alternate office and invite you to proceed.STATEMENT OF THE HONORABLE BEN S. BERNANKE, CHAIRMAN, BOARD OF CHRG-111hhrg52407--11 Mr. Royce," Thank you, Mr. Chairman. I think financial literacy here is key. I think, in my view, I am a little afraid that one of the reasons we are here today is because of the overreliance on the government to determine what is best for consumers. And I think a lot of consumers looked at this and said, well, if the government says it is okay, then it must be. And I think this flawed line of thinking led millions of consumers to get involved in subprime and Alt-A loans. They, after all, had that government support. And I think a similarly faulty line of thinking led investors in institutions around the world to embrace financial derivatives based on the U.S. housing market. Why? Well, the government-supported rating agencies rated these products Triple-A. So what could the problem be? And there was a belief that the rating agencies and Federal regulators knew something that everyone else did not know. And clearly, they didn't know the problem. But there was a reliance on the government, and in fact, in many instances, they were responsible for the development and proliferation of these products. According to a former Federal Reserve official, CRA regulations led to the development of subprime loans, and the proliferation of subprime and Alt-A loans was in itself enabled through low-income housing goals that were placed on Fannie Mae and Freddie Mac by their regulators and by Congress. So, clearly, the belief in an all-knowing regulator is flawed. And instead of attempting to address this problem through increasing the regulatory presence over the industry, which will exacerbate the belief that the government does know best, we should be encouraging an educated, knowledgeable consumer and investor base that makes sound financial decisions for themselves and their families; hence, the importance of financial literacy and the importance of disclosure. Thank you, Mr. Chairman. " CHRG-110hhrg38392--134 Mr. Royce," Thank you very much, Mr. Chairman. We discussed that since 2000, we have seen stagnant wages for low skilled workers. Well, supply and demand are a reality, and certain business interests on the right want low skilled labor because it will drive down wages. They want more low skilled labor in the country. On the other end of the spectrum, there are those who believe in open borders for the disadvantaged. But the result of the policy is that until we have enforcement against illegal immigration, wages will lag. They are going to lag if you have massive illegal immigration of low skilled wages in the United States. You can't expect anything else to happen if you have 20 million people here illegally other than to have the pressures of supply and demand force down wage rates. Indeed that has happened since--well, for the last decade. To encourage monetary inflation, shifting to that subject, is to encourage a return of the boom and bust in a business cycle and to abandon a stable monetary unit. That is what I think the effect would be if we move towards the direction that didn't attempt to really control inflation. Now, Chairman Bernanke, as you know, in the past decade we have also seen unprecedented growth in the mortgage industry. If you went back to the 1960's, there was very little movement back then in home ownership rates until the development of technology and tools such as risk based pricing, which allowed lending institutions to more accurately calculate the risk associated with potential borrowers. As a consequence of that, in 2004, the home ownership rate went up to just under 70 percent, hitting record highs. Much of this growth which we had not seen in the decades prior was in a sector of the population which was previously locked out from obtaining mortgages, therefore, they rented instead of owning homes. For the most part, they had blemished credit, and they benefited greatly from the transformation in the industry as a result. As you know, the subprime lending market has come under tremendous scrutiny. Some believe we should rush to legislate. I believe we should approach this topic with tremendous caution. While deceptive lending practices should be prevented, I believe effective disclosure is the proper anecdote. Expanding liability to include secondary market participants for abusive loan originations would be a misguided policy. My fear is that if we overlegislate, which we have been known to do, it will prompt a credit crunch for Americans. I believe that the availability of credit has been good for consumers, by and large. The economy has benefited as a result, and any potential solution to concerns that have arisen should be very closely scrutinized. So Chairman Bernanke, I would like to get your thoughts on this issue and whether you believe an ill-conceived legislative fix will have any potential unintended consequences. Lastly, as you know, the outflow of capital from our markets has been discussed at length over the last few months. Much of the debate is centered around two major burdens faced by our public companies. One is cumbersome regulation and the prevalence of securities class action lawsuits. The threat of overregulation and overlitigation has caused many companies to reconsider listing on our public markets. This has resulted in a growth in the amount of capital in a private equity and hedge fund industry. So my second question, Chairman, is if our private equity and hedge fund industries are subjected to a sharp increase in regulation and taxation, what do you believe will be the end result? Thank you. " CHRG-111shrg51303--58 Mr. Dinallo," It is completely severed now. So the concept of continued systemic risk from securities lending, to the extent anyone thought there was--and I would not agree that there was--it is a completely severed situation, because in order to sell the operating companies to various buyers to pay off the loan that you authorized them to give, you had to untangle the operating companies from the securities lending pool, and that required the Fed to buy $20 billion at face value of the securities. Those may actually perform well. They may not. But they were bought at the market price so we could unwind securities lending pool so we could sell the operating companies that have huge value. Senator Shelby. Thank you. " CHRG-111hhrg54872--30 OFFICER, CENTER FOR RESPONSIBLE LENDING " CHRG-111hhrg53248--38 Mr. Bachus," That is on the lending program. " CHRG-110hhrg45625--221 Mr. Meeks," Okay. But again, why wouldn't they want to then not replace the loss of shareholder value first before lending out money? Since they lost it, why wouldn't they want to replace their shareholder value first as opposed to lending out money once they-- " FOMC20080130meeting--34 32,MR. LACKER.," Well, on the last point, that's a matter of the ECB's willingness to lend to those institutions. You're saying that they would be willing to lend themselves to those institutions only if we did this. It's not about the economics of their borrowing from their central bank versus borrowing from us--nothing about the market functioning. " CHRG-110hhrg44901--43 Mr. Manzullo," And then with regard to regular loans, you have proof, do you not, that homeowners are making payments to lending institutions and the lending institutions are holding on to the checks while the interest grows on the loan and waiting days before applying that money to the principal balance of the mortgage, isn't that correct? " CHRG-111shrg56415--35 Mr. Tarullo," What I hope is that this Committee and the Congress as a whole will pass a strong set of reforms, no matter what other people out there are saying. Senator Tester. OK. Thank you very much. Thank you, Mr. Chairman. Senator Johnson. Senator Gregg. Senator Gregg. Thank you, Mr. Chairman, and I want to thank the panel for their excellent testimony. It has been most interesting. First off, I want to congratulate the FDIC for deciding to forward-fund the fees. I think that is the right approach. You do a lot of things right. You have done a lot of things right during this problem. You did a lot of things right when I was Governor in 1989 in New Hampshire and five of our seven largest banks closed. Mr. Seidman came in and basically was our white knight. But you did say something that really concerns me, and that is, how you interpret the TARP, this idea that the TARP should be now used as a capital source for a lot of smaller banks that are having problems raising capital. I think all of you basically in your testimony have said we are past the massive systemic risk of a financial meltdown that would have caused a cataclysmic event. TARP came about because of that massive potential cataclysmic event, and its purpose was to basically stabilize the financial markets and be used in that manner in order to accomplish that. As one of the authors, along with Senator Dodd--we sat through the negotiations of that--I think I am fairly familiar with that purpose. That was the goal. It should not now be used as a piggy bank for housing. It should not be used as a piggy bank for whatever the interest of the day is that can be somehow--it should not have been used for the automobile industry, and it really should not be used in order to have a continuum of capital available to smaller banks who have problems, in my opinion, because then you are just going to set up a new national program which will essentially undermine the forces of the market, and that would be a mistake. I did hear you say, Madam Chairman, that you expect $100 billion in losses. Is that a net number? Or do you expect to recoup some percentage of that? Ms. Bair. No, that is what we project our losses to be over the next 5 years. Senator Gregg. So that is a net number after recoupment? Ms. Bair. Yes. Senator Gregg. Well, is it--do you expect of that $100 billion in bad loans to be getting back 30 percent of---- Ms. Bair. The $100 billion would be our losses. So let us say we had a 25-percent loss rate on our bank failures so far, so you would be talking about $400 billion in failed bank assets. Senator Gregg. Well, OK, so it---- Ms. Bair. That is since the beginning of 2009, though. And, again, a lot of that has already been realized and reserved for. Senator Gregg. And you have got $64 billion, you said, or something, that has been realized and reserved against, so you have got about---- Ms. Bair. That is right, yes. Senator Gregg.----$36 billion to go. OK. I have got a philosophical question here. If we look at this problem--granted, commercial real estate is now the problem, but commercial real estate, as I understand it from your testimony, is not--it is a serious problem. It is just not a systemic event. It is not going to cause a meltdown of our industries--of our financial industry. It may impact rather significantly especially the middle-sized regional banks and some of the smaller banks, but it is not systemic. The systemic event was caused in large part in the banking industry by the primary residence lending activity--subprime, Alt-A, and regular loans. And all I heard about as the proposals for getting at this is regulatory upon regulatory layers to try to figure out a way to basically protect ourselves from having that type of excess in this arena occur again. But when you get down to it, it is all about underwriting. I mean, the bottom line is this is about underwriting. It is about somebody lent to somebody who either did not have the wherewithal to pay it back or who had an asset which was not worth what they lent on that asset. And probably the person who lent it did not really care because they were just getting the fee and they were going to sell it into the securitized market anyway. So if you really want to get at this issue, wouldn't it be more logical and simpler and--it is not the whole solution. Clearly, there has to be regulatory reform. But shouldn't we look at the issue of having different underwriting standards, both of which the OCC and the FDIC have the authority over, in the area of what percentage to asset can you lend? You know, do you have to have 90 percent, 80 percent? Shouldn't we have an underwriting standard that says you either get--that there is recourse? Shouldn't we have underwriting standards that gives you the opportunity to either have an 80-percent or 90-percent choice or a covered loan, something like that? Isn't that really a simpler way from a standpoint of not having--granted, it would chill the ability to get a house because people who could not afford to buy the house and could not afford to pay the loan back probably would not be able to get the loan. But isn't that where we should really start this exercise, with recourse and 80 percent or 90 percent equity--10, 20 percent equity value and/or, alternatively, covered funds? I would ask everybody who actually is on the front lines of lending today. Ms. Bair. Certainly underwriting is key, but poor underwriting is not necessarily the driver of future losses now. We are seeing loans go bad now that were good when they were made. But because of the economy--because people are losing their jobs, or retailers are having to close, or hotels cannot fill up--those loans are going bad. The economic dynamic is kicking in in terms of the credit distress that we are increasingly seeing on bank balance sheets. You are right, the subprime mortgage mess got started with very weak underwriting. It started in the non-bank sector. It spilled back into the banking sector. I think all of us wish we had acted sooner, but we did move to tighten underwriting standards, and strongly encouraged the Federal Reserve Board to impose rules across the board for both banks and non-banks. This, again, is the reason why you need to make sure that the stronger underwriting standards going forward apply to both banks and non-banks. Senator Gregg. Well, what should those underwriting standards be? Ms. Bair. You should have to document income. You should do teaser-rate underwriting. The Federal Reserve Board has put a lot of these in effect now under the HOEPA rules. You have to document income. You cannot do payment shock loans. You have got to make sure the borrower can repay the loan if it is an adjustable rate mortgage that resets. These are just common-sense underwriting principles that have applied to banks for a long time. Senator Gregg. Or should there be recourse? Ms. Bair. That has been a prerogative of the States. Some mortgage lending is recourse, some is non-recourse, depending on the State. Senator Gregg. Should there be a requirement that you cannot lend to 100 percent of value? Ms. Bair. I think there is a strong correlation with loan-to-value ratios (LTVs). We actually recognize that in our capital standards that we are working on now. We would require a much higher risk weighting of loans which have high LTVs. So through capital charges, we are recognizing and trying to incent lower LTVs. Senator Gregg. I am running out of time unfortunately. " FinancialCrisisInquiry--722 GORDON: Well it’s well documented that African American and Latino families disproportionately received the expensive and dangerous subprime loans that we’ve been talking about. You—you know, there—there are Federal Reserve papers on this. The HUMDA data will show that to you, because it collects the demographic data that you need to get this. I think—in one—one data point I have in my testimony is that in 2006 among consumers who received conventional mortgages for single family homes, about half of African Americans and Hispanic borrowers received a higher rate mortgage compared to about one fifth of White borrowers. You know, our—our research has shown that African Americans and Latinos were much more likely to receive higher rate subprime loans. Another study has shown that minority communities were more likely to get loans with prepayment penalties even after controlling for other factors. You know, and like I said while it’s hard right now to get really good demographic data on foreclosures, you know, given that we know which loans have the highest rates of default, it’s not that hard to connect the dots. CHRG-111shrg57322--442 Mr. Tourre," I think what I remember discussing with your staff, Mr. Chairman, is the fact that the very original portfolio that Paulson and Goldman discussed had been selected from a universe of 2006 vintage subprime RMBS obligations, removing, several obligations, and those obligations were removed based on certain criteria. Senator Levin. Right, and those criteria were selected by Paulson? " CHRG-111shrg57319--513 Mr. Killinger," This is relating to the subprime business? Senator Kaufman. Yes, the whole thing that they were just concerned about lax standards, poor reports from Long Beach, all the things that were coming into your office--you are the CEO--and your two top risk guys are saying we have a real serious problem here. And, obviously, you hired Mr. Rotella because you were concerned about this. " CHRG-110shrg46629--17 Chairman Bernanke," Thank you. Chairman Dodd, Ranking Member Shelby, and Members of the Committee, I am pleased to present the Federal Reserve's Monetary Policy Report to the Congress. As you know, this occasion marks the 30th year of semiannual testimony on the economy and monetary policy by the Federal Reserve. And in establishing these hearings, the Congress proved prescient in anticipating the worldwide trend toward greater transparency and accountability of central banks in the making of monetary policy. Over the years, these testimonies and the associated reports have proved an invaluable vehicle for the Federal Reserve's communication with the public about monetary policy even as they have served to enhance the Federal Reserve's accountability for achieving that dual objectives of maximum employment and price stability set forth by the Congress. I take this opportunity to reiterate the Federal Reserve's strong support of the dual mandate. In pursuing maximum employment and price stability, monetary policy makes its greatest possible contribution to the general economic welfare. Let me now review the current economic situation and the outlook beginning with developments in the real economy and the situation regarding inflation before turning to monetary policy. I will conclude with comments on issues related to lending to households and to consumer protection, topics not normally addressed in monetary policy testimony but, in light of recent developments, deserving of our attention today. After having run at an above trend rate earlier in the current economic recovery, U.S. economic growth has proceeded during the past year at a pace more consistent with sustainable expansion. Despite the downshift in growth, the demand for labor has remained solid, with more than 850,000 jobs having been added to payrolls thus far in 2007 and the unemployment rate having remained at 4.5 percent. The combination of moderate gains in output and solid advances in employment implies that recent increases in labor productivity have been modest by the standards of the past decade. The cooling of productivity growth in recent quarters is likely the result of cyclical or other temporary factors but the underlying pace of productivity gains may also have slowed somewhat. To a considerable degree, the slower pace of economic growth in recent quarters reflects the ongoing adjustment in the housing sector. Over the past year, home sales and construction have slowed substantially and house prices have decelerated. Although a leveling off of home sales in the second half of 2006 suggested some tentative stabilization of housing demand, sales have softened further this year, leading the number of unsold new homes in builders' inventories to rise further relative to the pace of new home sales. Accordingly, construction of new homes has sunk further, with starts of new single-family houses thus far this year running 10 percent below the pace of the second half of last year. The pace of home sales seems likely to remain sluggish for a time partly as a result of some tightening in lending standards and the recent increase in mortgage interest rates. Sales should ultimately be supported by growth in income and employment as well as by mortgage rates that--despite the recent increase--remain fairly low relative to historical norms. However, even if demand stabilizes as we expect, the pace of construction will probably fall somewhat further as builders work down stocks of unsold new homes. Thus, declines in residential construction will likely continue to weigh on economic growth over coming quarters, although the magnitude of the drag on growth should diminish over time. Real consumption expenditures appear to have slowed last quarter, following two quarters of rapid expansion. Consumption outlays are likely to continue growing at a moderate pace aided by a strong labor market. Employment should continue to expand, though possibly at a somewhat slower pace than in recent years, as a result of the recent moderation in the growth of output and ongoing demographic shifts that are expected to lead to a gradual decline in labor force participation. Real compensation appears to have risen over the past year and, barring further sharp increases in consumer energy costs, it should rise further as labor demand remains strong and productivity increases. In the business sector, investment in equipment and software showed a modest gain in the first quarter. A similar outcome is likely for the second quarter as weakness in the volatile transportation equipment category appears to have been offset by solid gains in other categories. Investment in nonresidential structures, after slowing sharply late last year, seems to have grown fairly vigorously in the first half of 2007. Like consumption spending, business fixed investment overall seems poised to rise at a moderate pace bolstered by gains in sales and generally favorable financial conditions. Late last year and early this year motor vehicle manufacturers and firms in several other industries found themselves with elevated inventories, which led them to reduce production to better align inventories with sales. Excess inventories now appear to have been substantially eliminated and should not prove a further restraint on growth. The global economy continues to be strong. Supported by solid economic growth abroad U.S. exports should expand further in coming quarters. Nonetheless our trade deficit, which was about 5.25 percent of nominal gross domestic product in the first quarter is likely to remain high. For the most part, financial markets have remained supportive of economic growth. However, conditions in the subprime mortgage sector have deteriorated significantly, reflecting mounting delinquency rates on adjustable-rate loans. In recent weeks, we have also seen increased concerns among investors about credit risk on some other types of financial instruments. Credit spreads on lower quality corporate debt have widened somewhat, and terms for some leveraged business loans have tightened. Even after their recent rise, however, credit spreads remain near the low end of their historical ranges and financing activity in the bond and business loan markets has remained fairly brisk. Overall, the U.S. economy appears likely to expand at a moderate pace over the second half of 2007, with growth then strengthening a bit in 2008 to a rate close to the economy's underlying trend. Such an assessment was made around the time of the June meeting of the Federal Open Market Committee by the members of the Board of Governors and the Presidents of the Reserve Banks, all of whom participate in deliberations on monetary policy. The central tendency of the growth forecasts, which are conditioned on the assumption of appropriate monetary policy, is for real GDP to expand roughly 2.25 to 2.5 percent this year and 2.5 to 2.75 percent in 2008. The forecasted performance for this year is about one-quarter percentage point below that projected in February, the difference being largely the result of weaker than expected residential construction activity this year. The unemployment rate is anticipated to edge up to between 4.5 and 4.75 percent over the balance of this year and about 4.75 percent in 2008, a trajectory about the same as the one expected in February. I turn now to the inflation situation. Sizable increases in food and energy prices have boosted overall inflation and eroded real incomes in recent months, both unwelcome developments. As measured by changes in the price index for personal consumption expenditures, PCE inflation, inflation ran at an annual rate of 4.4 percent over the first 5 months of this year, a rate that if maintained would clearly be inconsistent with the objective of price stability. Because monetary policy works with a lag, however, policymakers must focus on the economic outlook. Food and energy prices tend be quite volatile so that, looking forward, core inflation, which excludes food and energy prices, may be a better gauge than overall inflation of underlying inflation trends. Core inflation has moderated slightly over the past few months with core PCE inflation coming in at an annual rate of about 2 percent so far this year. Although the most recent readings on core inflation have been favorable, month-to-month movements in inflation are subject to considerable noise and some of the recent improvement could also be the result of transitory influences. However, with long-term inflation expectations contained, futures prices suggesting that investors expect energy and other commodity prices to flatten out, and pressures in both labor and product markets likely to ease modestly, core inflation should edge a bit lower on net over the remainder of this year and next year. The central tendency of FOMC participants forecast for core PCE inflation--2 to 2.25 percent for all of 2007 and 1.75 to 2 percent in 2008--is unchanged from February. If energy prices level off as currently anticipated, overall inflation should slow to a pace close to that of core inflation in coming quarters. At each of its four meeting so far this year, the FOMC maintained its target for the Federal funds rate at 5.25 percent, judging that the existing stance of policy was likely to be consistent with growth running near trend and inflation staying on a moderating path. As always, in determining the appropriate stance of policy, we will be alert to the possibility that the economy is not evolving in the way we currently judge to be the most likely. One risk to the outlook is that the ongoing housing correction might prove larger than anticipated, with possible spillovers onto consumer spending. Alternatively consumer spending, which has advanced relatively vigorously on balance in recent quarters, might expand more quickly than expected. In that case, economic growth could rebound to a pace above its trend. With the level of resource utilization already elevated, the resulting pressures in labor and product markets could lead to increased inflation over time. Yet another risk is that energy and commodity prices could continue to rise sharply, leading to further increases in headline inflation and, if those costs pass through to the prices of nonenergy goods and services, to higher core inflation as well. Moreover, if inflation were to move higher for an extended period and increase became embedded in longer-term inflation expectations, the reestablishment of price stability would become more difficult and costly to achieve. With the level of resource utilization relatively high and with a sustained moderation in inflation pressures yet to be convincingly demonstrated, the FOMC has consistently stated that upside risks to inflation are its predominant policy concern. In addition to its dual mandate to promote maximum employment and price stability, the Federal Reserve has an important responsibility to help protect consumers in financial services transactions. For nearly 40 years, the Federal Reserve has been active in implementing, interpreting, and enforcing consumer protection laws. I would like to discuss with you this morning some of our recent initiatives and actions, particularly those related to subprime mortgage lending. Promoting access to credit and to homeownership are important objectives and responsible subprime mortgage can help to advance both goals. In designing regulations, policymakers should seek to preserve those benefits. That said, the recent rapid expansion of the subprime market was clearly accompanied by deterioration in underwriting standards, and in some cases by abusive lending practices and outright fraud. In addition, some households took on mortgage obligations they could not meet, perhaps in some cases because they did not fully understand the terms. Financial losses have subsequently induced lenders to tighten their underwriting standards. Nevertheless, rising delinquencies and foreclosures are creating personal, economic, and social distress for many homeowners and communities, problems that will likely get worse before they get better. The Federal Reserve is responding to these difficulties at both the national and the local levels. In coordination with the other Federal supervisory agencies we are encouraging the financial industry to work with borrowers to arrange prudent loan modifications to avoid unnecessary foreclosures. Federal Reserve Banks around the country are cooperating with community and industry groups that work directly with borrowers having trouble meeting their mortgage obligations. We continue to work with organizations that provide counseling about mortgage product to current and potential homeowners. We are also meeting with market participants--including lenders, investors, servicers, and community groups--to discuss their concerns and to gain information about market development. We are conducting a top to bottom review of possible actions we might take to help prevent recurrence of these problems. First, we are committed to providing more effective disclosures to help consumers defend against improper lending. Three years ago, the Board began a comprehensive review of Regulation Z, which implements the Truth in Lending Act, or TILA. The initial focus of our review was on disclosures related to credit cards and other revolving credit accounts. After conducting extensive consumer testing, we issued a proposal in May that would require credit card issuers to provide clearer and easier to understand disclosures to consumers. In particular, the new disclosures would highlight applicable rates and fees, particularly penalties that might be imposed. The proposed rules would also require card issuers to provide 45 days advance notice of a rate increase or any other change in account terms so that consumers will not be surprised by unexpected charges and will have time to explore alternatives. We are now engaged in a similar review of the TILA rules for mortgage loans. We began this review last year by holding four public hearings across the country, during which we gathered information on the adequacy of disclosures for mortgages, particularly for nontraditional, traditional, and adjustable rate products. As we did with credit card lending, we will conduct extensive consumer testing of proposed disclosures. Because the process of designing and testing disclosures involves many trial runs, especially given today's diverse and sometimes complex credit products, it may take some time to complete our review and propose new disclosures. However, some other actions can be implemented more quickly. By the end of the year, we will propose changes to TILA rules to address concerns about mortgage loan advertisements and solicitations they may be incomplete or misleading and to require lenders to provide mortgage disclosures more quickly so that consumers can get the information they need when it is most useful to them. We already have improved a disclosure that creditors must provide to every applicant for an adjustable rate mortgage product to explain that better the features and risks of these products such as ``payment shock'' and rising loan balances. We are certainly aware, however, that disclosure alone may not be sufficient to protect consumers. Accordingly, we plan to exercise our authority under the Home Ownership and Equity Protection Act, HOEPA, to address specific practices that are unfair or deceptive. We held a public hearing on June 14 to discuss industry practices including those pertaining to prepayment penalties, the use of escrow accounts for taxes and insurance, stated income and low documentation lending, and the evaluation of a borrower's ability to repay. The discussion and ideas we heard were extremely useful and we look forward to receiving additional public comments in coming weeks. Based on the information we are gathering, I expect the Board will propose additional rules under HOEPA later this year. In coordination with the other Federal supervisory agencies, last year we issued principles-based guidance for nontraditional mortgages, and in June of this year we issued supervisory guidance on subprime lending. These statements emphasized the fundamental consumer protection principles of sound underwriting and effective disclosures. In addition, we reviewed our policies related to the examination of nonbank subsidiaries of bank and financial holding companies for compliance with consumer protection laws and guidance. As a result of that review and following discussions of the Office of Thrift Supervision, the Federal Trade Commission, and State regulators as represented by the Conference of State Bank Supervisors and the American Association of Residential Mortgage Regulators, we are launching a cooperative pilot aimed at expanding consumer protection compliance reviews at selected nondepository lenders with significant subprime mortgage operations. The reviews will begin in the fourth quarter of this year and will include independent state-licensed mortgage lenders, nondepository mortgage lending subsidies of bank and thrift holding companies, and mortgage brokers doing business with or serving as agents of these entities. The agencies will collaborate in determining the lessons learned and in seeking ways to better cooperate in ensuring effective and consistent examination of and improved enforcement for nondepository mortgage lenders. Working together to address jurisdictional issues and to improve information sharing among agencies, we will seek to prevent abusive and fraudulent lending while ensuring that consumers retain access to beneficial credit. I believe that the actions I have described today will help address the current problems. The Federal Reserve looks forward to working with Congress on these important issues. Thank you. " CHRG-111hhrg48867--70 Mr. Bachus," I would agree with that and advance a resolution, but I think we ought to put a provision in there that they don't use taxpayer dollars. Another thing that I think--what do you think about advancing local lending more? In the past several years with the consolidation, we are getting further away from sort of Main Street lending. Is that a problem? " CHRG-111shrg57321--230 Mr. McDaniel," Yes. Senator Levin. Now, after your mass downgrades in 2007, during the last 6 months, Moody's rated about 500 subprime RMBS securities and S&P rated over 700. So you are still allowing these dubious mortgages to be put into the market. Hadn't you already decided that these securities were high-risk in July? Hadn't you already reached that conclusion? " CHRG-111shrg57322--220 Mr. Sparks," These securities are backed by assets. There are years and years of input that regulators, internal and external counsel, and investors and market participants have had with respect to asset-backed securities. Senator McCaskill. You are talking about the assets, these subprime loans that you were buying from Long Beach that you knew had--already you had to buy back $1 billion worth of mortgages---- " FinancialCrisisReport--267 One more striking example involved a $1.6 billion hybrid CDO known as Delphinus CDO 2007-1, Ltd., which was downgraded a few months after its rating was issued. Moody’s gave AAA ratings to seven of its tranches and S&P to six tranches in July and August 2007, respectively, but began downgrading its securities by the end of the year, and by the end of 2008, had fully downgraded its AAA rated securities to junk status. 1034 Analysts have determined that, by 2010, over 90% of subprime RMBS securities issued in 2006 and 2007 and originally rated AAA had been downgraded to junk status by Moody’s and S&P. 1035 Percent of the Original AAA Universe Currently Rated Below Investment Grade Vintage Prime Fixed Prime ARM Alt-A Fixed Alt-A ARM Option ARM Subprime 2004 3% 9% 10% 17% 50% 11% 2005 39% 58% 73% 81% 76% 53% 2006 81% 90% 96% 98% 97% 93% 2007 92% 90% 98% 96% 97% 91% Source: BlackRock Solutions as of February 8, 2010. Prepared by the U.S. Senate Permanent Subcommittee on Investigations, April 2010. D. Ratings Deficiencies The Subcommittee’s investigation uncovered a host of factors responsible for the inaccurate credit ratings assigned by Moody’s and S&P to RMBS and CDO securities. Those factors include the drive for market share, pressure from investment banks to inflate ratings, inaccurate rating models, and inadequate rating and surveillance resources. In addition, federal regulations that limited certain financial institutions to the purchase of investment grade financial instruments encouraged investment banks and investors to pursue and credit rating agencies to provide those top ratings. All these factors played out against the backdrop of an ongoing conflict of interest that arose from how the credit rating agencies earned their income. If the 1034 For more details about these three examples, see “Fact Sheet for Three Examples of Failed AAA Ratings,” prepared by the Subcommittee based on information from S&P and Moody’s websites. 1035 See “Percent of the Original AAA Universe Currently Rated Below Investment Grade,” chart prepared by the Subcommittee using data from BlackRock Solutions, Hearing Exhibit 4/23-1i. See also 3/2008 “Understanding the Securitization of Subprime Mortgage Credit,” report prepared by Federal Reserve Bank of New York staff, no. 318, at 58 and table 31 (“92 percent of 1st-lien subprime deals originated in 2006 as well as … 91.8 percent of 2nd-lien deals originated in 2006 have been downgraded.”). See also “Regulatory Use of Credit Ratings: How it Impacts the Behavior of Market Constituents,” University of Westminster - School of Law International Finance Review (2/2009), at 65-104 (citations omitted) (“As of February 2008, Moody’s had downgraded at least one tranche of 94.2% of the subprime RMBS issues it rated in 2006, including 100% of the 2006 RMBS backed by second-lien loans, and 76.9% of the issues rated in 2007. In its rating transition report, S&P wrote that it had downgraded 44.3% of the subprime tranches it rated between the first quarter of 2005 and the third quarter of 2007.”) credit rating agencies had issued ratings that accurately exposed the increasing risk in the RMBS and CDO markets, they may have discouraged investors from purchasing those securities, slowed the pace of securitizations, and as a result reduced their own profits. It was not in the short term economic self-interest of either Moody’s or S&P to provide accurate credit risk ratings for high risk RMBS and CDO securities. (1) Awareness of Increasing Credit Risks CHRG-110hhrg44901--203 Mr. Bernanke," Well, the media trigger was the refusal of a bank to allow withdrawals from the hedge funds because it said it couldn't value the assets. Basically, more broadly, it was about that time that losses related to subprime mortgages and CDOs and other structured products became apparent, and there was a real change in risk perception and in risk attitude at that juncture last August. There were many off-balance-sheet vehicles, structured investment vehicles and so on that were holding CDOs, for example, that were financed by short-term money or commercial paper, creating a maturity mismatch. That was perceived to be fine as long as there was sufficient credit quality. Once the credit quality appeared to deteriorate, the overnight funders of those particular types of instruments withdrew, and they had either to be dissolved or taken off the balance sheet. So that whole class disappeared. You will notice that conventional commercial paper, unsecured or commercial paper, issued by corporations was much more stable because that wasn't the new part. The part that was proven to have some real flaws is once we began to see credit losses from subprime and other types of structured-- " fcic_final_report_full--182 When securitizers did kick loans out of the pools, some originators simply put them into new pools, presumably in hopes that those loans would not be captured in the next pool’s sampling. The examiner’s report for New Century Financial’s bank- ruptcy describes such a practice.  Similarly, Fremont Investment & Loan had a pol- icy of putting loans into subsequent pools until they were kicked out three times, the company’s former regulatory compliance and risk manager, Roger Ehrnman, told the FCIC. As Johnson described the practice to the FCIC, this was the “three strikes, you’re out rule.”  Some mortgage securitizers did their own due diligence, but seemed to devote only limited resources to it. At Morgan Stanley, the head of due diligence was based not in New York but rather in Boca Raton, Florida. He had, at any one time, two to five individuals reporting to him directly—and they were actually employees of a per- sonnel consultant, Equinox.  Deutsche Bank and JP Morgan likewise also had only small due diligence teams.  Banks did not necessarily have better processes for monitoring the mortgages that they purchased. At an FCIC hearing on the mortgage business, Richard Bowen, a whistleblower who had been a senior vice president at CitiFinancial Mortgage in charge of a staff of -plus professional underwriters, testified that his team con- ducted quality assurance checks on the loans bought by Citigroup from a network of lenders, including both subprime mortgages that Citigroup intended to hold and prime mortgages that it intended to sell to Fannie Mae and Freddie Mac. For subprime purchases, Bowen’s team would review the physical credit file of the loans they were purchasing. “During  and , I witnessed many changes to the way the credit risk was being evaluated for these pools during the purchase processes,” Bowen said. For example, he said, the chief risk officer in Citigroup’s Con- sumer Lending business reversed large numbers of underwriting decisions from “turn down” to “approved.”  Another part of Bowen’s charge was to supervise the purchase of roughly  bil- lion annually in prime loan pools, a high percentage of which were sold to Fannie Mae and Freddie Mac for securitization. The sampling provided to Bowen’s staff for quality control was supposed to include at least  of the loan pool for a given secu- ritization, but “this corporate mandate was usually ignored.” Samples of  were more likely, and the loan samples that Bowen’s group did examine showed extremely high rates of noncompliance. “At the time that I became involved, which was early to mid-, we identified that  to  percent of the files either had a ‘disagree’ deci- sion, or they were missing critical documents.”  Bowen repeatedly expressed concerns to his direct supervisor and company exec- utives about the quality and underwriting of mortgages that CitiMortgage purchased and then sold to the GSEs. As discussed in a later chapter, the GSEs would later re- quire Citigroup to buy back . billion in loans as of November , finding that the loans Citigroup had sold them did not conform to GSE standards. CHRG-111shrg53085--141 Mr. Attridge," Of removing what cap now, Senator. Senator Schumer. Removing the 12.5 percent limit on credit unions lending to small businesses. I mean, I understand it gives your membership more competition, but I am talking about now where we are desperately short of credit in the economy and lending to small businesses. " FOMC20070321meeting--41 39,MR. MOSKOW.," I just want to get back to the subprime market for a quick question. There have been a lot of newspaper stories about people who default on the first payment in these mortgages, which is a bit of a puzzle to me, unless it’s just pure fraud. I was just wondering if you had any information about whether there has been an increase in fraud here or whether there are other reasons for people defaulting on the very first payment on their mortgage." FOMC20070321meeting--113 111,MR. KOHN.," Thank you, Mr. Chairman. Like many others, I view the data over the intermeeting period as not fundamentally undermining the basic contours of our expected forecast. We’re still on track for moderate growth and gradually ebbing inflation. The economy has enough underlying strength, bolstered by financial conditions that remain quite supportive of growth, so that the housing correction should not be enough to knock the economy off the moderate growth track. Growth modestly below potential, along with the unwinding of some special factors like rent increases, should allow further declines in inflation. Real-side data reflect the fact that the downshift from above-trend growth for several years to expansion at or a little below trend hasn’t been entirely smooth, and maybe we never should have expected it to be so. Besides the overpricing and overbuilding of housing, businesses apparently built their stocks of inventories and fixed capital in anticipation of continued strong growth, and we’re seeing downshifts in demand for inventories and capital to align them with the slower pace of expected growth. Businesses typically also hoard labor under these circumstances, resulting in weaker productivity growth, and we may just be seeing this adjustment getting under way, judging from the gradual upcreep in initial and continuing claims. The inherently uneven nature of the stock adjustment process and the uncertainty around it help to explain both the overall contours of the recent data and the short-run swings in the data and perceptions of them. A number of factors, most of them mentioned by others, do support expectations of moderate growth ahead. Outside the subprime market, financial conditions remain supportive of growth. Intermediate and long-term rates are low in real as well as in nominal terms. The dollar has fallen. The fallout from the recent turbulence has been very limited. Aside from housing, a good portion of the inventory correction is behind us or is being put behind us. So over time production ought to line up better with sales. Both a rise in the national ISM index and increases in industrial commodity prices, especially in metals, support the notion of a coming recovery in manufacturing, though I admit the increase in metals prices may be a factor of the global economic expansion as well. Continued good growth of jobs to date will support increases in personal income, and as many have remarked, growth in the rest of the world has been pretty strong. I was struck by the upward revision in rest-of-world growth in the Greenbook despite weakness in the United States, the rise in oil prices, and the decline in equity values. So as Karen remarked, domestic demand abroad seems to be strengthening, and I think this bodes well for global external adjustment as well as for U.S. exports. But the information we have received over the intermeeting period not only shifted expected growth down a little but also highlighted some downside risk to activity. In housing, those downside risks center on the implications of the subprime debacle. Will it affect housing demand? Will lending terms tighten beyond the subprime market and the mortgage market? How much will tightening spill over to other lending markets, such as home equity lines of credit, and perhaps affect consumer demand? The possible answers to these questions seem to me to have downside tails that are fatter than the upside tails. Unexpected weakness in investment spending outside housing and auto-related industries is another risk factor. The question is whether this weakness represents just a short-term adjustment to moderate growth or whether businesses themselves see a downside shift in underlying demand that we don’t see. Financial conditions may not remain as supportive of growth, besides the possibility of the dropping of other shoes, such as private equity, as many have mentioned. I see a distinct downside risk to the staff’s assumption of continued increases in equity prices given the likelihood that, if the economy evolves the way the staff anticipates, long-term interest rates will rise and profits will be very disappointing to market analysts. Despite weaker spending, we still face upside risks to the gradual downdrift in inflation. Recent data haven’t been as favorable to deceleration as we would have hoped: Softer investments, slower growth of productivity, and continued strength in labor markets could suggest a slower path of trend productivity growth. If so, we would need to adjust down our expectations for growth, and labor costs would get a boost even at slower growth rates unless increases in nominal wages also downshifted pretty promptly. Good growth in labor demand could suggest a stronger path for demand and less slack than the staff is estimating. Finally, the NAIRU could well be lower than the 5 percent that the staff is estimating, especially in light of the relatively slow updrift in many measures of compensation. But, at 4½ percent, the unemployment rate is low by historical standards, and this suggests to me that the risks from resource utilization remain toward higher inflation. In sum, downside risks to our maximum employment objective have increased, but I do not think they outweigh the continuing upside risk to more-moderate inflation, at least not yet. Thank you, Mr. Chairman." CHRG-110shrg50416--41 Mr. Kashkari," We are, Senator. Again, we completely agree with the spirit of that, and we want our banks to lend. But we also did not want to be in a position of micromanaging our banks. We wanted to create a program where thousands of institutions across our country would volunteer to participate, and if we came in with very specific guidance on ``you must do this, you must do that,'' we were afraid that we would discourage firms, discourage healthy institutions from participating. And it is the healthy institutions that we want to take the capital because they are going to be in the best position to lend. Senator Shelby. One of the big rationales from Treasury in injecting this money into these nine large banks was to make them perhaps more solvent and have more capital to lend. Is that central to the whole scheme here? " FinancialCrisisReport--23 GAO, many of these borrowers: “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 purchase.” 25 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 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. 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. 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 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 24 7/28/2009 “Characteristics and Performance of Nonprime Mortgages,” GAO, Report No. GAO-09-848R at 24, Table 3. 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. CHRG-111hhrg48874--106 Mr. Green," I don't want to talk about everyone. We are trying to ascertain whether or not we have a significant number such that it is becoming a part of the problem that we are trying to extricate ourselves from. Let me go on. If we conclude, as some have, that creditworthy borrowers, many are not getting loans--what I would like to do is get to the root of the problem. Is it because of capital requirements or is it because of money that is not available within the bank to lend? The capital requirements, the TARP money that the banks received, generally speaking, was to capitalize the banks. That was not money to lend, generally speaking. Is this a true statement? If you agree that it is a true statement, raise your hand. Alright, everybody has agreed. Now if that was not money to lend, the money that the bank would lend will come from either money that it gets from overnight circumstances or from various discount windows, true? If so, raise your hand. You are going to have to participate, everyone. Okay, good, everyone agrees. Or it can come from monies that the banks will have in their loan portfolios, which comes from deposits, true? So the question is this. Is the problem one of being undercapitalized such that they can't lend money from deposits or from the discount windows, or is one of being capitalized properly, fully capitalized, and not having the money available from deposits? Do you follow my question? If you do not, raise your hand and I will give it to you again. So if you would, Mr. Polakoff, give your commentary, please. " fcic_final_report_full--538 This dissenting statement argues that the U.S. government’s housing policies were the major contributor to the financial crisis of 2008. These policies fostered the development of a massive housing bubble between 1997 and 2007 and the creation of 27 million subprime and Alt-A loans, many of which were ready to default as soon as the housing bubble began to deflate. The losses associated with these weak and high risk loans caused either the real or apparent weakness of the major financial institutions around the world that held these mortgages—or PMBS backed by these mortgages—as investments or as sources of liquidity. Deregulation, lack of regulation, predatory lending or the other factors that were cited in the report of the FCIC’s majority were not determinative factors. The policy implications of this conclusion are significant. If the crisis could have been prevented simply by eliminating or changing the government policies and programs that were primarily responsible for the financial crisis, then there was no need for the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, adopted by Congress in July 2010 and often cited as one of the important achievements of the Obama administration and the 111 th Congress. The stringent regulation that the Dodd-Frank Act imposes on the U.S. economy will almost certainly have a major adverse effect on economic growth and job creation in the United States during the balance of this decade. If this was the price that had to be paid for preventing another financial crisis then perhaps it’s one that will have to be borne. But if it was not necessary to prevent another crisis—and it would not have been necessary if the crisis was caused by actions of the government itself—then the Dodd-Frank Act seriously overreached. Finally, if the principal cause of the financial crisis was ultimately the government’s involvement in the housing finance system, housing finance policy in the future should be adjusted accordingly. 533 -----------------------------------------------------Page 562-----------------------------------------------------  FinancialCrisisReport--37 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 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 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. 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 CHRG-111shrg49488--65 Mr. Nason," No. That is actually one of the premises of the Paulson plan, is clarity of mission and clarity of objective. See, one of the problems that we dealt with was that there was a lot of finger pointing. There were battles between the State regulators versus the Federal regulators on who was in charge of mortgage origination. So there were concerns about who was in charge of the holding company of Lehman Brothers. Was it the OTS or the SEC? So there is much less chance for finger pointing under an objectives-based criteria like the Dutch and the Australians have. Senator McCaskill. Mr. Clark, I heard you say that you originate mortgages to hold them, and I keep explaining that one of my concerns about reverse mortgages that we are now ramping up in this country is that they are very similar to subprimes in that the people who are closing loans have no skin in the game. Now, the scary thing about reverse mortgages is that all of the skin is taxpayer skin. If those assets are sold at term and they are not sufficient to cover the loan, the Federal Government has to cover the loan. But in the subprime, it was all of these exotic sliced and diced derivatives that were spread out all over that we are trying, like Humpty-Dumpty, to put back together again now. I assume that in Canada the people who are holding the mortgage are the same ones who made them and, therefore, they continue to have skin in the game. " CHRG-111shrg51303--48 Mr. Polakoff," Yes, Senator. When you look through the weeds, it is clear that the various insurance subsidiaries that participate in the security lending business, the insurance commissioners had responsibility for understanding and approving any agreements between the insurance companies and the entity that was formed for the security lending business and any of the losses that were recorded were recorded on the insurance company's books. The Insurance Commissioner's staff would have known that when they looked at the books and records. Senator Shelby. Were these securities lending losses greater than the statutory cap? For example, in 2008, it is my understanding that American International Life's statutory cap was 662 and the losses were 771. " CHRG-111hhrg48674--70 Mr. Bernanke," Well, in many cases, they don't have--so the reserves at the Fed are very, very safe and have a very low weight against capital. In many cases, they either don't have enough capital, or they are simply worried about the creditworthiness of the borrowers or the demand for lending. That inhibits their willingness to take those reserves and lend them out. If they were to lend them out and the money supply began to grow, I am sure Congressman Paul would be very concerned about that, then the Fed would pull back and let them take the lead. But for the moment, their capital, their worries about creditworthiness, and their lack of loan demand and uncertainty about the economy is causing them to be very reticent. " FinancialCrisisReport--399 If the Department’s existing long positions could be transferred off SPG’s books by finding a “structured place to go with the risk,” the ABS Trading Desk would then be free to “double down” by taking on new positions and risk. That same month, September 2006, the ABS and CDO Desks reached agreement on constructing a new CDO to provide the ABS Desk with a “structured exit” from some of its existing investments. The result was Hudson Mezzanine 2007-1, a CDO designed by Goldman to transfer to Hudson investors the risk associated with $1.2 billion in net long ABX assets then in Goldman’s inventory. The Hudson CDO was also designed to allow Goldman to short $800 million in RMBS securities to offset a portion of its long ABX assets. 1611 In December 2006, even after the $2 billion Hudson CDO was constructed, the Mortgage Department calculated that it still had a $6 billion net long position in subprime mortgage related assets. 1612 Goldman’s ABX holdings continued to be a major source of its long assets. Goldman’s Long ABX Assets. In January 2006, Goldman, Deutsche Bank, and several other Wall Street firms launched the ABX Index which, for the first time, allowed investors to use standardized CDS contracts to invest in baskets of subprime RMBS securities. The ABX Index measured the aggregate performance of a selected basket of 20 RMBS securitizations, producing a single value that rose or fell over time in line with the performance of the underlying RMBS securities. 1613 Investors could enter into CDS contracts that used a particular ABX Index as the “reference obligation,” without physically purchasing or holding any of the RMBS securities in the underlying basket. Because the ABX Index itself was synthetic, and did not depend upon the acquisition of large blocks of RMBS securities, it enabled an unlimited number of investors to make unlimited bets on the performance of a group of subprime RMBS securities, using standardized contracts that could be bought and sold. The ABX Index also made it economical for investors to short subprime RMBS securities in bulk. 1614 1610 1611 Id. Goldman responses to Subcommittee QFRs at PSI_QFR_GS0239. For more information on Hudson, see section C(5)(b)(ii)AA., below. 1612 3/10/2007 email to Daniel Sparks, “Mortgage presentation to the Board, ” GS M BS-E-013323395, Hearing Exhibit 4/27-17 (M ortgage Department was $6 billion net long at start of the quarter). 12/13/2006 Goldman email, “Subprime Mortgage Risk, ” Hearing Exhibit 4/27-2. 1613 The ABX Index actually consisted of five separate indices. Each index tracked a different set of RMBS securities pulled from the 20 RM BS securitizations in the ABX basket. The sets varied according to their assigned credit ratings. One index tracked the 20 RMBS securities with AAA ratings, another tracked the 20 RMBS securities with AA ratings, and so on. 1614 Subcommittee interview of Joshua Birnbaum (10/1/2010); Subcommittee interview of Rajiv Kamilla (10/12/2010). CHRG-111hhrg56776--31 Mr. Bachus," Through the discount lending window. " CHRG-111hhrg56776--29 Mr. Bachus," They should not be lending money to failing institutions? " CHRG-111shrg51303--152 Mr. Kohn," We lend on a secured basis. " FOMC20080310confcall--87 85,MR. ALVAREZ.," You'll be asked to vote on three resolutions today--one that deals with the term securities lending facility and two that deal with the swaps. The Board is also voting separately to authorize part of the term securities lending facility. One matter I would note, because the rate on the TSLF must be set in the same way that other discount rates are set, we do need a recommendation on how to set the rates. However, because this facility involves just securities lending from the SOMA portfolio, it will be sufficient to receive a rate recommendation from just the New York Reserve Bank, and so the resolutions would not be needed from the boards of directors of the other Reserve Banks at this point. With that, I'll read the resolution for the term securities lending facility, and I will ask for a vote on that. ""In addition to the current authorization granted to the Federal Reserve Bank of New York to engage in overnight securities lending transactions, and in order to ensure the effective conduct of open market operations, the Federal Open Market Committee authorizes the Federal Reserve Bank of New York to lend up to $200 billion of U.S. government securities held in the System Open Market Account to primary dealers for a term that does not exceed thirty-five days at rates that shall be determined by competitive bidding. These lending transactions may be against pledges of U.S. government securities, other assets that the Reserve Bank is specifically authorized to buy and sell under section 14 of the Federal Reserve Act (including federal agency residential-mortgage-backed securities), and nonagency AAA-rated residential-mortgage-backed securities. The Federal Reserve Bank of New York shall set a minimum lending fee consistent with the objectives of the program and apply reasonable limitations on the total amount of a specific issue that may be auctioned and on the amount of securities that each dealer may borrow. The Federal Reserve Bank of New York may reject bids which could facilitate a dealer's ability to control a single issue as determined solely by the Federal Reserve Bank of New York. This authority shall expire at such time as determined by the Federal Open Market Committee or the Board of Governors."" " CHRG-110shrg50416--40 Chairman Dodd," I agree. They said that. I am not ruling out acquisitions. The hoarding notion is the one that really is distracting. Senator Shelby. Senator Shelby. Thank you. Secretary Kashkari, why did Treasury not attach a requirement to increase lending as a price for receiving the Government money? In other words, we are talking about lending to keep our economy going, are we not? " CHRG-111hhrg54869--31 Mr. Bachus," Let me ask you another question, and I really have two. One is I just want to acknowledge something and see--we did have--some of our failures were a result of the derivative trading and instruments that didn't exist 20 years ago. And you have talked about that. You had another problem and that is depository institutions that went out and bought subprime affiliates that were not regulated at all. And I think that was a tremendous threat to the system. " CHRG-111hhrg53238--224 Mr. Manzullo," Now, Ms. Leonard, do you agree with my assessment that had the Fed had some reasonable--I mean, the Fed finally has put these into effect, will take effect in October of this year-- wouldn't that have stopped a lot of the subprime? Ms. Leonard. Yes. If the lenders were not allowed to create those products, those, you know, riskier guidelines, yes. " CHRG-111shrg57319--21 Mr. Vanasek," Yes. Washington Mutual purchased subprime loans from Ameriquest Mortgage primarily, New Century on occasion, and that was a separate pool, separate and distinct from Long Beach. Senator Levin. All right. Now, Mr. Vanasek, let me start with you. Were you aware during your tenure how these Long Beach loans and securities that were sold to investors performed? " CHRG-111shrg57320--192 Mr. Dochow," We obviously are concerned with an institution's ability to prove the ability of the customer to repay the loan, and that is why the agencies on an inter-agency basis issued the Non-Traditional Mortgage Guidance and the Subprime Guidance, to make sure that you documented the customer's ability to repay. Senator Kaufman. Right. Mr. Reich, I assume you agree with what Mr. Dochow was saying? " CHRG-111hhrg54872--240 Mr. Calhoun," I will start with that. The bill currently pushes preemption back close to what it was in 2004. So the one issue is, do you roll back some of what many of us believe was excessive preemption that led to the problems that we have now, not just the mortgages, but in credit card overdraft. There is a second question that there are proposals to actually increase the amount of preemption that we have in the bill and, specifically, to make any rule of the CFPA preemptive, even though most of its authority comes from statutes such as truth in lending which today are not preempted. States are allowed to build on those protections. And I think, importantly, truth in lending is a good example. There has been virtually no State activity, although it is permitted, because you have comprehensive regulation. States like North Carolina moved in and Georgia attempted to move in, in predatory mortgage lending, due to the failure of the Federal regulators to take action. When Federal regulators have taken action, typically States adhere to those standards because they are beneficial to the community in that State. But I think that is the line that it crosses. If it becomes fully preemptive, it undercuts current protections in a wide array, consumer car purchases, furniture purchases across-the-board, payday lending, all of that could be swept aside by a single administrator. Ms. Speier. Let me move on to payday lending, because in the bill, it prohibits the CFPA from establishing a usury limit. Now, I feel pretty passionately about that issue, I realize. But nonetheless, why would we want to tie the hands of a consumer protection agency from actually putting in place a usury limit of let us say 36 percent? " CHRG-111hhrg52261--62 Mrs. Dahlkemper," Let me ask you then a question that goes along with that, because it has been reported that mortgage brokers who processed the subprime loans are now counseling individuals who are indebted by those loans regarding their restructuring. So does your association promote standards by which brokers evaluate the financial suitability of loan products by prospective borrowers? Or do you just rely upon the lenders, underwriters for that? " CHRG-111shrg52966--40 Mr. Polakoff," Senator, I would offer that we need to ensure that there is a level playing field. We have had some products--80 percent of subprime loans were underwritten by mortgage brokers. There is no Federal oversight for that. Senator Bunning. Well, I am sorry, but the Federal Reserve got that job in 1994. That was their job. I mean, we wrote a law that gave them that job. Whether they did it or not is another question, but we handed that over to the Fed. SEC? " CHRG-110hhrg38392--76 Mr. Pearce," I would note that the National Petroleum Council met just yesterday--these are inside industry experts--and they forecast that supply will be very tight and that prices will be high, trending higher, and then I think that we are doing things--I have seen the bill that we have marked-up in the Committee on Resources that would begin to limit access internally to Federal lands and to also slow the process down so that our supplies internally are beginning--will collapse. I will tell you that, as a life-long member of the oil industry and growing up in an oil town that already--because of the things that we are doing here, that as to the remedial work on the wells that keeps the production curve steady instead of declining, it is beginning to shut down. That utilization of equipment is beginning to lag nationwide, but also, specifically, in the remedial area, and so you have to anticipate that there might be some clouds on the horizon in that forecast and then the effect. Now, there are about three pages of your report from about the bottom of page 6 on where we are dealing with the subprime market, and some portion of that is a difficult market. My question is as to the worst-case scenario: I am wondering why we have so much attention on the subprime market. If the entire market collapsed--let us take the worst, worst, worst-case scenario--how much effect would that have on our economy? I would like that answer in kind of the context of, recently, Dow Chemical announced, because of high energy prices, that they are building a $22 billion facility in Saudi Arabia, another $8 billion facility in China, and together, 10,000 jobs are going to those places. Those would be high-six-figure jobs here, and yet they are building. So my question is that 30 percent of your report is about subprime, and the addressing of things that we should be addressing, but I am not sure that 30 percent of our time should be addressed versus the effect of high energy prices. Could you give me some understanding of those two factors? " CHRG-111shrg57322--176 Mr. Swenson," Yes. We worked together on the same desk. Senator Coburn. Mr. Swenson, you also say in this assessment that it was clear to you in the early summer of 2006 that ``the market fundamentals in subprime and the highly levered nature of CDOs was going to have a very unhappy ending.'' That is a quote from your self-assessment. Did you share that knowledge with anybody else at the firm other than those who read your self-assessment? " CHRG-111hhrg48674--317 Mr. Castle," Thank you. What criteria are you looking at to determine the effectiveness of the various programs, not only your regular lending to the banks, but to the other institutions, the AIGs and Bear Stearnses? I mean, do you look at just the capitalization and liquidity, or are you looking at what they are doing with it and how they are conforming to their normal lending practices or whatever? What criteria do you look at? " CHRG-111hhrg54872--297 Mr. Menzies," Coordination is important on anything that can be done to produce greater coordination between the regulatory agencies and the CFPA will produce a positive benefit. But, Congressman, community banks and our customers were equally injured by predatory lending. And in our State, we have been aggressive about that, because predatory lending benefits no one. " CHRG-110shrg50409--2 Chairman Dodd," Well, good morning. Let me welcome my colleagues and others to this very important hearing this morning. I want to thank the Chairman of the Federal Reserve. Today we are meeting in the most unusual and extraordinary moments in many ways in the recent history of our country. Let me tell you how we are going to proceed this morning. This is, of course, a scheduled hearing with the Chairman of the Federal Reserve on Humphrey-Hawkins and dealing with monetary policy, and over the next hour or so, we are going to focus on that and give the Chairman an opportunity to give us his statement this morning on that statutorily mandated requirement to appear before the Committee and share his thoughts on this issue. And then, as I understand it, we are due to have a vote around 11 o'clock, and my hope would be that we would recess for a few minutes for that vote, and when we come back, the Secretary of the Treasury, Hank Paulson, and Christopher Cox, the Chairman of the Securities and Exchange Commission, will be with us to engage in a discussion of the financial services issues that are before us. I want to thank Senator Shelby and my colleagues here for waiving the normal requirements of having several days of notice before we actually have a hearing like this. But I think all of us recognize the significance of the issues that are going on in our country at this moment and the importance of having the Secretary of the Treasury and the Chairman of the SEC as well as the Chairman of the Federal Reserve to be with us this morning. So I am very grateful to you and to the Secretary of the Treasury and Chris Cox. So the first hearing will be to receive the Semiannual Monetary Policy Report from the Federal Reserve as previously scheduled, and after the conclusion of that hearing, we will convene a second hearing on Recent Developments in U.S. Financial Markets and Regulatory Responses to Them. The second hearing was noticed yesterday with the consent of Senator Shelby--and, again, I am grateful to him--due to the special and exigent circumstances in our Nation's financial markets. I want to thank Chairman Bernanke for testifying at both hearings. I also thank Secretary Paulson and Chairman Cox for agreeing to appear on very short notice at the second hearing. In deference to them and the importance of the matters at hand, I will provide a brief opening statement. I will ask Senator Shelby to do likewise. And then I would ask my fellow Members here if they would reserve their question period to make their opening statements. All statements will be included in the record as if read so that we can get to the statement by the Chairman of the Federal Reserve and then get to the questions as quickly as we can. In considering the state of our economy and, in particular, the turmoil in recent days, it is important to distinguish between fear and facts. In our markets today, far too many actions are being driven by fear and ignoring crucial facts. One such fact is that Fannie Mae and Freddie Mac have core strengths that are helping them weather the stormy seas of today's financial markets. They are adequately capitalized. They are able to access the debt markets. They have solid portfolios with relatively few risky subprime mortgages. They are well regulated, and they have played a vital role in maintaining the flow of affordable mortgage credit even during these volatile times. Another fact is that the subprime lending fiasco was preventable. In this Committee, 18 months of exhaustive hearings have documented what I have called a ``pattern of regulatory neglect.'' The previous leadership, along with other financial agency leaders appointed by this administration, in my view ignored the clear and present danger posed by predatory lending to homeowners, to financial institutions, and to the economy as a whole. The result of this neglect is that the American people are experiencing unprecedented hardships and uncertainties. Foreclosure rates continue at record levels. Each and every day in America, more than 8,000 families enter foreclosure. For those lucky enough to keep their homes, the value of their homes has dropped by the greatest amount in some cases since the Great Depression. Millions more are paying record-high prices for gasoline, for health care, for education, and even for the food that they put on their tables. They are watching the value of their pension funds and 401(k)s plummet. And they want to know when will things start to turn around, when will America get back on track. Chairman Bernanke, you are to be commended, in my view, for your efforts to bring greater stability to our financial system during an unprecedented period of volatility. You also deserve credit for your willingness to address some of the unsafe, unsound, and predatory practices that proliferated over the last several years in the subprime mortgage market, as well as in the credit card lending. And we look forward to hearing from you today about the outlook for the Nation's economy and what can be done to improve it. Certainly, this Committee has worked diligently in that regard. On Friday evening, the Senate passed, with an overwhelming bipartisan majority, a bill that we believe will assist homeowners at risk of foreclosure, establish a new, permanent affordable housing fund, modernize the FHA, strengthen the regulation of the GSEs, and help restore confidence to the mortgage markets as a whole. It is certainly my view that this legislation deserves to be enacted as soon as possible, and I hope that will occur. In addition, we are all by now aware that the Treasury and the SEC as well as the Fed made important policy announcements this past weekend, which we intend to examine carefully in the hearing later this morning with you, Mr. Chairman, Secretary Paulson, and Chairman Cox. I think I can speak for everyone, I hope, on this Committee in saying that we all share a common desire to promote the common good of our country, and I think we all certainly appreciate the spirit in which the Fed, the SEC, and the Treasury Department have acted. But we do them and the American people a disservice if we do not examine very carefully the proposals that are being put forward. That is particularly true of the Treasury proposals. It is in many respects unprecedented. Although limited in duration, these proposals would give the Treasury unlimited new authority to purchase GSE debt and equity, it would exempt those purchases from pay-as-you-go budget rules, and it would grant to the Federal Reserve considerable new powers in relation to the regulation of the GSEs. These new powers could have the effect of crippling the efforts of virtually every Member of this Committee to create a true world-class regulator for the GSEs. These proposals raise serious questions--questions about the nature of the economic crisis facing our Nation, about the ability of these proposals to address this crisis effectively, and about the burden to the American taxpayer potentially being asked to carry. These questions deserve serious answers. Above all, this is a time to act on the basis of fact and not fear, as I said at the outset of these remarks. For too many years, leaders have shirked their duty, in my view, to protect the American taxpayer and to promote the American economy. At this critical moment, we must not flinch from our duty to do the same. With that, let me turn to Senator Shelby. CHRG-111hhrg56766--121 Mr. Castle," Thank you, Mr. Chairman. Chairman Bernanke, like many others here, probably all of us, I'm very concerned about the job situation in the United States and we can argue politically whether the Stimulus Program has worked well or not. Mr. Zandi, an economist, yesterday indicated that the jobs that were created were probably to some degree temporary in that we funded governments so they could keep on employees for a period of time and various capital projects that will expire at some point or another. So we still have a continuing problem, and I have had a couple of job fairs in my State and I have been surprised both at the number of people who have come out for that and the backgrounds of some of these people. It's not the usual unemployed, it's people with college degrees, even graduate degrees, who are unemployed at this point. I see that the lending by banking institutions has fallen by some 7.5 percent in 2009, and my question to you is, is there anything that you as the head of the Fed or the Fed itself or us as Members of Congress could be doing to help with the employment circumstance? My further question is what is happening in this whole bank lending? I mean, we have put a lot of--we, being both the TARP Program and the Federal Reserve, have put a lot of money into banking institutions, primarily larger banking institutions, and the theory was that they're the ones who are going to lend to the other commercial banks who would then lend to the business people on main streets throughout America and that somehow seems to have not connected. The lending is down for a lot of the reasons you're talking about, the commercial real estate issues and various aspects like that which I understand, but what is it that we could do to make sure that the lending does pick up so that jobs can be created and, perhaps as an economist beyond even the Federal Reserve, what else should we be doing differently or considering doing in terms of helping with employment, by we meaning Congress and the Federal Reserve? " CHRG-111hhrg54872--293 Mr. Manzullo," I agree with that. I guess the issue is the powers have already been out there to stop the subprime meltdown. But it is interesting that some of the people who complain now that those powers were not used, were the first in line to say, we have to have housing for everybody. Housing became a right, and then an entitlement, and then the meltdown started on it. Thank you. " Mr. Green," [presiding] Mr. Driehaus of Ohio is recognized for 5 minutes. " CHRG-111hhrg53244--324 Mr. Bernanke," Those are swaps that were done with foreign central banks. Many foreign banks are short dollars. And so they come into our markets looking for dollars and drive up interest rates and create volatility in our markets. What we have done with a number of major central banks like the European Central Bank, for example, is swap our currency, dollars, for their currency, euros. They take the dollars, lend it out to the banks in their jurisdiction. That helps bring down interest rates in the global market for dollars. And, meanwhile, we are not lending to those banks; we are lending to the central bank. The central bank is responsible for repaying us. " CHRG-110shrg46629--33 Chairman Bernanke," Senator, we are looking at that very carefully. Our subprime mortgage guidance, which has already been issued with the other banking agencies, takes the position that prepayment penalties should not extend into the period where the interest rates reset. So they should not prevent people from refinancing when their industries are about to go up. We are looking at that specifically as part of our HOEPA rules, as well. I agree with you, there are situations where prepayment penalties are not in the interest of the borrowers and we are looking at those. Senator Brown. Are those just guidelines or are those actually requirements? " FinancialCrisisInquiry--106 But I do believe that one of the issues we must explore is, was this purely a perfect storm? Or was it a manmade perfect storm in which the clouds receded? And that’s why I’m driving towards questions and answers about responsibility. I’m going to put aside for a minute my view that I’m troubled by your inability to accept the probability or certainty that your firm would not have made it through the storm but for the vast array of federal assistance. But I really want to turn to this issue of mortgages, which you securitized, as did other firms. BofA stopped making subprime loans in 2001, but you still did securitize mortgage packages, Alt-A, jumbo, that had significant problems, 16 to 25 percent default. So maybe those are like the Murder on the OrientExpress, everyone did it. Having said that, Mr. Blankfein, I read your testimony you said there was cheap money. Albeit there was, there was public policy driving this mortgage business, but you weren’t subject to the Community Reinvestment Act. They were the standards at the time, but I would hope that we always would try to elevate standards. I think what I’m bothered by is this. You weren’t just a market maker. You were securitizing and underwriting packages of mortgages, and when it was clear the market was going bad, even though there was information about bad lending practices that other people moved on, you kept moving this product in the market. And I guess what I’d ask you is what is your responsibility when you put your name on a security to investor to underwrite that thoroughly? There were FBI warnings. There were loan tapes available. Did you fail in that respect in that you did not underwrite the loans that you then securitized and moved into the market? BLANKFEIN: Mr. Chairman, all these loans—what we did in that business was underwrite to again the most sophisticated investors who sought that exposure. I know it’s become part of the narrative to some extent that people knew what was going to happen at every minute. We did not know at any minute what would happen next, even though there was a lot of writing. The FBI may have wrote a report in ‘04, but I will tell you that there were people in the market who thought that -- was going down and there were others who thought, gee, these prices have gone down so much they’re going to bounce up again. CHRG-111shrg53085--138 Mr. Mica," We could put $10 billion on Main Street, $10 billion into Main Street small loans almost immediately if they lifted that cap. Senator Schumer. Mr. Attridge, let me just ask you, why at this time--we can debate whether this should be done permanently--but why at this time when so many banks, big and small, are not lending for a variety of reasons, and I hear about it regularly--I have several instances in my State where a small business is going to go under because they can't get bank lending. The existing bank has pulled the line of credit. They don't think the value of the inventory is as great as it used to be. Credit unions want to lend and they can't because they are at the cap. Give me a reason why we shouldn't, at the very least, temporarily lift the cap, given the state of our economy. " FOMC20070628meeting--126 124,MR. LOCKHART.," Thank you, Mr. Chairman. I would like to speak earlier next time, so I don’t have to give credit to so many of the previous speakers—[laughter] including President Poole, who really said a lot of what I have to say. There wasn’t much change in the Sixth District economic picture during the intermeeting period, particularly regarding things that are relevant to the national outlook. So I am not going to devote a lot of time to discussing across-the-board conditions in the District. My staff’s outlook— and my outlook—for the national economy doesn’t differ much from the Greenbook analysis and forecast, so I also won’t detail small differences between those two forecasts. The Greenbook outlook reflects the baseline expectation of a diminishing drag on real growth from residential investment. Since our forecast largely agrees with the Greenbook, we obviously see the most likely playout of the housing correction similarly. However, as suggested in the Greenbook’s first alternative simulation, we may be too sanguine. I think this is really President Poole’s message about a recovery in the housing sector. That is to say, the downturn in residential investment will be deeper and more prolonged and possibly involve spillovers. So I would like to devote my comments, in a cautionary tone, to this particular concern. Credit available for residential real estate purchases is contracting, and the credit contraction, specifically in the subprime mortgage market, has the potential to lengthen the transition period required to reduce housing inventories to normal levels. This tightening of credit availability, along with higher rates, may affect the timeline of the recovery. One market of concern is the starter home market. The subprime mortgage market has been a major credit source for first-time homebuyers—although, as has been mentioned earlier, subprime mortgages are a small portion of the aggregate stock of mortgages. Subprimes were 20 percent of originations in 2005 and 2006, and if you added alt-A nonprime mortgages, you would get 33 percent of originations in the past two years. In many suburban areas, like those around Atlanta and Nashville in my District, much home construction was targeted at first-time buyers. We have heard anecdotal reports from banking and real estate contacts in our region that tighter credit conditions have aggravated the already sluggish demand for homes. The country’s largest homebuilder—there may be a debate with President Fisher—[laughter] so one of the country’s largest homebuilders, headquartered in Miami, reported on Tuesday a 29 percent drop in homes delivered and a 7.5 percent drop in average prices. But that is combined with a 77 percent increase in sales incentives. They attribute their negative sales experience to rising defaults among subprime borrowers and higher rates. That company’s CEO said that he sees no sign of a recovery, and he provided guidance of a loss position in the third quarter. Because of the major role that homebuilding—and, I might add, construction materials, particularly in forest products—plays in the Sixth District economy and because of some tentative signs of spillover, we will continue to monitor these developments in our District very carefully. As I stated at the outset, we share the basic outlook described in the Greenbook, but observation of the housing sector dynamics in the Sixth District has raised our level of concern that the national housing correction process may cause greater-than-forecasted weakness in real activity. If that is the case and inflation gains prove transitory, as suggested in the Greenbook commentary, we may be dealing with a far more challenging policy tradeoff than we are today. Thank you, Mr. Chairman." fcic_final_report_full--502 Your CRA business is very important to us. Since 1997, we have done nearly $7 billion in specially targeted CRA business—all with depositories like yours. But that is just the beginning. Before the decade is over, Fannie Mae is committed to finance over $20 billion in specially targeted CRA business and over $500 billion in CRA business altogether… We want your CRA loans because they help us meet our housing goals… We will buy them from your portfolios, or package them into securities… We will also purchase CRA mortgages you make right at the point of origination... You can originate CRA loans for our purchase with one of our CRA-friendly products, like our 3 percent down Fannie 97. Or we have special community lending products with flexible underwriting and special financing… Our approach is “CRA your way”. 91 The 50 percent level in the new HUD regulations was a turning point. Fannie and Freddie had to stretch a bit to reach the previous goal of 42 percent, but 50 percent was a significant challenge. As Dan Mudd told the Commission, Fannie Mae’s mission regulator, HUD, imposed ever-higher housing goals that were very diffi cult to meet during my tenure as CEO [2005-2008]. The HUD goals greatly impacted Fannie Mae’s business, as a great deal of time, resources, energy, and personnel were dedicated to finding ways to meet these goals. HUD increased the goals aggressively over time to the point where they exceeded the 50% mark, requiring Fannie Mae to place greater emphasis on purchasing loans to underserved areas. Fannie Mae had to devote a great deal of resources to running its business to satisfy HUD’s goals and subgoals. 92 Mudd’s point can be illustrated with simple arithmetic. At the 50 percent level, for every mortgage acquired that was not goal-qualifying, Fannie and Freddie had to acquire a goal-qualifying loan. Although about 30 percent of prime loans were likely to be goal-qualifying in any event (because they were made to borrowers at or below the applicable AMI), most prime loans were not. Subprime and other NTM loans were goals-rich, but not every such loan was goal-qualifying. Accordingly, in order to meet a 50 percent goal, the GSEs had to purchase ever larger amounts of goals-rich NTMs in order to acquire suffi cient quantities of goals-qualifying loans. Thus, in a presentation to HUD in 2004, Fannie argued that to meet a 57 percent LMI goal (which was under consideration by HUD at the time) it would have to acquire 151.5 percent more subprime loans than the goal in order to capture enough goal-qualifying loans. 93 Moreover, with the special affordable category at 20 percent in 2004, the GSEs had to acquire large numbers of NTM loans from borrowers who were at or below 60 percent of the AMI. This requirement drove Fannie and Freddie even further into risk territory in search of loans that would meet this subgoal. 91 Jamie S. Gorelick, Remarks at American Bankers Association conference, October 30, 2000. http:// web.archive.org/web/20011120061407/www.fanniemae.com/news/speeches/speech_152.html. 92 Daniel H. Mudd’s Responses to the Questions Presented in the FCIC’s June 3, 2010, letter, Answer to Question 6: How influential were HUD’s affordable housing guidelines in Fannie Mae’s purchase of subprime and Alt-A loans? Were Alt-A loans “goals-rich”? Were Alt-A loans net positive for housing goals? 93 Fannie Mae, “Discussion of HUD’s Proposed Housing Goals,” Presentation to the Department of Housing and Urban development, June 9, 2004. CHRG-111hhrg48674--10 Mr. Bernanke," I thank you, Mr. Chairman. I would like to maintain throughout this hearing a very clear distinction between the 95 percent of our balance sheet which is devoted to regular lending programs, such as lending to sound financial institutions or supporting the credit commercial paper facility, versus the other 5 percent of our balance sheet which has been involved in-- " FinancialCrisisInquiry--832 BORN: Thank you. Listening to your testimony, it strikes me to ask where were the regulators. Mr. Rosen, you said that the Federal Reserve Board had a lot of data about the predatory lending that was going on. They had been given the authority and responsibility by statute to oversee and prevent predatory lending. Do you know why the Fed failed to act in this respect? fcic_final_report_full--527 The result of Fannie’s competition with FHA in high LTV lending is shown in the following figure, which compares the respective shares of FHA and Fannie in the category of loans with LTVs equal to or greater than 97 percent, including Fannie loans with a combined LTV equal to or greater than 97 percent. Figure 7. Whether a conscious policy of HUD or not, competition between the GSEs and FHA ensued immediately after the GSEs were given their affordable housing mission in 1992. The fact that FHA, an agency controlled by HUD, substantially increased the LTVs it would accept in 1991 (just before the GSEs were given their affordable housing mission) and again in 1999 (just before the GSEs were required to increase their affordable housing efforts) is further evidence that HUD was coordinating these policies in the interest of creating competition between FHA and the GSEs. The effect was to drive down underwriting standards, which HUD had repeatedly described as its goal. 5. Enlisting Mortgage Bankers and Subprime Lenders in Affordable Housing In 1994, HUD began a program to enlist other members of the mortgage financing community in the effort to reduce underwriting standards. In that year, 143 GAO, “Federal Housing Administration: Decline in Agency’s Market Share Was Associated with Product and Process Developments of Other Mortgage Market Participants,” GAO-07-645, June 2007, pp. 42 and 44. 523 the Mortgage Bankers Association (MBA)—a group of mortgage financing firms not otherwise regulated by the federal government and not subject to HUD’s legal authority—agreed to join a HUD program called the “Best Practices Initiative.” 144 The circumstances surrounding this agreement are somewhat obscure, but at least one contemporary account suggests that the MBA signed up to avoid an effort by HUD to cover mortgage bankers under the Community Reinvestment Act (CRA), which up to that point had only applied only to government-insured banks. In mid-September [1994], the Mortgage Bankers Association of America- whose membership includes many bank-owned mortgage companies, signed a three-year master best-practices agreement with HUD. The agreement consisted of two parts: MBA’s agreement to work on fair-lending issues in consultation with HUD and a model best-practices agreement that individual mortgage banks could use to devise their own agreements with HUD. The first such agreement, signed by Countrywide Funding Corp., the nation’s largest mortgage bank, is summarized [below]. Many have seen the MBA agreement as a preemptive strike against congressional murmurings that mortgage banks should be pulled under the umbrella of the CRA. 145 CHRG-111hhrg48674--311 Mr. Green," Thank you. Now, a quick comment and a response from you. All banks are not bad banks; and somehow all banks are getting the rap of being bad banks because of what is happening, but they are not. Some desire to lend, but they are not fully capitalized to the extent that they would like to be, or if they are, they are having problems with making loans because of, one, not getting good applicants, two, because they don't have the money to lend. While they received money to capitalize, to be capitalized--the money that we, for example, placed in banks; that money was to take an equity position, and they used that money for capitalization--they don't use that money for lending. So since they have that money--and the public believes by the way, Mr. Bernanke, and I am sure you are aware of this, that they could have taken that money and immediately started to lend it, which is a mistake; and somehow we have to communicate that message that there are rules that require that they be fully capitalized or capitalized to the extent that they can make loans at a certain ratio. So here is my concern: If we don't get this message out--and I think this is what one of the chairpersons has talked about earlier in another way. But if we don't get this message out, the public continues to believe that the banks are getting money, and they are just holding on to it because they just like holding money, which is highly unusual for banks. They kind of like to lend at a high rate and borrow at a cheap rate, if they have to borrow, and prefer not to borrow if they can help it. So now would you kindly comment on how we can deal with this perception that the public has about banks? " CHRG-111hhrg53248--67 Secretary Geithner," I want to just agree with one thing you said in your opening statement first, which is to say there is a lot of dumb regulation in our country. And part of our challenge is smarter regulation, not just more regulation. But I think if you look at credit products marketed to consumers, not just subprime, a broader array of mortgage products, and in the credit card area, beyond credit cards, too, there were a lot of examples of practices that we should not have tolerated in this country. " CHRG-110hhrg46596--49 Mr. Scott," Thank you, Mr. Chairman. What we have here, quite honestly, is one big mess. That is exactly what we have. The people sitting at that table looking at us ought to be Secretary Paulson and the Treasury Department and the banks. We have been lied to; the American people have been lied to. We have been bamboozled; they came to us to ask for money for one thing, then used it for another. They said we would have oversight, and no oversight is in place. We have given these banks $290 billion for the sole purpose of so-called buying these toxics. They change it, and all of a sudden now they are not lending it but using it for acquisitions, using it for salaries. These are lies. We have been bamboozled. The Secretary of the Treasury owes us an explanation about this, owes the American people an explanation about this. We have the auto companies coming to us. In a few days, we are going to give them a $15 billion loan. When they were here, we asked them, why can't you go to the banks? The banks won't lend it. Here we have sent them $290 billion, but they won't lend it. Why won't the banks lend the money to small businesses and the American people? That is the question. " CHRG-111shrg57319--511 Mr. Rotella," We also brought that business down significantly. So if I was not concerned, I would not have taken some of the actions I did to bring in new management, to bring in new technology, to restructure the business, and to take volume down, and ultimately shut down the subprime business totally, as well as Option ARMs. Senator Kaufman. And also shut down Long Beach, right? " CHRG-110shrg46629--34 Chairman Bernanke," They are requirements. That is, they are enforced by examination and supervision of the banks. But the subprime guidance, which is a collaboration of the four banking agencies, applies only to banks and thrifts and not to lenders outside of the banking system, which is what the HOEPA was about, would apply to everything. Senator Brown. If this is about investors protecting their interests, as it should be in part, doesn't failure to escrow create the very risk that prepayment penalties allegedly guard against? " FinancialCrisisReport--243 CASE STUDY OF MOODY’S AND STANDARD & POOR’S Moody’s Investors Service, Inc. (Moody’s) and Standard & Poor’s Financial Services LLC (S&P), the two largest credit rating agencies (CRAs) in the United States, issued the AAA ratings that made residential mortgage backed securities (RMBS) and collateralized debt obligations (CDOs) seem like safe investments, helped build an active market for those securities, and then, beginning in July 2007, downgraded the vast majority of those AAA ratings to junk status. 953 The July mass downgrades sent the value of mortgage related securities plummeting, precipitated the collapse of the RMBS and CDO secondary markets, and perhaps more than any other single event triggered the financial crisis. In the months and years of buildup to the financial crisis, warnings about the massive problems in the mortgage industry were not adequately addressed within the ratings industry. By the time the rating agencies admitted their AAA ratings were inaccurate, it took the form of a massive ratings correction that was unprecedented in U.S. financial markets. The result was an economic earthquake from which the aftershocks continue today. Between 2004 and 2007, taking in increasing revenue from Wall Street firms, Moody’s and S&P issued investment grade credit ratings for the vast majority of the RMBS and CDO securities issued in the United States, deeming them safe investments even though many relied on subprime and other high risk home loans. In late 2006, high risk mortgages began to go delinquent 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 subprime RMBS and CDO securities. In July 2007, as mortgage defaults intensified and subprime 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 were suddenly forced to sell off their 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 the financial crisis, the vast majority of RMBS and CDO securities with AAA ratings incurred substantial losses; some failed outright. Investors and financial institutions holding those AAA 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 953 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.” credit ratings introduced systemic risk into the U.S. financial system and constituted a key cause of the financial crisis. CHRG-111hhrg56778--57 Mr. Royce," Any other commentary there? Ms. Frohman. I guess in terms of where we have been with securities lending, we have in the lessons learned imposed a risk capital charge. We have also enhanced our disclosures, and prior to the credit crisis, we were well aware of the issue and the insurance regulators had required a reduction I think by 50 percent in the securities lending activity. " FinancialCrisisInquiry--828 WALLISON: Right. OK. I just wanted to be sure. That’s a large number—four and a half trillion dollars in CRA loans is large. And so when you said that CRA are not an important part of the subprime problem, I just wanted to make sure that you went back and took a look at the annual report of the NCRC and verified that. That’s—those are the only questions I have, Mr. Chairman. fcic_final_report_full--197 Mudd testified that by , when the housing market was in turmoil, Fannie Mae could no longer balance its obligations to shareholders with its affordable hous- ing goals and other mission-related demands: “There may have been no way to sat- isfy  of the myriad demands for Fannie Mae to support all manner of projects [or] housing goals which were set above the origination levels in the marketplace.”  As the combined size of the GSEs rose steadily from . trillion in  to . tril- lion in ,  the number of mortgage borrowers that the GSEs needed to serve in order to fulfill the affordable housing goals also rose. By , Fannie and Freddie were stretching to meet the higher goals, according to a number of GSE executives, OFHEO officials, and market observers. Yet all but two of the dozens of current and former Fannie Mae employees and regulators interviewed on the subject told the FCIC that reaching the goals was not the primary driver of the GSEs’ purchases of riskier mortgages and of subprime and Alt-A non-GSE mortgage–backed securities. Executives from Fannie, including Mudd, pointed to a “mix” of reasons for the purchases, such as reversing the declines in market share, responding to originators’ demands, and responding to shareholder demands to increase market share and profits, in addition to fulfilling the mission of meeting affordable housing goals and providing liquidity to the market. For example, Levin told the FCIC that while Fannie, to meet its housing goals, did purchase some subprime mortgages and mortgage-backed securities it would other- wise have passed up, Fannie was driven to “meet the market” and to reverse declining market share. On the other hand, he said that most Alt-A loans were high-income- oriented and would not have counted toward the goals, so those were purchased solely to increase profits.  Similarly, Lund told the FCIC that the desire for market share was the main driver behind Fannie’s strategy in . Housing goals had been a factor, but not the primary one.  And Dallavecchia likewise told the FCIC that Fan- nie increased its purchases of Alt-A loans to regain relevance in the market and meet customer needs.  Hempstead, Fannie’s principal contact with Countrywide, told the FCIC that while housing goals were one reason for Fannie’s strategy, the main reason Fannie en- tered the riskier mortgage market was that those were the types of loans being origi- nated in the primary market.  If Fannie wanted to continue purchasing large quantities of loans, the company would need to buy riskier loans. Kenneth Bacon, Fannie’s executive vice president of multifamily lending, said much the same thing, and added that shareholders also wanted to see market share and returns rise.  For- mer Fannie chairman Stephen Ashley told the FCIC that the change in strategy in  and  was owed to a “mix of reasons,” including the desire to regain market share and the need to respond to pressures from originators as well as to pressures from real estate industry advocates to be more engaged in the marketplace.  FinancialCrisisReport--149 Long Beach regularly made changes to the compensation plan, but the basic volume incentives remained. In the 2007 incentive plan, which took effect after the collapse of the subprime market, the volume requirements were even greater than 2004 requirements. In 2007, the Tier 1 represented 1-9 qualified loans and up to $1,499,999 funded; Tier 2 was 10-13 qualified loans and between $1,500,000 and $2,399,000 funded; Tier 3 was 14-35 qualified loans and between $2,400,000 and $5,999,999 funded; Tier 4 was 36 or more loans and $6,000,000 or more funded. 554 (b) WaMu Loan Consultants Like Long Beach, at WaMu loan officers were compensated for the volume of loans closed and loan processors were compensated for speed of loan closing rather than a more balanced scorecard of timeliness and loan quality. According to the findings and recommendations from an April 2008 internal investigation into allegations of loan fraud at WaMu: “A design weakness here is that the loan consultants are allowed to communicate minimal loan requirements and obtain various verification documents from the borrower that [are] need[ed] to prove income, employment and assets. Since the loan consultant is also more intimately familiar with our documentation requirements and approval criteria, the temptation to advise the borrower on means and methods to game the system may occur. Our compensation and reward structure is heavily tilted for these employees toward production of closed loans.” 555 An undated presentation obtained by the Subcommittee entitled, “Home Loans Product Strategy, Strategy and Business Initiatives Update,” outlines WaMu’s 2007 Home Loans Strategy and shows the decisive role that compensation played, while providing still more evidence of WaMu’s efforts to execute its High Risk Lending Strategy: “2007 Product Strategy Product strategy designed to drive profitability and growth -Driving growth in higher margin products (Option ARM, Alt A, Home Equity, Subprime) … 553 Id. 554 Documents regarding Long Beach compensation, Hearing Exhibit 4/13-59b. 555 4/4/2008 WaMu Memorandum of Results, “AIG/UG and OTS Allegation of Loan Frauds Originated by [name redacted],” at 11, Hearing Exhibit 4/13-24. -Recruit and leverage seasoned Option ARM sales force, refresh existing training including top performer peer guidance -Maintain a compensation structure that supports the high margin product strategy” 556 CHRG-110hhrg44900--47 The Chairman," The gentlewoman from California. Ms. Waters. Thank you very much, Mr. Chairman. I would like to thank you first for holding this very important hearing today, and I would like to thank both Secretary Paulson and Chairman Bernanke for being here today. Let me start by saying that which you have probably heard too often, how disappointed I am with all of us, Members of Congress, for what appears to have been weak oversight of our regulatory agencies, and our regulatory agencies for what appears to have been weak oversight of our financial institutions. I have to tell you, I have been holding hearings throughout the country on the subprime meltdown, and I'm absolutely stunned by the extent of the devastation to some of our families and communities caused by this subprime meltdown. I'm stunned when I hear about these exotic products and how they could ever have come into being without any oversight. I'm really stunned about some of the ARMs and the way that they reset, and the fact that there's something called a margin that I never knew about before, and that margin can be whatever the financial institution decides it should be, above and beyond the going interest rate. I came on this committee right after the S&L scandal, and I heard a lot about reform. And so while I suppose I should be impressed with the fact that there's a President's Working Group on Financial Markets and the reports that have been issued, I'm skeptical about what is being proposed. As it said in March, the President's Working Group on Financial Markets issued a report and recommendations for addressing the weaknesses revealed by recent events, both at the international level--between the two reports--and at the domestic level, between the two reports, focused on a number of specific problems, including mortgage lending practices and their oversight, risk management and management at large financial institutions. And then there was, Mr. Bernanke, the Blueprint that you talked about for a modernized financial regulatory structure, and you proposed a new regulatory architecture, and the third regulatory agency would be focused on protecting consumers and investors. I have to tell you, I'm surprised, because I thought that our regulatory agencies, no matter how they were organized, whether it was by financial institution category or not, had as its prime objective, all of those things that you talk about doing now. So what I really want to know is not so much what you plan that may not be instituted for some time, because it takes some time to get this into practice, I want to know what you're doing now. I want to know what you know about servicers. We have found that there's little if any regulation of mortgage servicers. And I want to know if you have anything in your plans to deal with them, because after we get finished with all of the President's HOPE NOW program and the money that we are giving to NeighborWorks and other organizations to do counseling, they can't do very much good, because the servicers are the ones who make the decisions. They're the ones that are in charge of these accounts. They decide to collect--well, they have to collect the fees, they have to collect the mortgage payment. They increase fees. They agree to extend or modify arrangement, but they can do practically whatever they want. I want to know what you know about them, what you're doing about them. And secondly, I want to know and understand Mr. Bernanke, what you know about the sale of Countrywide to Bank of America. I understand that Bank of America bought these mortgages at quite a reduced rate. And I want to know what that rate was and whether or not these properties could go back on the market appraised at a higher rate than the bank purchased them for, and who gets the profit and the difference, and why can't that go back to the homeowners who are losing their homes through foreclosure. First, I would like to hear from Secretary Paulson. " fcic_final_report_full--192 Lund told the FCIC that in , the board would adopt his recommendation: for the time being, Fannie would “stay the course,” while developing capabilities to com- pete with Wall Street in nonprime mortgages.  In fact, however, internal reports show that by September , the company had already begun to increase its acquisi- tions of riskier loans. By the end of , its Alt-A loans were  billion, up from  billion in  and  billion in ; its loans without full documentation were  billion, up from  billion in ; and its interest-only mortgages were  billion in , up from  billion in . (Note that these categories can over- lap. For example, Alt-A loans may also lack full documentation.) To cover potential losses from all of its business activities, Fannie had a total of  billion in capital at the end of . “Plans to meet market share targets resulted in strategies to increase purchases of higher risk products, creating a conflict between prudent credit risk management and corporate business objectives,” the Federal Housing Finance Agency (the successor to the Office of Federal Housing Enterprise Oversight) would write in September  on the eve of the government takeover of Fannie Mae. “Since , Fannie Mae has grown its Alt-A portfolio and other higher risk products rapidly without adequate controls in place.”  In its financial statements, Fannie Mae’s disclosures about key loan characteristics changed over time, making it difficult to discern the company’s exposure to subprime and Alt-A mortgages. For example, from  until , the company’s definition of a “subprime” loan was one originated by a company or a part of a company that spe- cialized in subprime loans. Using that definition, Fannie Mae stated that subprime loans accounted for less than  of its business volume during those years even while it reported that  of its conventional, single-family loans in ,  and  loans were to borrowers with FICO scores less than .  Similarly, Freddie had enlarged its portfolios quickly with limited capital.  In , CEO Richard Syron fired David Andrukonis, Freddie’s longtime chief risk offi- cer. Syron said one of the reasons that Andrukonis was fired was that Andrukonis was concerned about relaxing underwriting standards to meet mission goals. He told the FCIC, “I had a legitimate difference of opinion on how dangerous it was. Now, as it turns out . . . he was able to foresee the market better than a lot of the rest of us could.”  The new risk officer, Anurag Saksena, recounted to the FCIC staff that he repeatedly made the case for increasing capital to compensate for the increasing risk,  although Donald Bisenius, Freddie’s executive vice president for single-family housing, told FCIC staff that he did not recall such discussions.  Syron never made Saksena part of the senior management team.  FinancialCrisisInquiry--361 CHAIRMAN ANGELIDES: Thank you, Mr. Vice Chairman, members. There is, I know you’ll be glad to know, a little remaining time. So I’d like to just ask a few follow-up questions before we move out of here. And, Mr. Blankfein, maybe you’re going to suffer from me having been A all my life and you having been B, but I do want to revisit some of the issues we talked January 13, 2010 about. And let me preface this by saying if I die 51 percent right and 49 percent wrong I will be a happy man. But I do believe that one of the issues we must explore is, was this purely a perfect storm? Or was it a manmade perfect storm in which the clouds receded? And that’s why I’m driving towards questions and answers about responsibility. I’m going to put aside for a minute my view that I’m troubled by your inability to accept the probability or certainty that your firm would not have made it through the storm but for the vast array of federal assistance. But I really want to turn to this issue of mortgages, which you securitized, as did other firms. BofA stopped making subprime loans in 2001, but you still did securitize mortgage packages, Alt-A, jumbo, that had significant problems, 16 to 25 percent default. So maybe those are like the Murder on the OrientExpress, everyone did it. Having said that, Mr. Blankfein, I read your testimony you said there was cheap money. Albeit there was, there was public policy driving this mortgage business, but you weren’t subject to the Community Reinvestment Act. They were the standards at the time, but I would hope that we always would try to elevate standards. I think what I’m bothered by is this. You weren’t just a market maker. You were securitizing and underwriting packages of mortgages, and when it was clear the market was going bad, even though there was information about bad lending practices that other people moved on, you kept moving this product in the market. And I guess what I’d ask you is what is your responsibility when you put your name on a security to investor to underwrite that thoroughly? There were FBI warnings. There were loan tapes available. Did you fail in that respect in that you did not underwrite the loans that you then securitized and moved into the market? CHRG-111shrg57319--596 Mr. Killinger," Yes. Well, clearly, the money was flooding into Wall Street both from international sources and domestic sources with a very strong appetite for buying various mortgage-related securities, and I think that very strong pressure to buy certainly had an influence on the products that they were willing to buy and ultimately the kind of conditions around those loans. Where we saw a particular change, I will say, is in the Option ARM, which for many years was a portfolio product and there was not a secondary market. What we saw in the mid-2000s is the emergence of a secondary market with Wall Street and Fannie Mae and Freddie Mac, and that led to a huge surge in brokers originating Option ARMs, and I think that certainly changed the competitive landscape for us. It caused us to lose significant market share and, I think, had an impact on the different competitive features of that product. So certainly the development of the secondary markets had a huge impact on that product. Similarly, it was the primary outlet for the origination of subprime loans, so that demand from Wall Street had, I think, a big impact on the criteria that were used to underwrite subprime loans. Senator Levin. And would you say that the criteria were looser as a result of that demand? " CHRG-110shrg50416--62 Mr. Kashkari," Well, Senator, as you and I have discussed, we share the spirit of your question completely and want these institutions to lend and provide credit to our communities. In fact, it is not published yet, but when the final purchase agreement is put out there between the Treasury and the individual institutions, there is specific language in the purchase agreement about lending and about taking aggressive steps on foreclosure mitigation. It is not a legally binding contract. Senator Schumer. Right. " CHRG-110shrg50410--9 Mr. Cox," Thank you very much, Mr. Chairman, Senator Shelby, and Members of the Committee, for this opportunity to describe the SEC's actions to deal with the recent developments in our financial markets. Since the credit market crisis began with the deterioration of mortgage underwriting standards and a contagion of abusive lending practices, and then spread to the capital markets through securitization, the SEC has used its law enforcement and regulatory powers to contribute to orderly and liquid markets. We have acted in three main areas: the investigation and prosecution of violations of the securities laws; the regulation of problem areas in the markets, including credit rating agencies under recent authority granted to us by the Congress; and accounting and disclosure standards in order to bring hidden risk into the light. Our work in these areas has been both national and international. First and foremost, the SEC is a law enforcement agency. Our enforcement actions to address the capital markets turmoil have involved not only our Division of Enforcement and each of the agency's 11 regional offices, but also nearly every major SEC division and office, and every area of professional emphasis, through our agency-wide Subprime Task Force. We are also working closely with other Federal and State regulators. The SEC has over four dozen pending law enforcement investigations in the subprime area. They are focused on the activities of subprime lenders, on the roles of credit rating agencies, insurers, investment banks, and others involved in the securitization process; and on the banks and broker-dealers who sold mortgage-backed investments to the public. As one example of these initiatives, just a few weeks ago the Commission brought enforcement actions against two portfolio managers of Bear Stearns Asset Management, whose hedge funds collapsed in June of last year and caused investor losses of over $1.8 billion. These cases, and others like them in the subprime area, are making it clear that vigorous investor protection extends to hedge funds, which are by no means unregulated when it comes to fraud. The same vigorous commitment to investors extends to our jealous protection of the integrity of public disclosure. Because the reliability of information about public companies is so important to market confidence, there have long been clear rules that prohibit market manipulation by knowingly spreading false rumors. But for the entirety of its 74-year history until 2008, the Commission had never brought an enforcement action of this kind. It is probably because of the difficulty in tracing where a false rumor starts, and proving that it was knowingly false, that these cases haven't been brought in the past. But now the same technology that instantly spreads rumors around the globe is also helping law enforcement track down the culprits. As a result, just a few weeks after the demise of Bear Stearns, we successfully sued a trader who used instant messages to other brokerage firms and hedge funds to spread fake information about a pending acquisition. The false rumors that he started caused the stock to drop by 17 percent and caused a wipeout of market capitalization of $1 billion in 30 minutes and led to a halt in trading in those securities on the New York Stock Exchange. Following our enforcement action, the Commission not only hit the trader with penalties and other sanctions, but also banned him for life from the industry. This was a landmark case, and it will not be unique. If we are successful in bringing future cases like this, I believe the penalties should be commensurate with the enormous amount of shareholder value that is destroyed by this kind of wantonness toward other people's money. For several months, we have had other active investigations underway concerning the possible manipulation of securities prices through various combinations of manufacturing false rumors and short selling. In addition, the Commission has joined with other securities regulators in undertaking industry-wide sweep examinations that will include hedge fund advisors, aimed at preventing the spread of intentionally false rumors to manipulate securities prices. In addition to enforcing our existing regulations, the Commission is also using our authority to promulgate new rules. Today, the Commission will issue an order designed to enhance protections against ``naked'' short selling in the securities of primary dealers, Fannie Mae, and Freddie Mac. The emergency order will provide that all short sales in the securities of primary dealers, Fannie, and Freddie will be subject to a pre-borrow requirement. In addition to this emergency measure, we will undertake a rulemaking to address these same issues across the entire market. We are also using our new authority under the Credit Rating Agency Reform Act to write sweeping new regulations that will apply to the rating of structured investments. Until the passage of this landmark legislation, the credit rating industry has been largely unregulated. Now, in the 10 months since the first firms became registered under the new law, they are subject to thorough and ongoing regulation of everything from their public disclosures, to their management of conflicts of interest, to their ability to prevent unfair, abusive, or coercive behavior in the ratings process. The new law also gave us the authority to examine these firms, and we are using it aggressively. As you know, we recently provided to the Committee a complete report of our staff's findings in these examinations. The subprime crisis was also deepened by problems with disclosure and accounting, and so in recent months, we have has asked financial institutions to provide additional disclosure regarding both off-balance-sheet arrangements and the application of fair value to financial instruments. Last Wednesday, the Commission held a roundtable to hear from market participants and regulators about the challenges of current fair value accounting and auditing requirements, which will provide the basis for potential new guidance from the SEC, the FASB, and the PCAOB. Since the events of mid-March that culminated in the Bear Stearns acquisition, the SEC has broadly engaged with other regulators on issues related to capital and liquidity. We have broadly strengthened liquidity requirements, and we are closely scrutinizing the secured funding activities of each CSE firm. Working together with the Federal Reserve, we have developed additional stress scenarios in light of the Bear experience. These scenarios entail a substantial loss of secured funding and assume no access to the Fed's liquidity facilities. Our recently concluded Memorandum of Understanding with the Federal Reserve Board is facilitating this cooperation as well as our joint work in a number of other important areas. Finally, I note that the subprime crisis has affected markets not only here in the United States but all over the world, and so we have been working closely with our international regulatory counterparts to ensure that our solutions to these problems work across national borders and in other markets. Thank you, again, Mr. Chairman, for this opportunity to discuss these important issues, and I will be happy to take your questions. " fcic_final_report_full--87 While investors in the lower-rated tranches received higher interest rates because they knew there was a risk of loss, investors in the triple-A tranches did not expect payments from the mortgages to stop. This expectation of safety was important, so the firms structuring securities focused on achieving high ratings. In the structure of this Citigroup deal, which was typical,  million, or , was rated triple-A. GREATER ACCESS TO LENDING: “A BUSINESS WHERE WE CAN MAKE SOME MONEY ” As private-label securitization began to take hold, new computer and modeling tech- nologies were reshaping the mortgage market. In the mid-s, standardized data with loan-level information on mortgage performance became more widely avail- able. Lenders underwrote mortgages using credit scores, such as the FICO score, de- veloped by Fair Isaac Corporation. In , Freddie Mac rolled out Loan Prospector, an automated system for mortgage underwriting for use by lenders, and Fannie Mae released its own system, Desktop Underwriter, two months later. The days of labori- ous, slow, and manual underwriting of individual mortgage applicants were over, lowering cost and broadening access to mortgages. This new process was based on quantitative expectations: Given the borrower, the home, and the mortgage characteristics, what was the probability payments would be on time? What was the probability that borrowers would prepay their loans, either because they sold their homes or refinanced at lower interest rates? In the s, technology also affected implementation of the Community Rein- vestment Act (CRA). Congress enacted the CRA in  to ensure that banks and thrifts served their communities, in response to concerns that banks and thrifts were refusing to lend in certain neighborhoods without regard to the creditworthiness of individuals and businesses in those neighborhoods (a practice known as redlining).  The CRA called on banks and thrifts to invest, lend, and service areas where they took in deposits, so long as these activities didn’t impair their own financial safety and soundness. It directed regulators to consider CRA performance whenever a bank or thrift applied for regulatory approval for mergers, to open new branches, or to en- gage in new businesses.  The CRA encouraged banks to lend to borrowers to whom they may have previ- ously denied credit. While these borrowers often had lower-than-average income, a  study indicated that loans made under the CRA performed consistently with the rest of the banks’ portfolios, suggesting CRA lending was not riskier than the banks’ other lending.  “There is little or no evidence that banks’ safety and sound- ness have been compromised by such lending, and bankers often report sound busi- ness opportunities,” Federal Reserve Chairman Alan Greenspan said of CRA lending in .  FinancialCrisisInquiry--610 ZANDI: I think the hubris in the financial system was widespread. I think it was clearest and most evident in the residential mortgage market, thus the focus on that. But I think it extends well beyond that, and, as we can see to this day, into commercial real estate lending, which many small banks are now struggling with, to corporate lending, all various kinds of—of corporate lending. It was evident more broadly in financial markets, in the derivatives market, stock prices, obviously in commodity markets at certain points in time. So I think the hubris among investors, global investors, was extraordinarily widespread and cut across lots of different markets, a whole range of markets. In fact, it would be more difficult to identify the markets that weren’t affected at the height of this by that hubris. CHRG-110shrg50415--6 STATEMENT OF SENATOR DANIEL AKAKA Senator Akaka. Thank you very much, Mr. Chairman. Thank you for conducting this hearing today. I am hopeful that this hearing will help clear up some misconceptions and help promote a greater understanding of the cause of this financial crisis as we work to reform the financial services regulatory structure. And I thank you for this opportunity, Mr. Chairman. I want to express some of my thoughts thus far on what has been happening. The uninformed have blamed much of the current financial crisis on the Community Reinvestment Act. That is simply not true. The CRA has helped empower individuals in low-income communities by promoting access to mainstream financial services and investment. Instead of finding excuses to stop Federal efforts to expand across to mainstream financial services, we must do more. Low- and moderate-income working families are much better off utilizing mainstream financial service providers rather than unregulated or fringe financial service providers. Working families would have been better off obtaining mortgages from their local financial institutions instead of obtaining mortgages through independent peddlers such as Countrywide. The majority of subprime mortgage lending was done by independent mortgage companies that are not subject to CRA requirements and lacked effective consumer protections. I have greatly appreciated the extraordinary leadership and judgment shown by the Chairman of the Federal Deposit Insurance Corporation, Sheila Bair, during her tenure. I also have highly valued Chairman Bair's efforts to promote financial literacy and address issues so important to working families. Under Chairman Bair's leadership, the FDIC is encouraging the development of affordable, small-dollar loans using CRA initiatives. Working families are exploited by predatory lenders who often charge triple-digit interest rates. As access to legitimate credit tightens, more working families will be susceptible to unscrupulous lenders. We must encourage consumers to utilize the credit unions and banks for affordable small loans. Banks and credit unions have the ability to improve lives of working families by helping them save, invest, and borrow at affordable rates. Repealing or weakening the CRA would be a mistake. Low- and moderate-income families must have greater access to regulated mainstream financial institutions, not less. Critics of the CRA seem to forget that it does not apply to investment banks. Investment banks bought securitized and sold subprime mortgages. The CRA does not apply to credit rating agencies. The CRA does not apply to the sale of derivatives or credit default swaps. These products have contributed significantly to the financial situation that we are in now. The causes of this crisis are complex and cannot simply be blamed on the CRA. Instead of repealing the CRA, we must overhaul and strengthen the regulation of financial services to better protect consumers, protect markets ability, and empower the regulators to be more forward-looking. Instead of just reacting to a crisis, regulators must quickly adapt to the financial service innovations. I thank the witnesses for appearing here today, and I look forward to their testimony, and thank you very much, Mr. Chairman. " FOMC20070131meeting--46 44,MR. LACKER., Ex post subprime mortgage-backed securities seem to have been overvalued in the sense that they underestimated default risk for some market segments. So the presumption would be that such information gets taken on board and reflected in the prices of new mortgage-backed securities and that it would translate into higher credit spreads at the retail level. In your remarks you seemed to suggest that there is a chance that this process of adjustment might cause markets not to work. I’m wondering what you meant by that. CHRG-111shrg57319--83 Mr. Vanasek," That is true. Senator Coburn. And did that violate any banking or mortgage lending rules? " CHRG-111hhrg53240--18 Mr. Green," Thank you, Mr. Chairman. And I thank the witness, Ms. Duke, for appearing today. It is an honor to have you with us, Ms. Duke. My concern has to do with what I called to your attention earlier about being proactive as opposed to reactive. And while I appreciate much of what was done in December of last year, it appeared to be reactive, and I am interested in how do you move from that level of engagement, such that you start to look for ways to protect the consumer, which is what I think most people assume that a consumer protection agency would do. Let me just give you an example. My suspicion is that a consumer protection agency would have, or a consumer protector would have, looked at the yield spread premium, an undisclosed yield spread premium, and probably have concluded that there is something wrong this as it relates to the consumer, the one who actually received it. And I said ``undisclosed,'' wherein you qualify the buyer for 5 percent, and you don't tell the buyer that you qualified for 5 percent; and you give them a loan for 8 or 10 percent, and he or she never knows that he or she qualified for prime and was pushed into the subprime market. How would you do this? How would you become proactive on an issue like this? Ms. Duke. I appreciate that question. We have actually talked about this quite a bit and have recognized the need to be proactive, and I think, at least in recent years, have become quite proactive. The regulations that I appreciate you mentioning, the regulations governing both mortgages and credit cards that we recently passed are one example of that. A second example that you may not be as much aware of is the review of disclosures that we have done, the review of disclosures under truth in lending, and we have finalized new disclosure rules for credit cards. We will this week be unveiling new disclosures for mortgage loans, as well as home equity, which will address exactly the yield spread premium that you are talking about. As part of doing that, we have instituted consumer testing, and we have spent quite a bit of time testing disclosures with consumers to make sure we understand how they make decisions and what information is meaningful to them. And what we are finding is that, in some cases, there are some practices that you just plain can't explain with a disclosure, no matter how hard you try, and those are the practices we elect to prohibit. " FinancialCrisisReport--298 Increased Loss Protection. In July 2006, S&P made significant adjustments to its subprime RMBS model. S&P had determined that, to avoid an increasing risk of default, subprime RMBS securities required additional credit enhancements that would provide 40% more protection to keep the investment grade securities from experiencing losses. 1157 Moody’s made similar adjustments to its RMBS model around the same time, settling on parameters that required 30% more loss protection. As Moody’s explained to the Senate Banking Committee in September 2007: “In response to the increase in the riskiness of loans made during the last few years and the changing economic environment, Moody’s steadily increased its loss expectations and subsequent levels of credit protection on pools of subprime loans. Our loss expectations and enhancement levels rose by about 30% over the 2003 to 2006 time period, and as a result, bonds issued in 2006 and rated by Moody’s had more credit protection than bonds issued in earlier years.” 1158 The determination that RMBS pools required 30-40% more credit enhancements to protect higher rated tranches from loss reflected calculations by the updated CRA models that these asset pools were exposed to significantly more risk of delinquencies and defaults. Requiring increased loss protection meant that Moody’s and S&P analysts had to require more revenues to be set aside in each pool to provide AAA ratings greater protection than before the model adjustments. Requiring increased loss protection also meant RMBS pools would have a smaller pool of AAA securities to sell to investors. That meant, in turn, that RMBS pools would produce fewer profits for issuers and arrangers. Requiring increased loss protection had a similar impact on CDOs that included RMBS assets. Retesting RMBS Securities. Even though S&P and Moody’s had independently revised their RMBS models and, by 2006, determined that additional credit enhancements of 30-40% were needed to protect investment grade tranches from loss, in 2006 and the first half of 2007, neither company used its revised models to evaluate existing rated subprime RMBS securities as part of its surveillance efforts. 1159 Instead S&P, for example, sent out a June 2006 email announcing that no retests would be done: 1157 3/19/2007 “Structured Finance Ratings - Overview and Impact of the Residential Subprime Market,” S&P Monthly Review Meeting, at S&P SEC-PSI 0001473, Hearing Exhibit 4/23-52b. 1158 Prepared statement of Michael Kanef, Group Managing Director of Moody’s Asset Backed Finance Rating Group, “The Role and Impact of Credit Rating Agencies on the Subprime Credit Markets,” before the U.S. Senate Committee on Banking, Housing, and Urban Affairs, S.Hrg. 110-931 (9/26/2007), at 17. 1159 6/2006 S&P internal email exchange, Hearing Exhibit 4/23-72; and 3/31/2008 Moody’s Structured Finance Credit Committee Meeting Notes, Hearing Exhibit 4/23-80. See also 7/16/2007 Moody’s email from Joseph Snailer to Qingyu Liu, and others, PSI-MOODYS-RFN-000029 (when an analyst sought guidance on whether to use the new or old methodology for testing unrated tranches of outstanding deals, she was advised: “The ratings you are generating should reflect what we would have rated the deals when they were issued knowing what we knew then and using the methodology in effect then (ie, using the OC model we built then.”); 6/1/2007 email from Moody’s Senior Director in Structured Finance, “RE: Financial Times inquiry on transparency of assumptions,” MIS-OCIE- RMBS-0364942-46, at 43. “Simply put – although the RMBS Group does not ‘grandfather’ existing deals, there is not an absolute and direct link between changes to our new ratings models and subsequent rating actions taken by the RMBS Surveillance Group. As a result, there will not be wholesale rating actions taken in July or shortly thereafter on outstanding RMBS transactions, absent a deterioration in performance and projected credit support on any individual transaction.” 1160 FOMC20080625meeting--261 259,MR. LACKER.," Thank you, Mr. Chairman. The issues around the liquidity facility and what supervisory apparatus we have wrapped around primary dealers have to do with our having extended our lending reach. I think there's now a substantial gap between our implied lending commitment and the scope of our supervisory authority. Vice Chairman Geithner spoke very eloquently about that earlier this month. I think it's paramount that we close that gap in order to keep borrowers from exploiting the obvious lending commitment and choosing to leave themselves vulnerable to runs and run-like behavior. But this leaves open the question of the extent of our lending reach and how we close that gap, and I think that that's the most critical challenge for us in the year ahead, particularly as we approach negotiations with the Congress. I'd like to share a couple of thoughts on that broader question because the questions posed to us sort of get at those. It's important to start this from a peacetime perspective, sort of a timeless perspective, and ask the question as if you were choosing afresh a lending and regulatory policy that was going to last a long time. If you imagine for the moment that whatever we announce and adopt would be perfectly credible and immediately viewed as credible, I think you'd obviously choose to not have this gap. You'd obviously choose to have lending and regulatory policies that are mutually incentive compatible. So you'd want an adequate supervisory regime in place for any institution that market participants believe we'll lend to. Conversely, it means that you would want market participants to believe that we will constrain our lending to those institutions for which we have an adequate supervisory regime in place. So then the question comes up: How do you choose the boundaries of our lending commitment? I take it as self-evident that our lending commitment shouldn't be open-ended and unlimited. We don't want to supervise every financial intermediary in the world or in the United States, much less all individuals, partnerships, and corporations. But even limiting ourselves to what's called systemically important financial institutions is going to be problematic as well. I take that phrase to mean any institution whose failure could be costly or disruptive to many other market participants. Any institution that chooses to engage in maturity transformation to some extent faces the potential for run-like behavior by the creditors. Unless we impose draconian regulations, market participants will always have a virtually unlimited capacity for creating financial arrangements that run the risk of disruptive failures. So extending our lending reach to whatever institution that makes itself systemically important just leads us down a path of ever more financial regulation of an ever larger portion of the financial system. I think we're going to have to set some boundaries. I'd like to see them tighter rather than looser, and making them credible is going to be the hard problem for us going forward. In doing that, we're going to face a classic time-consistency problem. I take that as given. I'm not sure everyone else shares that view, but I take it as obvious. Inevitably the exigencies of crisis management are excruciating, but I think there are times when they conflict with our long-run interest in the type of financial system that we would design from a peacetime, timeless perspective, just the way short-run concerns about growth sometimes conflict with our long-run interest in price stability. But just as sustaining monetary policy credibility sometimes requires resisting the temptation to ease policy to stimulate growth, sustaining credible lending limits is going to sometimes require not preventing a disruptive failure of an institution and not ameliorating the cost of financial distress. To put it another way, I think it would be a mistake to adapt our supervisory reach to a purely discretionary lending policy. We're going to have to choose a policy and commit to it and then take hard actions to make that credible. From this point of view, I have a deep question about the questions posed by the staff. They focus entirely on primary dealers, and it doesn't strike me that the fact that Bear Stearns was a primary dealer was what made us lend. It was the fact that it was more disruptive. I think it's likely that any other institution that presents the same threat of a disorderly resolution is going to be perceived as benefiting from our implicit lending support, whether or not they're a primary dealer, unless we say something otherwise, unless we draw a boundary, and unless we make that credible. So, for example, other large broker-dealers, hedge funds, private equity firms, or insurance companies could easily fail in a disruptive way. We need to think through whether we're going to let that happen or whether we're going to be forced to step in. At some point we're going to have to choose to let something disruptive happen. I think that ambiguity about our lending limits would be a bad choice. Market participants are going to form their own views about the likelihood of us lending. Any lack of clarity about the boundaries is just going to lead some firms to test the boundaries, and it's not going to help us resist the temptation to lend beyond the boundaries we want to establish. Besides, Mr. Chairman, you've emphasized the value of de-personalizing and institutionalizing the conduct of monetary policy. It's important that we strive for lending policy that isn't critically dependent on particular officeholders. As I said, I'd favor fairly tight limits on our lending commitments, and you are probably not surprised about that. I think we really ought to maintain this section 13(3) hurdle at a fairly high level, but the exit strategy makes me nervous. Crafting this MOU, a permanent shift in our visibility into and in our ability to protect the system from primary dealers, is just going to sustain the expectations that have arisen since Bear--which have been described and referenced a couple of times and which you see in the fall in CDS spreads for those institutions--and it is just really hard to see how to put that genie back in the bottle and limit the extent to which we're viewed as backstopping them. But I think we ought to strive to make that somehow be viewed as unusual as possible. More broadly, my reading of the history of economics and financial intermediation is just my reading. But I'm motivated broadly by the sense that we'd be better served in the long run with as small an extent of central bank lending commitment as possible. Central bank credit is fiscal policy. It entangles us in politics. It risks compromising the independence of our monetary policy. You've heard me say this before. Expanding our lending forces us to extend our regulatory reach, and that can't be good for the financial system even though I trust our staff to do a very good job of being as efficient and effective as they can be. I've argued this before. It's not obvious on the evidence that our financial system is terribly fragile apart from the volatility induced by uncertainties about government and central bank policies. Besides, I think that we should take seriously the notion that some amount of financial instability is undoubtedly optimal, as work by economists such as Allen and Gale has demonstrated. Those are the kinds of considerations that I think ought to guide our policy. Finally, Mr. Chairman, a word about process. At our last meeting we discussed interest on reserves, a historic and consequential decision for us. We had a briefing package of 100-plus pages reflecting substantial staff work. The Committee very much benefited from that. At an upcoming meeting we're going to talk about inflation dynamics, another consequential topic. We've received somewhat less material, even going back several months, about financial markets, their character, and the welfare economics of our interventions. I'd urge you to consider a special topic at some future meeting at which we explore the economics of financial stability, since it is becoming such a consequential part of what we do. Related to that, I was happy to learn from Art that an after-action review by the SEC was under way. Because our role is different from the SEC's, I'd like to suggest that maybe building on that or maybe in parallel to that we conduct our own after-action review of the factors that went into how that event played out. Thank you very much, Mr. Chairman. " CHRG-111hhrg54869--134 Mr. Volcker," It meant that, the falling-off-the-cliff analogy applied to the rapid decline in the economic activity for 6 months or so, which found its expression, cause, the rapidity of it, in that the supply of credit dried up. Banks were not lending. Banks could not lend. The open market was constipated. So there was no availability of credit, and that led to, obviously, difficulties in carrying on economic activity. " CHRG-111hhrg56766--248 Mr. Paulsen," Okay. Thank you, Mr. Chairman. " Mr. Minnick," [presiding] The Chair recognizes the gentleman from North Carolina for 5 minutes. Mr. Miller of North Carolina. Thank you, Mr. Chairman. My questions are also about how to encourage lending. I am sure as a scholar of the Great Depression, you know the Reconstruction Finance Corporation did not start out with a direct lending program. They only resorted to that when they could not persuade banks to lend, when they tried to lend to banks for the banks to lend in turn, that did not work. They tried to buy preferred stock in banks so banks could have additional capital. That did not work. It was only then that the Reconstruction Finance Corporation began direct lending, and 20 years later, when the program was ratcheted down, it had turned a slight profit. It does appear it is possible to lend even in a bad economy with proper underwriting. I am sure I am in a distinct minority in this committee in thinking that it was probably a mistake to--we were probably better off having mark-to-market rules for accounting, that it is better to know what is on a bank's books, to have an accurate idea of the assets and of the liabilities. I was also skeptical a year ago about the stress test, that would be seen as a rigorous test, a real measure of the sovereignty of banks. I have been surprised at the amount of capital that has gone into those 19 banks. A couple of questions. To what extent was that the result of investors getting confidence to cause the stress test, because they did feel reassured their books were accurate, and to what extent was that because investors became convinced that the government was not going to allow any of those 19 institutions to fail, that they were too-big-to-fail? Second, with respect to community and regional banks, it does not appear that capital is flowing into community and regional banks in the same way they flowed into those 19 bigger banks. Do you agree it is important they have additional capital? Are they trying to acquire it? Is that because of the skepticism about what is really on their books? Do they have accurate books or are their books being cooked somewhat? To what extent because they are too small to fail and investors know they may in fact lose their entire investment in a way they cannot possibly lose their entire investment at the bigger banks? " FOMC20080130meeting--354 352,MR. MISHKIN.," We could talk about Arthur Andersen, too, because I am going to talk about the more complicated issues of conflicts of interest. With plain vanilla conflicts of interest, if there is enough information, the market frequently can solve the problem because if you know that if you do what the issuer wants and you give a good rating, then you lose your reputation. Then, if it has no value, issuers won't pay for it. What is interesting here is that for the subprime market, you didn't find any evidence of conflicts of interest, and I am not surprised by that, because those securities are much more straightforward. Where I really do worry about the conflict of interest is in the structured products because one thing that happened was that it became less plain vanilla. You actually had consulting practices inside the credit rating agencies; these structures are very complicated, and you need to slice here and dice here, and consultants were providing advice on structuring them and making a lot of money, and then it was much less transparent. What I wondered about here is that you didn't say this for the first one, subprime RMBS. You said you didn't find the evidence. I buy that. But what about the CDOs and the SIVs, for which I would expect that this problem would have been more severe? In the book that I wrote with others on conflicts of interest in the financial services industry, we actually said that there was not a problem with the plain vanilla products because the markets have the information, but we worried about exactly this issue in terms of the structured products. I am just wondering whether or not it was an accident that you said for the plain vanilla that there was less problem. Could there have been an issue here? The reason this gets complicated is that the standard view of conflicts of interest in Arthur Andersen was in the firm's compensation scheme. Actually, the conflict of interest was that the Texas unit did not worry about and weakened--not their ethics, but what is it? The center has rules for its branches so that they don't screw the overall firm, and that is what got weakened during the fight between the consulting part and the auditing part. So do you have any information on these very complicated elements, particularly the nontransparent parts? Was it an accident that you said for subprime that you didn't find evidence, and for these is there more possibility that there was a problem? That really does have important implications for the nature of the regulation and accreditation agencies and also their ability to give good ratings for these very complex nontransparent products. You talked about investor practices later, Bev, when you said that we should differentiate between plain vanilla and this very complex stuff. I don't know whether or not you have views on this. " CHRG-111hhrg52397--157 Mr. Pickel," I would also just add that the risk that AIG was taking on through their use of credit default swaps represented a very small portion of the overall CDS business and what they were doing was taking on exposure again to underlying subprime risk. And to the extent that, I think somebody said earlier, the CDS were hard to value, the CDS value is driven by the value of the underlying position. It was the CDOs that they sold protection on that were in fact hard to value. " FOMC20070628meeting--16 14,MR. KOHN.," I was just going to remark that the situation was quite different. LTCM followed the Russian debt default. The markets were already in considerable disarray. All those correlations had already begun to turn, and then on top of that you had the fire sale effects of LTCM. You can see some of that in the subprime market, where this thing is concentrated. It is just not spread out now, and the whole market situation was very different at that time." FinancialCrisisInquiry--182 Can you turn your mic on, Mr. Rosen? ROSEN: I’m Ken Rosen. I want to thank Chairman Angelides and Vice Chairman Thomas, and the commission for having me here. I want to not read my testimony since you have it. But I’m going to talk a little bit about what I think is the epicenter of the crisis—where this started, how it got there, and where we are today, which is the housing market—the housing and residential mortgage market. Excessively easy credit, extremely low interest rates created a house price bubble. And the house price bubble when it burst has really caused a significant part of the problems that we had—at least the—initially. And of course it caused—helped cause the great recession where we have lost over eight million jobs. I think the most important thing to say is how did we get here. And I would say that low interest rates is part of the blame, but really it’s the poorly structured products that came about in this environment. Innovative products are important, and a good thing. And I’ve written papers on—on this in the 1970s and 80s while we needed innovative mortgage products. And they’re good for some people—some households. Subprime— there is a need for having that. But not to the market share it got. Low down payment loans – Alt-A loans, option arms. All those made some sense for a portion of the population. What happened is we layered all these risks. We went from a conservatively written subprime loan to a subprime loan that had no down payment, and didn’t document someone’s income or employment. So we made a mistake from what was a good idea by financial institutions became a bad idea for the entire overall market. And then we combine that with a second component which was I thought bad underwriting. We lowered underwriting standards dramatically. We started this in California, and it spread everywhere. We—we do this sometimes. Liars loans which are stated income loans, and there was rampant fraud at the consumer level. We’ve heard discussion of this at the institutional level, but I think the consumer basically really did this so they could qualify for the loan. There was some complicity on the part of brokers and originators. I think—I do not think this was at the high level institutions, but it’s at the individual originator level. CHRG-110hhrg34673--57 Mr. Watt," Okay. The increase in foreclosures is a serious problem, and one of the concerns we have is that the Fed has never adopted a final rule under its authority under the truth and lending act to prohibit practices or acts that it found to be unfair or deceptive or designed to evade the purposes of HOPA over the entire class of mortgage loans. There has never been a real rule on these things, and I think that is one of the things that is putting pressure on us to be more aggressive in having a Federal predatory lending standard, or at least a Federal predatory lending floor. I am wondering whether you view that as a problem, and maybe I could just get you to discuss with me why the Fed has never used that more aggressive, unfair, deceptive trade practices language to be more aggressive in this area in light--and especially in light of the increasing number of foreclosure that we are experiencing. " CHRG-111hhrg53248--66 Mr. Hensarling," I understand your answer, Mr. Secretary. I have limited time. Let's think about another ambition then of the Administration. Again, I am not going to adhere to your terminology or the chairman's terminology. What I see is a new government agency being proposed to approve consumer financial products, the CFPA. Apart from subprime mortgages, can you point to any other consumer financial product that you believe was a but-for cause of this credit crisis? " FinancialCrisisInquiry--718 GORDON: We don’t see CRA as a contributor to the—the crisis that occurred. CRA had been working for several decades to get some more lending to people who were qualified for the loans that they were getting. CRA was not intended to put unqualified people into home loans. It was intended to get lending to otherwise qualified people who weren’t being serviced by the financial institutions. CHRG-110hhrg46593--35 Mr. Bernanke," Yes. We only lend to good quality banks. We lend on a recourse basis, that is post, post, post collateral, and if the collateral were to be insufficient, then the bank itself is still responsible. We have never lost a penny doing this. I think it is a totally standard practice for central banks around the world, and it is very constructive to provide liquidity to the financial system. " CHRG-111hhrg53244--118 Mr. Donnelly," In regards to the TALF program, which is an area that we had hoped for some help on and that we had discussed before, at the present time none of it has gone to floor plan lending, as we discussed. What other areas do you think can help open up floor plan lending? We know the SBA has helped a little bit. What other avenues, if any, are being explored or do you think are available out there? " fcic_final_report_full--574 Register 60, no. 86 (May 4, 1995): 22155–223. 83. Division of Consumer and Community Affairs, memorandum to Board of Governors, August 10, 1998. 84. Federal Reserve Board press release, “Order Approving the Merger of Bank Holding Companies,” August 17, 1998, pp. 63–64. 85. Lloyd Brown, interview by FCIC, February 5, 2010. 86. Andrew Plepler, interview by FCIC, July 14, 2010. 87. Assuming 75% AAA tranche ($1.20), 10% AA tranche ($0.20), 8% A tranche ($0.30), 5% BBB tranche ($0.40), and 2% equity tranche ($2.00). See Goldman Sachs, “Effective Regulation: Part 1, Avoid- ing Another Meltdown,” March 2009, p. 22. 88. David Jones, interview by FCIC, October 19, 2010. See David Jones, “Emerging Problems with the Basel Capital Accord: Regulatory Capital Arbitrage and Related Issues,” Journal of Banking and Finance 24, nos. 1–2 (January 2000): 35–58. 89. Henry Paulson, testimony before the FCIC, Hearing on the Shadow Banking System, day 2, ses- sion 1: Perspective on the Shadow Banking System, May 6, 2010), transcript, p. 34. 90. Jones, interview. Chapter 7 1. For example, an Alt-A loan may have no or limited documentation of the borrower’s income, may have a high loan-to-value ratio (LTV), or may be for an investor-owned property. 2. Inside Mortgage Finance, The 2009 Mortgage Market Statistical Annual, vol. 2, The Secondary Mar- ket (Bethesda, MD: Inside Mortgage Finance, 2009), p. 9, “Mortgage & Asset Securities Issuance” (show- ing Wall St. securitizing a third more than Fannie and Freddie); p. 13, “Non-Agency MBS Issuance by Type.” FCIC staff calculations from 2004 to 2006 (for growth in private label MBS). 3. Charles O. Prince, interview by FCIC, March 17, 2010. 4. John Taylor, interview by FCIC, September 23, 2010. 5. William A. Fleckenstein and Frederick Sheeham, Greenspan’s Bubbles: The Age of Ignorance at the Federal Reserve (New York: McGraw-Hill, 2008), p. 181. 6. Alan Greenspan, “The Fed Didn’t Cause the Housing Bubble,” Wall Street Journal, March 11, 2009. See also Ben Bernanke, “Monetary Policy and the Housing Bubble,” speech at the Annual Meeting of the American Economic Association, Atlanta, Georgia, January 3, 2010. 7. Alan Greenspan, testimony before the Senate Committee on Banking, Housing, and Urban Affairs, 109th Cong., 1st sess., February 16, 2005. 8. Fed Chairman Ben S. Bernanke, “The Global Saving Glut and the U.S. Current Account Deficit,” re- marks at the Sandridge Lecture, Virginia Association of Economics, Richmond, Virginia, March 10, 2005. 9. Frederic Mishkin, interview by FCIC, October 1, 2010. 10. Pierre-Olivier Gourinchas, written testimony for the FCIC, Forum to Explore the Causes of the Financial Crisis, day 1, session 2: Macroeconomic Factors and U.S. Monetary Policy, February 26, 2010, pp. 25–26. . 11. Paul Krugman, interview by FCIC, October 6, 2010. 571 12. Ellen Schloemer, Wei Li, Keith Ernst, and Kathleen Keest, “Losing Ground: Foreclosures in the Subprime Market and Their Cost to Homeowners,” Center for Responsible Lending, December 2006, p. 22. 13. 2009 Mortgage Market Statistical Annual , vol. 1, The Primary Market , p. 4, “Mortgage Originations by Product.” 14. Christopher Mayer, Karen Pence, and Shane M. Sherlund, “The Rise in Mortgage Defaults,” Jour- nal of Economic Perspectives 23, no. 1 (Winter 2009): Table 2, Attributes for Mortgages in Subprime and Alt-A Pools, p. 31. 15. 2009 Mortgage Market Statistical Annual, 2:13, “Non-Agency MBS Issuance by Type.” 16. 2009 Mortgage Market Statistical Annual , 1:6, “Alternative Mortgage Originations”; previous data extrapolated in FCIC estimates from Golden West, Form 10-K for fiscal year 2005, and Federal Reserve, “Residential Mortgage Lenders Peer Group Survey: Analysis and Implications for First Lien Guidance,” November 30, 2005. 17. Inside Mortgage Finance. 18. Countrywide, 2005 Form 10-K, p. 39; 2007 Form 10-K, p. 47 (showing the growth in Country- wide’s originations). 19. Angelo Mozilo, email to Sambol and Kurland re: Sub-prime Seconds. See also Angelo Mozilo, email to Sambol, Bartlett, and Sieracki, re: “Reducing Risk, Reducing Cost,” May 18, 2006; Angelo Mozilo, interview by FCIC. September 24, 2010. 20. David Sambol, interview by FCIC, September 27, 2010. 21. See Countrywide, Investor Conference Call, January 27, 2004, transcript, p. 5. See also Jody Shenn, “Countrywide Adding Staff to Boost Purchase Share,” American Banker, January 28, 2004. 22. Patricia Lindsay, written testimony for the FCIC, hearing on Subprime Lending and Securitization and Government-Sponsored Enterprises (GSEs), day 1, sess. 2: Subprime Origination and Securitization, April 7, 2010, p. 3 23. Andrew Davidson, interview by FCIC, October 29, 2020. 24. Ibid. 25. David Berenbaum, testimony before Senate Committee on Banking, Subcommittee on Housing, CHRG-111shrg57322--323 Mr. Birnbaum," Well, typically when people are talking about the housing market declining or going up, they are talking about housing prices. So we all have publicly available information on housing prices that is released, typically monthly, sometimes quarterly, and if that is what you are referring to---- Senator Tester. So the housing decline was based on housing prices around the middle to end of 2006. It was not based on subprime or--it was based on that pattern. I am not trying to set you up for anything. " CHRG-111hhrg53244--344 Mr. Bernanke," We are lending to all U.S. financial institutions in exactly the same way. " CHRG-111hhrg49968--66 Mr. Scott," Because that would convert directly into reduced lending capacity? " FOMC20081029meeting--30 28,MR. LACKER.," Or we could lend to them, collateralized by the Treasuries rather than by their own currency. " CHRG-111hhrg53238--220 Mr. Manzullo," Mr. Chairman, you know it is amazing, if I had asked each of you guys--that of course includes the gentlelady--what caused everything, the answer is pretty simple: too easy credit. The Federal Reserve had the authority to stop the 2/28 and the 3/27 mortgages, and the Federal Reserve also had the authority to require, goodness gracious, written proof of a person's income before that person was eligible to get the mortgage. You know something? No one starts with the problem. The problem is not in the derivatives, the problem is in the stinky piece of financial garbage that was generated because of the bad subprime loans. So if we already have a government agency that had the powers to stop this, and didn't do so for any number of reasons, why create another agency given the authority to come in and mess up? I mean, I don't know if you guys have taken a look at this Consumer Financial Protection Agency Act of 2009, the proposal on it. You know what that does? That says that this new organization gets to work with HUD, and perhaps FHSA, on a Truth-in-Lending and RESPA financial disclosure form. And how long did we fight those people at HUD on RESPA? When I chaired the Small Business Committee, that went on for 6 years. They finally came up with something they thought would work. And now FHA says well, we are going to take care of the appraisers. It allows banks to own an appraisal management company so that the appraisal management company can be wholly owned by the bank. But if you separate the men's bathroom from the women's bathroom, they can go out there and do an independent appraisal. And if a person gets an appraisal that he doesn't like--you know, we were told by the head of the FHFA what his resolution is: to contact them or the CC. You know, the more power and the more agencies we set up, it just screws everything up. I mean, Mr. Menzies, you know, you are a community banker. In your opinion--I like to pick on you--this is the third time since you have been here. In your opinion, if we did not have those exotic mortgages, if they were not allowed, and people had to show proof of their income, don't you agree that this crisis probably never would have occurred? " CHRG-110hhrg41184--196 Mr. Garrett," And just to close, the two gentlemen raised the issue about the dollar and the falling value there, the old axiom in there is, you know, inflation comes when too many dollars are chasing too few goods. So far, what we've done on the fiscal side of this is basically throw more dollars into it with a stimulus package, and my two questions to you are: One, does that do anything to actually change the mind set of creditors as far as their lending practice as a short-term lending like that? Does that really change their actual lending practices. And two, with the overall dollar value, there was an article in the Wall Street Journal today by David Ranson, I believe it is, which looks to say as far as the CPI and the way that we're evaluating the value of these things, that they're really backwards-looking and not forwards-looking, and that maybe we need to change the structure as to how we looked and measured the CPI and some of these valuations as well, in addition. " CHRG-111shrg57321--186 Mr. McDaniel," And that is why the performance of the subprime mortgage securities, particularly in 2006 and 2007, is so frustrating to me as a CEO, among other reasons. Senator Kaufman. Well, I don't see why it would be frustrating, because basically, what happened was we had this housing market blow-up, and through no fault of our own, everything went south. There was nothing--you have not identified a single thing that was going on at Moody's other than just you guys got caught in a bad housing market, not in a bad business market, a bad housing market. " fcic_final_report_full--456 The Commission’s authorizing statute required that the Commission report on or before December 15, 2010. The original plan was for us to start seeing drafts of the report in April. We didn’t see any drafts until November. We were then given an opportunity to submit comments in writing, but never had an opportunity to go over the wording as a group or to know whether our comments were accepted. We received a complete copy of the majority’s report, for the first time, on December 15. It was almost 900 double-spaced pages long. The date for approval of the report was eight days later, on December 23. That is not the way to achieve a bipartisan report, or the full agreement of any group that takes the issues seriously. This dissenting statement is organized as follows: Part I summarizes the main points of the dissent. Part II describes how the failure of subprime and other high risk mortgages drove the growth of the bubble and weakened financial institutions around the world when these mortgages began to default. Part III outlines in detail the housing policies of the U.S. government that were primarily responsible for the fact that approximately one half of all U.S. mortgages in 2007 were subprime or otherwise of low quality. Part IV is a brief conclusion. -----------------------------------------------------Page 478-----------------------------------------------------  fcic_final_report_full--614 Bank Regulators, 111th Cong., 2nd sess., April 16, 2010, Exhibits, p. 6. 64. OTS Regional Director Darrel Dochow, letter to FDIC Regional Director Stan Ivie, July 22, 2008. 65. Offices of Inspector General, Department of the Treasury and Federal Deposit Insurance Corpo- ration, “Evaluation of Federal Regulatory Oversight of Washington Mutual Bank,” Report No. EVAL 10- 002, April 2010, pp. 31, 12. 66. FDIC, Confidential Problem Bank Memorandum, September 8, 2008, p. 4. 67. Treasury and FDIC IGs, “Evaluation of Federal Regulatory Oversight of WaMu,” p. 39. 68. Confidential OTS Memorandum to FDIC Regional Director, September 11, 2008; Treasury and FDIC IGs, “Evaluation of Federal Regulatory Oversight of WaMu,” pp. 45–47. 69. Quoted in Damian Paletta, “FDIC Presses Bank Regulators to Use Warier Eye,” Wall Street Journal, August 19, 2008. 70. Sheila Bair, interview by FCIC, August 18, 2010. 71. Treasury and FDIC IGs, “Evaluation of Federal Regulatory Oversight of WaMu,” p. 3. 72. Comptroller of the Currency, Large Bank Supervision: Comptroller’s Handbook, January 2010, p. 3. 73. Cole, interview. 74. Rich Spillenkothen, “Observations and Perspectives of the Director of Banking Supervision and Regulation at the Federal Reserve Board from 1991 to 2006 on the Performance of Prudential Supervi- sion in the Years Preceding the Financial Crisis,” paper prepared for the FCIC, May 21, 2010, p. 24. 75. Doug Roeder, interview by FCIC, August 4, 2010. 76. “Treasury Releases Blueprint for Stronger Regulatory Structure,” Treasury Department press re- lease, March 31, 2008. Chapter 17 1. Henry Paulson, interview by FCIC, April 2, 2010; Henry Paulson, On The Brink: Inside the Race to Stop the Collapse of the Global Financial System (New York: Business Plus, 2010), p. 57. 2. Paulson, interview. 3. James Lockhart, testimony before the FCIC, Hearing on Subprime Lending and Securitization and Government-Sponsored Enterprises (GSEs), day 3, session 2: Office of Federal Housing Enterprise Over- sight, April 9, 2010, transcript, p. 163. 4. Daniel Mudd, letter to James Lockhart, August 1, 2007, p. 1. 5. Ibid., pp. 1, 5. 6. Daniel Mudd, letter to shareholders, in Fannie Mae, “2007 Annual Report,” p. 3. 7. Thomas Lund, interview by FCIC, March 4, 2010. 8. Robert Levin, interview by FCIC, March 17, 2010. 9. James Lockhart, letter to Daniel Mudd, August 10, 2007, p. 1. 10. James Lockhart, letter to Senator Charles Schumer, August 10, 2007. 11. James Lockhart, written testimony for the FCIC, Hearing on Subprime Lending and Securitiza- tion and Government-Sponsored Enterprises (GSEs), day 3, session 2: Office of Federal Housing Enter- prise Oversight, April 4, 2010, pp. 12, 2, 12. 611 12. Ibid., pp. 2, 4, 7. 13. Paulson, interview. 14. David Nason, Tony Ryan, and Jeremiah Norton, Treasury officials, interview by FCIC, March 12, 2010. 15. James Lockhart, quoted in Steven Sloan, “Setting an OFHEO Plan, But Wishing Otherwise,” CHRG-110hhrg46593--46 Mr. Bernanke," Well, our balance sheet is about $2 trillion, of which--I am guessing now--$600 billion is Treasury's and agencies'. The rest is some kind of credit extension of some type. The overwhelming amount, however, is of two classes. It is either collateralized lending to financial institutions. I described earlier, those are loans made with recourse and on haircut collateral. They are short-term loans, and they are quite safe. We have never lost a penny on one of those. The other type of lending we have been doing is we have been doing currency swaps with some major central banks in order to try to address dollar funding problems in other jurisdictions. There the credit risk is of the Foreign Central Bank, like the European Central Bank, and we consider that to be zero risk, essentially. So the overwhelming majority of our lending is at very low credit risk. " CHRG-111shrg54533--9 Chairman Dodd," Well, I appreciate the answer to that. Let me go to the issue--and, again, I want to state--I think all of us have had a chance to talk about this, and obviously the debate about, one, whether or not you want a systemic risk regulator, which I certainly do, and then the question who does it and what authorities do you give them. From my standpoint, I am open on the issue. I have not made up my own mind what is the best alternative. Obviously, you have submitted a plan that gives that authority to the Fed. But let me raise some questions that have been raised by others about the wisdom of that move to the Fed and not looking at the more collegial approach or some other alternative. A fellow by the name of Mark Williams, a professor of finance and economics at Boston University and a former Fed examiner, said the following: ``Giving the Fed more responsibility at this point''--and he had a rather amusing analogy--``is like a parent giving his son a bigger, faster car right after he crashed the family station wagon.'' SEC former Chairman Richard Breeden testified before this Committee, and he said the following: ``The Fed has always worried about systemic risk. I remember in 1982 and 1985 the Fed talking about that it worried about systemic risk. They have been doing that, and still we had a global banking crisis. The problems like the housing bubble, the massive leverage in the banks, the shaky lending practices, and subprime mortgages, those things were not hidden. They were in plain sight.'' And perhaps most significantly, Chairman Volcker in response to a question by Richard Shelby back in February in a hearing we had in this Committee testified that he had concerns about giving the Fed too many responsibilities that would undermine their ability to conduct monetary policy. So the question that many are asking, not just myself but others on this Committee and elsewhere, is: Given the concerns that have been expressed by the former Chairman of the Federal Reserve, the former Chairman of the SEC, and others about the Fed's track record as well as the multiple responsibilities that the Fed already has, why is it your judgment that the Fed should be given this additional extraordinary authority and power? And does it not conflict in many ways or could it not conflict with their fundamental responsibility of conducting monetary policy? " FinancialCrisisReport--83 Again, he expressed hope that the situation would improve: “The good news is David and his team are pros and are all over it.” 238 Two months later, in November 2006, however, the head of WaMu Capital Markets in New York, David Beck, relayed even more bad news to Mr. Schneider, the Home Loans President: “LBMC [Long Beach] paper is among the worst performing in the mkt [market] in 2006.” 239 Despite the additional focus on improving its lending operations throughout 2006, Long Beach was once again flooded with repurchase requests. According to a memorandum later written by an FDIC examination specialist, “[d]uring 2006, more than 5,200 LBMC loans were repurchased, totaling $875.3 million.” 240 Even though, in January 2006, the bank had ceased executing whole loan sales which allowed an automatic repurchase in the event of an EPD, 46% of the repurchase volume was as a result of EPDs. Further, 43% of the repurchase volume resulted from first payment defaults (FPDs) in which the borrower missed making the first payment on the loan after it was sold. 241 Another 10% of the repurchases resulted from violations related to representation and warranties (R&W) not included in the EPD or FPD numbers, meaning the violations were identified only later in the life of the loan. R&W repurchases generally pose a challenge for a bank’s loss reserves, because the potential liability – the repurchase request – continues for the life of the loan. The FDIC memorandum observed: “Management claims that R&W provisions are industry standard and indeed they may be. However, I still found that the Mortgage Loan Purchase Agreement contains some representations and warranties worth noting. For example, not only must the loans be ‘underwritten in accordance with the seller’s underwriting guideline,’ but the ‘origination, underwriting, and collection practices used by the seller with respect to each mortgage loan have been in all material respects legal, proper, prudent, and customary in the subprime mortgage business.’ This provision elevates the potential that investors can put back a problem loan years after origination and not only must the loan have been underwritten in line with bank guidelines but must also have been underwritten in accordance with what is customary with other subprime lenders.” 242 R&W repurchase requests and loss reserves continued to be an issue at Long Beach. The fourth quarter of 2006 saw another spike in R&W repurchase requests, and in December the required amount of R&W loss reserves jumped from $18 million to $76 million. 243 238 Id. 239 11/7/2006 WaMu internal email, Hearing Exhibit 4/13-50. 240 See 6/5/2007 memorandum by Christopher Hovik, Examination Specialist, sent to FDIC Dedicated Examiner Steve Funaro, “WaMu – Long Beach Mortgage Company (LMC) Repurchases,” at 1, FDIC_WAMU_000012348, Hearing Exhibit 4/13-13b. 241 Id. 242 Id. 243 Id. at 3. CHRG-111shrg56415--36 Mr. Dugan," Senator, I think that you are onto a very important point that I do not think has gotten the same kind of attention that it deserved and what got us here in the mortgage market, not just in subprime. I think we lost our way as a country in terms of some of our basic underwriting standards on loan-to-value and on stated income, and I think it is worth exploring having a more common set of minimum underwriting standards that apply across the board with more specificity than what we have today, which I think is what you are suggesting. " fcic_final_report_full--120 But as house prices rose after , the /s and /s acquired a new role: help- ing to get people into homes or to move up to bigger homes. “As homes got less and less affordable, you would adjust for the affordability in the mortgage because you couldn’t really adjust people’s income,” Andrew Davidson, the president of Andrew Davidson & Co. and a veteran of the mortgage markets, told the FCIC.  Lenders qualified borrowers at low teaser rates, with little thought to what might happen when rates reset. Hybrid ARMs became the workhorses of the subprime securitiza- tion market. Consumer protection groups such as the Leadership Conference on Civil Rights railed against /s and /s, which, they said, neither rehabilitated credit nor turned renters into owners. David Berenbaum from the National Community Rein- vestment Coalition testified to Congress in the summer of : “The industry has flooded the market with exotic mortgage lending such as / and / ARMs. These exotic subprime mortgages overwhelm borrowers when interest rates shoot up after an introductory time period.”  To their critics, they were simply a way for lenders to strip equity from low-income borrowers. The loans came with big fees that got rolled into the mortgage, increasing the chances that the mortgage could be larger than the home’s value at the reset date. If the borrower could not refinance, the lender would foreclose—and then own the home in a rising real estate market. Option ARMs: “Our most profitable mortgage loan” When they were originally introduced in the s, option ARMs were niche prod- ucts, too, but by  they too became loans of choice because their payments were lower than more traditional mortgages. During the housing boom, many borrowers repeatedly made only the minimum payments required, adding to the principal bal- ance of their loan every month. An early seller of option ARMs was Golden West Savings, an Oakland, Califor- nia–based thrift founded in  and acquired in  by Marion and Herbert San- dler. In , the Sandlers merged Golden West with World Savings; Golden West Financial Corp., the parent company, operated branches under the name World Sav- ings Bank. The thrift issued about  billion in option ARMs between  and .  Unlike other mortgage companies, Golden West held onto them. Sandler told the FCIC that Golden West’s option ARMs—marketed as “Pick-a- Pay” loans—had the lowest losses in the industry for that product. Even in —the last year prior to its acquisition by Wachovia—when its portfolio was almost entirely in option ARMs, Golden West’s losses were low by industry standards. Sandler attrib- uted Golden West’s performance to its diligence in running simulations about what would happen to its loans under various scenarios—for example, if interest rates went up or down or if house prices dropped , even . “For a quarter of a cen- tury, it worked exactly as the simulations showed that it would,” Sandler said. “And we have never been able to identify a single loan that was delinquent because of the structure of the loan, much less a loss or foreclosure.”  But after Wachovia acquired Golden West in  and the housing market soured, charge-offs on the Pick-a-Pay portfolio would suddenly jump from . to . by September . And fore- closures would climb. CHRG-110hhrg46596--501 Mrs. Maloney," First of all, I want to thank you for your testimony and your hard work, and for assuming this critically important oversight position. As you could tell, and I noticed you were here for the entire hearing-- Ms. Warren. Yes, ma'am. " Mrs. Maloney," --many of my colleagues, including myself, were very concerned about getting credit out into the community. We appear to have stabilized our financial markets. I would like your comments on whether or not you agree that we have accomplished that goal. And could you comment on programs or ways we can get credit out into Main Street? We have helped Wall Street. What are we doing to help people buy cars, and purchase homes? I like the proposal from Treasury that they are studying of a 4.5 percent interest rate over 30 years to start moving our housing program. I would like to hear your comments on that and any other ideas about getting credit into Main Street. They testified, and we need to work on really an accounting system so that we can understand where the money is going. We have put out $7.8 trillion, and still people say that interest rates for cars are at 14 percent, which is unaffordable for most Americans, and many people cannot get mortgages for their homes with a 30-year mortgage. Could you comment on steps we need to take now? Ms. Warren. It would be premature for me to make specific recommendations, but I would turn to page 19 of our report. We actually had a little bit to say about this. The reminder that our friends in Great Britain faced a similar problem, and they were quite explicit up front. The money was given to financial institutions in return for the financial institutions to lend to small- and medium-sized enterprises. It was an explicit quid pro quo from the beginning. There have been measurements of what was your lending a year ago at this point and what is your lending now. Recapitalized banks, as part of their obligation in receiving funds, have to turn around and put those funds back into the economy. I mention this by way of saying that is not an entirely novel idea. It is one that has been tested somewhere else and seems to be working at least with some success. So there are ways to measure this. It is not impossible to measure what is happening to lending volume and to put metrics in to compare lending volume now with lending volume by the same bank or per dollar capitalized in the past. And this may be something that it will be appropriate to at least continue to question Treasury vigorously about. " CHRG-110hhrg46593--28 Mr. Bachus," Thank you, Mr. Chairman. You have just been told, if you don't give assistance or lend to folks, you will be waxed. It is sort of a continuation of what we have been hearing since the 1970's by Federal policy and the GSEs, is, lend and meet the needs of folks and assist them. I think, as a result of that, the financial system and the economy has been waxed by lending to people who weren't creditworthy. And I hope--and I appreciate that your intergovernment statement stressed creditworthy borrowers. Secretary Paulson, I very much appreciate something that you did in your opening statement. I think you distinguished between the economy and the financial system, because people did question some of the actions by saying, well, the economy is strong. But the financial system, chaos or distress there will affect the economy. It has that effect. I think we have heard good news here. There is stability returning to the financial system. And I think the good news is, just like the instability in the financial system affected the economy, going forward, and it may take a while to do, but the stability that has returned to the system will in the long term strengthen the economy. I think that is good news for all of us. The TARP program, the capital purchase program, all of them had as a design two things. One was restoring the stability to the financial markets. And I think that we are well on our way to achieving that. And as you said, you don't get credit for something that you avoid, and that would be a collapse of the financial system. The second objective was to strengthen the economy by restoring lending to companies and borrowers. And on that score, it hasn't worked as well. Would you comment on, do you think we are on the right track in restoring lending? " CHRG-111shrg52966--38 Mr. Sirri," What a firm does is it takes the security it has, it gives it someone who lends it out---- Senator Bunning. I am familiar. " Mr. Sirri,"----it comes back. Because that is a secured lending market, the lenders were thought to be not sensitive to the health of the firm, but sensitive to the quality of the collateral they got. So our thought was always that if you as a firm gave someone a Treasury bill or gave them an agency security, they would take that and fund you, even if you as a firm were in trouble. That was an assumption we made, and that is, I think, many in the financial community made. And we were wrong. When firms got in trouble, other funding counterparties--money market funds, people with cash to lend--would not take Treasury's to fund, and that was something we had never seen before. Senator Bunning. Mr. Long, what changes in law do you suggest to protect against future failures like we are in right now? " FinancialCrisisReport--232 America for $2.8 billion. 885 Neither the OCC nor OTS ever filed a public enforcement action against the bank. In June 2009, the SEC filed suit against the three most senior Countrywide executives, the chief executive officer, the chief operating officer and president, and the chief financial officer, charging them with fraudulently misleading investors by representing that Countrywide had issued loans primarily to “prime” or low risk borrowers, when it had actually written increasingly risky loans that senior executives knew would result in substantial defaults and delinquencies. 886 In addition, the SEC charged that CEO Angelo Mozilo had violated his federal disclosure obligations and engaged in insider trading. 887 The SEC complaint detailed the bank’s increasingly risky underwriting and lending practices from 2005 to 2007, including its use of stated income loans, loan-to-value ratios in excess of 95%, loans to borrowers with low FICO scores, frequent use of loan exceptions, and willingness to match the loan terms of any competitor. Like WaMu, from 2003 to 2007, the bank switched from issuing primarily low risk, 30-year loans, to subprime and other high risk mortgages. 888 The complaint also described how Mr. Mozilo was internally alarmed and critical of the increased credit risks that Countrywide was incurring, while at the same time telling investors that the bank was more prudent than its competitors. 889 The SEC complaint cited, for example, an April 2006 email from Mr. Mozilo discussing Countrywide’s issuance of subprime 80/20 loans, which are loans that have no down payment and are comprised of a first loan for 80% of the home’s value and a second loan for the remaining 20% of the value, resulting in a loan-to- value ratio of 100%. Mr. Mozilo wrote: “In all my years in the business I have never seen a more toxic pr[o]duct.” 890 In another email that same month, after being informed that most borrowers were making the minimum payments allowed on Option ARM loans, Mr. Mozilo wrote: “Since over 70% have opted to make the lower payment it appears it is just a matter of time that we will be faced with much higher resets and therefore much higher delinquencies.” 891 883 OCC, “Annual Report: Fiscal Year 2009,” http://www.occ.gov/static/publications/annrpt/2009AnnualReport.pdf. 884 See, e.g., SEC v. Mozilo , Case No. CV09-03994 (USDC CD Calif.), Complaint (June 4, 2009), at ¶¶ 102-104 (hereinafter “SEC Complaint against Countrywide Executives”). 885 “Countrywide Financial Corporation,” New York Times (10/15/2010). 886 SEC Complaint against Countrywide Executives. 887 Id. 888 See, e.g., SEC Complaint against Countrywide Executives, at ¶¶ 17-19. 889 See, e.g., id. at ¶¶ 6-7. 890 Id. at ¶ 50. 891 Id. at ¶ 63. CHRG-110hhrg46591--330 Mr. Cleaver," Thank you, Mr. Chairman. Whenever we begin this discussion of regulation, it always creates ideological differences. Mr. Yingling and Mr. Washburn, I am wondering, since someone here on our committee made a comment before the break that the CRA and minorities were responsible for the subprime mortgage debacle, I would like to find out from you, from the banking industry, do you believe that the CRA is a regulatory burden? Mr. Yingling or Mr. Washburn. " FOMC20080724confcall--46 44,MR. PLOSSER.," I want to go back to the collateral issue for a minute. I share some of the concerns about the options on the TSLF that President Lacker and President Hoenig were discussing. I assume we will come back and talk more about some of those things, but I do have a question about the collateral. My understanding in the discussion about the larger collateral on term lending is that it would also apply to the primary credit lending, which means that if somebody came into the primary credit facility and asked for primary credit of two or three days, they would have to have this 125 percent or this extra collateral. Is that the way we are interpreting this thing, and is that really what we want to be doing by raising the collateral on term loans at the primary credit facility? I am just confused about that and whether--particularly on things less than 30 days, the primary credit facility--we want to be applying the same standard to that lending as we are on the longer TAF stuff. Just a question. " CHRG-111shrg57319--524 Mr. Killinger," Well, Senator, we approved a new strategic plan in actually that summer of 2004, and this is not the whole plan. Remember, this is a small part of our business. But part of that plan was increasing the subprime portfolio that we had in our portfolio over a period of time. But I also was very careful to say that is going to be subject to market conditions and we will be opportunistic. And the reality is we did not execute on that. We ended up shrinking that portfolio that we held, rather than growing it. Senator Coburn. Yes, and this chart actually shows that. " fcic_final_report_full--243 COMMISSION CONCLUSIONS ON CHAPTER 11 The Commission concludes that the collapse of the housing bubble began the chain of events that led to the financial crisis. High leverage, inadequate capital, and short-term funding made many finan- cial institutions extraordinarily vulnerable to the downturn in the market in . The investment banks had leverage ratios, by one measure, of up to  to . This means that for every  of assets, they held only  of capital. Fannie Mae and Freddie Mac (the GSEs) had even greater leverage—with a combined  to  ratio. Leverage or capital inadequacy at many institutions was even greater than re- ported when one takes into account “window dressing,” off-balance-sheet expo- sures such as those of Citigroup, and derivatives positions such as those of AIG. The GSEs contributed to, but were not a primary cause of, the financial crisis. Their  trillion mortgage exposure and market position were significant, and they were without question dramatic failures. They participated in the expansion of risky mortgage lending and declining mortgage standards, adding significant demand for less-than-prime loans. However, they followed, rather than led, the Wall Street firms. The delinquency rates on the loans that they purchased or guar- anteed were significantly lower than those purchased and securitized by other fi- nancial institutions. The Community Reinvestment Act (CRA)—which requires regulated banks and thrifts to lend, invest, and provide services consistent with safety and sound- ness to the areas where they take deposits—was not a significant factor in sub- prime lending. However, community lending commitments not required by the CRA were clearly used by lending institutions for public relations purposes. fcic_final_report_full--299 With the TSLF, the Fed would be setting a new precedent by extending emergency credit to institutions other than commercial banks. To do so, the Federal Reserve Board was required under section () of the Federal Reserve Act to determine that there were “unusual and exigent circumstances.” The Fed had not invoked its section () authority since the Great Depression; it was the Fed’s first use of the authority since Congress had expanded the language of the act in  to allow the Fed to lend to investment banks.  The Fed was taking the unusual step of declaring its willing- ness to soon open its checkbook to institutions it did not regulate and whose finan- cial condition it had never examined. But the Fed would not launch the TSLF until March , more than two weeks later—and it was not clear that Bear could last that long. The following day, Jim Em- bersit of the Federal Reserve Board checked on Bear’s liquidity with the SEC. The SEC said Bear had . billion in cash—down from about  billion at the start of the week—and was able to finance all its bank loans and most of its equity securities through the repo market. He summarized, “The SEC indicates that no notable losses have been sustained and that the capital position of the firm is ‘fine.’”  Derivatives counterparties were increasingly reluctant to be exposed to Bear. In some cases they unwound trades in which they faced Bear, and in others they made margin or collateral calls.  In Bear’s last few years as an independent company, it had substantially increased its exposure to derivatives. At the end of fiscal year , Bear had . trillion in notional exposure on derivatives contracts, compared with . trillion at  fiscal year-end and . trillion at the end of . Derivatives counterparties who worried about Bear’s ability to make good on their payments could get out of their derivative positions with Bear through assign- ments or novations. Assignments allow counterparties to assign their positions to someone else: if firm X has a derivatives contract with firm Y, then firm X can assign its position to firm Z, so that Z now is the one that has a derivatives contract with Y . Novations also allow counterparties to get out of their exposure to each other, but by bringing in a third party: instead of X facing Y , X faces Z and Z faces Y . Both assign- ments and novations are routine transactions on Wall Street. But on Tuesday, Brian Peters of the New York Fed advised Eichner at the SEC that the New York Fed was “seeing some HFs [hedge funds] wishing to assign trades the clients had done with Bear to other CPs [counterparties] so that Bear ‘steps out.’”  Counterparties did not want to have Bear Stearns as a derivatives counterparty any more. Bear Stearns also encountered difficulties stepping into trades. Hayman Capital Partners, a hedge fund in Texas wanting to decrease its exposure to subprime mort- gages, had decided to close out a relatively small  million subprime derivative posi- tion with Goldman Sachs. Bear Stearns offered the best bid, so Hayman expected to assign its position to Bear, which would then become Goldman’s counterparty in the derivative. Hayman notified Goldman by a routine email on Tuesday, March , at : P . M . The reply  minutes later was unexpected: “GS does not consent to this trade.”  CHRG-111hhrg48674--57 Mr. Bernanke," First of all, I want to insist that the Fed does not spend. We lend. " FOMC20080724confcall--75 73,MR. LACKER.," Yes. I want to, first, just express appreciation to President Yellen for the full account of their experience. I think it is useful for us to share notes on experiences like that. We had an experience with the OTS, and we found that their rating plus 1 was the rating we usually came to. We had the luxury of having someone on our staff who had experience with Countrywide, and we essentially treated them like an institution that we supervised and insisted on the full panoply of information, such as reports and financial reporting, to be able to make our own independent assessment. Our guys did a great job. I have to commend them--they did a lot of work. But it was a strain on our staff. I do think, if lending is going to play such a large role for us going forward, that we should build up the capability of developing our own independent assessment of institutions whose primary regulator is not us. In this instance, I think it is outrageous that the OTS downgraded them and didn't inform the San Francisco Fed. I hope, Mr. Chairman, that the unacceptability of that sort of behavior is communicated at the highest levels to the OTS. This instance demonstrates the principle that lending on which we incur no loss doesn't necessarily equal lending that is appropriate. I think it is a good thing, President Yellen, that you folks insisted on comfort from the FDIC that they were pursuing a least-cost strategy. But it will not necessarily be the case that lending to allow the chartering institution to delay closure will be the least-cost resolution. I am curious, President Yellen, whether there were uninsured claimants that were able to withdraw funds in the interim during your lending. " CHRG-110hhrg34673--44 Mrs. Maloney," Thank you, Mr. Chairman. And welcome back, Chairman Bernanke. Many of my colleagues have been quoting ``American Banker.'' I would like to show you ``The Hill.'' There you are on the cover. It says your testimony sparked a stock price rally, and the Dow is up 87 percent, and there is great optimism for our economy, and I hope you are right. I hope the stock market is right. But regrettably, some of my constituents are not feeling optimistic. They feel that the economic expansion has not ended up in their take-home pay, and some are very concerned about losing their homes, and I share that concern. They are concerned about the rising rate of mortgage defaults and home foreclosures. In my district employment is high and stable, yet I am being told that foreclosures are at rates that are up by an order of magnitude--they have jumped up dramatically from what they were last year. Some of my colleagues tell me that they are experiencing the same thing in their districts around the country, and they are being told that homeowners are losing their homes in very stable neighborhoods, and some say that this is due to various causes such as unemployment. Yet in my district and others where employment is high, and in some other areas, it is due to the decline in the housing market. But many also ask whether certain mortgage products, particularly in the subprime market, have contributed to this foreclosure crisis or challenge. In particular, many point to the so-called 2/28 ARM's, and some have described them--and I quote--as an inherent predatory product. And as you have told me and others, these 2/28 ARM's are 80 percent of the subprime market. Recently the Fed wrote back to Senator Dodd, taking the position that in its recent guidance on nontraditional mortgages, they did not extend to 2/28 for similar projects. And since these are what many people think is the problem, my question is why is the Fed not addressing the 2/28's and issuing guidance for what many people feel is the main problem in the foreclosure rates and the loss of homes of many people? You eloquently have said many times that homeownership leads to participation in our economy and increased wealth for Americans, yet if you are losing your home, it is leading you to a personal crisis, and if it continues, we will be facing a tremendous crisis in our economy and in our districts. And now for your comments on whether or not the Fed plans to extend guidance to the 2/28 subprime project, products. " FinancialCrisisInquiry--191 We stand ready to assist the commission over the coming year and we look forward to your findings on these matters of utmost importance to America’s families. Thank you very much. CHAIRMAN ANGELIDES: Thanks, Ms. Gordon. Mr. Cloutier? CLOUTIER: Thank you very much. Chairman Angelides, Vice Chairman Thomas and members of the commission, my name is Rusty Cloutier, and I am pleased to testify today on the current state of the financial crisis and in particular the effect it has had on the small- business lending community. I am president and chief executive officer of MidSouth Bank, a $980 million community bank headquartered in Lafayette, Louisiana, with locations throughout south Louisiana and southeast Texas. I am also the author of the book “Big Bad Banks,” which details how a few megabanks and powerful individuals fueled the current financial and economic crisis. I’m proud to testify today on behalf of the Independent Community Bankers of America and its 5,000 community bank members nationwide. Mr. Chairman, it is difficult to talk about the effects of the financial crisis without speaking to the root cause. Too-big-to-fail institutions and the systemic risks that they pose were the heart of our financial and economic meltdown. Equally responsible were those institutions making up the unregulated shadow banking industry operating just not outside of legal parameters, of the regulatory framework, which made most of the subprime exotic loans and brought the housing markets to its knees. For far too long, these institutions have enjoyed privileges of favorable government treatment, easier access to cheaper funding sources, lower or no compliance cost, and little if any oversight. A little more than a few years ago, a key element of the financial system nearly collapsed due to the failure of these institutions to manage their highly risky activities. CHRG-110hhrg38392--49 Mr. McHenry," I thank the chairman. Chairman Bernanke, I am certainly glad to have you here. It seems your presentation today is largely about residential real estate. You mentioned that declines in residential construction will continue to weigh on economic growth over the coming quarters. Do you have any words for Congress--at a time when lending standards have been tightened--on whether or not we should further tighten lending with additional rules and regulations on the mortgage marketplace? " CHRG-110hhrg46595--126 Mr. Manzullo," Thank you, Mr. Chairman. I am quite distressed over the continuous talk coming from the Big Three that there is no money available for consumers to buy your automobiles. Credit unions, local branches of national banks, and community banks are loaded with money and are ready, willing, and eager to give to people to buy your automobiles. On the current business environment on the Ford, page 3, quoting the Federal Reserve's senior loan officers, it says, ``Over 60 percent of banks have tightened standards for consumer credit.'' That is not the case. I talked to a bank yesterday. I said, ``Have you changed any standards in the past year?'' He said, ``No.'' He said what happened is the Big Three set up their own financing arm and they pushed the community banks out of lending. And then you come back here, and you have created much of the crisis among yourselves because you created your own subprime market in automobile loans that is sitting out there because it was too easy credit to people who couldn't afford to buy the automobiles that you sold to them. That originally is what TARP was set up for was to buy that back. And now, Mr. Wagoner, you want to go into the commercial banking business. You want to be able to take demand deposits or set up checking accounts. I mean, you would be a bank on the order of Wal-Mart, which we stopped, and Mr. Nardelli, of Home Depot, which we also stopped. Why would an automobile manufacturer go into the commercial banking business and wreak havoc on the community banks, credit unions, and local branches of national banks? You are there to make cars, not to run a banking operation. That is part of the bailout, so that you can become a commercial bank? I don't expect an answer because there is no good answer to that. Your job is to make cars. And the other thing is I noticed that both Ford and GM have overseas subsidiaries that are doing quite well. My question to each of you is, have you taken advantage of the IRS 60-day window to bring back profits from overseas operations to infuse them into your domestic operation without having to pay 35 percent tax? Mr. Wagoner, have you done that? " FinancialCrisisInquiry--656 CLOUTIER: January 13, 2010 Yes, yes, we’ll do that. But let me—let me add on, too, that you need to be well aware that the subprime crisis was brought – the products were brought to Citicorp when it was acquired by Sandy Weil, who was a -- who had become very big in commercial credit. And so they developed it. And a lot of the people that were unregulated were mules for the larger Wall Street firms that were pushing these products. But we will get you some data. We appreciate it. FinancialCrisisReport--81 In addition to the early payment default problem, a September 2005 WaMu audit observed that at Long Beach, policies designed to mitigate the risk of predatory lending practices were not always followed. The audit report stated: “In 24 of 27 (88%) of the refinance transactions reviewed, policies established to preclude origination of loans providing no net tangible benefit to the borrower were not followed.” 226 In addition, in 8 out of 10 of the newly issued refinance loans that WaMu reviewed, Long Beach had not followed procedures designed to detect “loan flipping,” an industry term used to describe the practice of unscrupulous brokers or lenders quickly or repeatedly refinancing a borrower’s loan to reap fees and profits but provide no benefit to the borrower. 227 2006 Purchase of Long Beach. In response to all the problems at Long Beach, at the end of 2005, WaMu fired Long Beach’s senior management and moved the company under the direct supervision of the President of WaMu’s Home Loans Division, David Schneider. 228 Washington Mutual promised its regulator, OTS, that Long Beach would improve. 229 The bank also filed a formal application, requiring OTS approval, to purchase Long Beach from its parent company, so that it would become a wholly owned subsidiary of the bank. 230 WaMu told OTS that making Long Beach a subsidiary would give the bank greater control over Long Beach’s result of the EPD provision for the year ended December 31, 2005 was $837.3 million. The net loss from these repurchases was approximately $107 million.”). 223 Id. 224 Id. 225 Washington Mutual Inc. 2005 10-K filing with the SEC. 226 9/21/2005 WaMu audit of Long Beach, JPM_WM04656627. 227 Id. 228 Subcommittee interview of David Schneider (2/17/2010). 229 See, e.g., 12/21/2005 OTS memorandum, “Long Beach Mortgage Corporation (LBMC),” OTSWMS06-007 0001009, Hearing Exhibit 4/16-31. 230 Id. at OTSWMS06-007 0001009 (stating WaMu filed a 12/12/2005 application to acquire Long Beach). operations and allow it to strengthen Long Beach’s lending practices and risk management, as well as reduce funding costs and administrative expenses. 231 In addition, WaMu proposed that it replace its current “Specialty Mortgage Finance” program, which involved purchasing subprime loans for its portfolio primarily from Ameriquest, with a similar loan portfolio provided by Long CHRG-111hhrg55809--212 Mr. Clay," Well, going along those lines of thinking, then, how does the Federal Reserve repair the damage that has been done to communities like the one I represent which had a disproportionate number of subprime loans when really the consumer probably should have had a prime loan, but yet now it has caused them to go into foreclosure? It has damaged those communities. Now you have all of these vacant properties sitting there destroying those communities. How can the Federal Reserve at least help repair that damage? " FinancialCrisisReport--194 Significant Deficiency in its financial reporting. Despite the sudden evidence of Long Beach’s poor quality loans, inadequate repurchase reserves, and negative earnings impact on its parent company, Washington Mutual Inc., OTS approved the bank’s application to purchase Long Beach. OTS explained its decision to the Subcommittee by contending that the change in status gave WaMu more control over Long Beach to ensure its improvement. 731 WaMu ultimately purchased Long Beach on March 1, 2006. 732 After the purchase, Long Beach’s practices did not improve, but continued to exhibit numerous problems, as described in the prior chapter. A May 2006 OTS examination of Long Beach loans concluded, for example, “that the number and severity of underwriting errors noted remain at higher than acceptable levels.” 733 In a June 2006 internal email to his colleagues, the OTS Regional Deputy Director wrote: “We gave them the benefit of doubt based on commitments and some progress when we allowed them to bring [Long Beach] into the bank, but … we have the same type of concerns remaining 6 months later.” 734 In the annual 2006 ROE and again in the annual 2007 ROE, OTS found that Long Beach’s lending practices “remain[ed] less than satisfactory.” 735 At a hearing of the Subcommittee on April 13, 2010, WaMu’s chief credit risk officers from 2004 to 2008 uniformly condemned Long Beach’s poor performance and testified that it had never developed an effective risk management system. 736 730 See 4/17/2006 memorandum by WaMu General Auditor to Board of Directors’ Audit Committees of Washington Mutual Inc. and Washington Mutual Bank, “Long Beach Repurchase Reserve Root Cause Analysis,” JPM_WM02533760, Hearing Exhibit 4/13-10 (Long Beach “experienced a dramatic increase in EPD’s [early payment defaults], during the third quarter of 2005 [which] … led to a large volume of required loan repurchases. The unpaid principal balance repurchased as a result of the EPD provision for the year ended December 31, 2005 was $837.3 million. The net loss from these repurchases was approximately $107 million.”). 731 Subcommittee interview of Benjamin Franklin (2/18/2010). 732 See “Washington Mutual Regulators Timeline,” chart prepared by the Subcommittee, Hearing Exhibit 4/16-1j. 733 5/25/2006 OTS Findings Memorandum, “Loan Underwriting Review - Long Beach Mortgage,” OTSWMS06- 008 0001243, Hearing Exhibit 4/16-35. See also 1/20/2006 email from Darrel Dochow to Michael Finn, et al., “LBMC EDP Impact,” OTSWMS06-007 0001020 (emphasis added). 734 6/9/2006 email from Darrel Dochow to Richard Kuczek, Lawrence Carter, and Benjamin Franklin, “Findings Memos,” OTSWMS06-008 0001253, Hearing Exhibit 4/16-36. 735 8/29/2006 OTS Report of Examination, at OTSWMS06-008 0001680, Hearing Exhibit 4/16-94 [Sealed Exhibit]; 9/18/2007 OTS Report of Examination, OTSWMEF-0000047146, Hearing Exhibit 4/16-94 (“Based on our review of 75 subprime loans originated by LBMC, we concluded that subprime underwriting practices remain less than satisfactory . . . . Given that this is a repeat concern and MRBA, we informed management that underwriting must be promptly corrected, or heightened supervisory action would be taken, including limiting the Bank’s ability to continue SFR subprime underwriting.”) [Sealed Exhibit]. 736 April 13, 2010 Subcommittee Hearing at 22. (e) Over 500 Deficiencies in 5 Years FOMC20070321meeting--12 10,MR. DUDLEY.," You’re absolutely right. The market was much smaller at that time. I would characterize the deterioration that you saw in 2001 as probably mostly driven by the macroeconomy, and the deterioration that you saw in 2006 as driven mostly by two things: more laxity in the underwriting process and a change in the trajectory of home prices. So I think the causes of the deterioration in the two cases were quite different. The subprime mortgage market in 2006 is several times the size of the originations in 2001; so obviously it will have a bigger consequence." CHRG-111shrg54789--185 RESPONSES TO WRITTEN QUESTIONS OF CHAIRMAN DODD FROM MICHAEL S. BARRQ.1. Correcting Incentives--We have heard a number of reports of how financial sector employees are incentivized to push harmful financial products on to customers--sometimes to keep their jobs. For example, one Bank of America call-center worker claimed, ``the more money [she] sold [a customer] and the higher the rate, the more money [she] made. That's what the bank rewards--sales, not service.'' These products harmed not just customers but the entire U.S. economy. The President's plan recognizes that ``an important component of risk management involves properly aligning incentives, and that properly designed compensation practices for both executives and employees are a necessary part of ensuring safety and soundness in the financial sector.'' \1\ Secondly, it suggests the creation of a whistleblower fund, saying that ``financial firms and public companies should be accountable to their clients and investors by expanding protections for whistleblowers.'' \2\ This raises two questions:--------------------------------------------------------------------------- \1\ See http://www.financialstability.gov/docs/regs/FinalReport_web.pdf, p. 30. \2\ See http://www.financialstability.gov/docs/regs/FinalReport_web.pdf, pp. 15 and 72.--------------------------------------------------------------------------- How could a Consumer Financial Protection Agency ensure that employees are not provided with these incentives to push negative financial products onto customers?A.1. The Consumer Financial Protection Agency (CFPA) will have the authority and tools to address practices that harm consumers in the marketplace for consumer financial products and services. This authority would extend to business practices, including compensation practices that push consumers to purchase inappropriate products and services. The authority the CFPA would have to address harmful employee incentive practices includes, for example, the following: Under Section 1031, the CFPA could issue rules to restrict unfair, deceptive or abusive acts and practices. The CFPA will also have the authority, under Section 1033, to promulgate rules regarding sales practices, to ensure that consumer financial products and services are provided in a manner, setting and circumstances which ensure that the risks, costs, and benefits of the products or services are fully and accurately represented to consumers. In addition, under Section 1037, the CFPA will have the authority to prescribe rules imposing duties on a covered person, or an employee of a covered person, who deals directly with consumers in providing financial products and services, as the CFPA deems appropriate to ensure fair dealing with consumers. With this authority, the CFPA will be able to impose duties on salespeople and mortgage brokers to offer appropriate loans, take care with the financial advice they offer, and meet the duty of best execution. The CFPA also would be able to prevent lenders from paying higher commissions to brokers or salespeople (yield spread premiums) for selling loans to consumers with higher rates than consumers qualify for.Q.2. Would the Consumer Financial Protection Agency play any role in protecting whistleblowers who call attention to abuses against consumers, much like the whistleblower protections given to employees of contractors and State and local governments in this year's stimulus bill? \3\--------------------------------------------------------------------------- \3\ American Recovery & Reinvestment Act of 2009, Pub. L. No. 111-5, 1553.---------------------------------------------------------------------------A.2. Yes, the CFPA will play a role in protecting whistleblowers who call attention to abuses against consumers. Section 1057 provides protections for employees who, among other things, provide information to the Agency or testify in any proceeding resulting from the enforcement of the CFPA Act. Employees who believe they have been terminated or otherwise discriminated against because of the information they have provided have a right to review by the Agency of such action, including a right to a public hearing as part of the required investigation by the Agency. After investigation, the Agency has the authority to issue an order which provides for reinstating or rehiring the employee.Q.3. Senators Wyden and Whitehouse's Amendments From the Credit Card Bill--Earlier this year when the Credit Card Accountability, Responsibility and Disclosure Act was on the Senate floor, Senator Wyden and Senator Whitehouse each had an amendment that ultimately did not get incorporated into the final legislation. Senator Wyden's amendment would have established a five-star rating system for credit cards, and Senator Whitehouse's amendment would have overturned the Supreme Court's Marquette decision that allowed interest rates to be exported across State lines. How would your proposal deal with the issues that these two amendments sought to address? Would the proposal allow the Consumer Financial Protection Agency to set up some type of rating system for credit cards to the extent it determines necessary to protect cardholders? And what effects would your proposal have on the Marquette decision?A.3. The CFPA would have the authority to achieve the same ends as the proposed credit card rating system--fairness and transparency. It is given the mandate to ensure that consumers have the clear and accurate information they need to make responsible financial decisions. Ensuring that consumers have, reasonably can understand, and can use the information they need to make responsible decisions is the first of the CFPA's four objectives under Section 1021(b)(1). We do not propose to alter existing law under Marquette, which allows banks to charge the interest rate permitted by their chartering State.Q.4. In his testimony, Mr. Yingling cites the Treasury's plan as saying ``that 94 percent of high cost mortgages were made outside the traditional banking system,'' (p. 4). On the other hand, you testify that ``about one-half of the subprime originations in 2005 and 2006--the shoddy originations that set off the wave of foreclosures--were by banks and thrifts and their affiliates.'' Please explain the discrepancy.A.4. Mr. Yingling's assertion is incorrect. Here is the relevant paragraph from our white paper, Financial Regulatory Reform: A New Foundation (pp. 68-69). http://10.75.16.79:8080/docs/regs/FinalReport_web.pdf. See in particular the last sentence. Rigorous application of the Community Reinvestment Act (CRA) should be a core function of the CFPA. Some have attempted to blame the subprime meltdown and financial crisis on the CRA and have argued that the CRA must be weakened in order to restore financial stability. These claims and arguments are without any logical or evidentiary basis. It is not tenable that the CRA could suddenly have caused an explosion in bad subprime loans more than 25 years after its enactment. In fact, enforcement of CRA was weakened during the boom and the worst abuses were made by firms not covered by CRA. Moreover, the Federal Reserve has reported that only 6 percent of all the higher-priced loans were extended by the CRA-covered lenders to lower income borrowers or neighborhoods in the local areas that are the focus of CRA evaluations. The information from the last sentence is from an article by Federal Reserve economists and refers just to subprime loans made by a bank or thrift (a) to lower-income people or neighborhoods and (b) in a bank or thrift's CRA assessment area. See http://www.minneapolisfed.org/publications_papers/pub_display.cfm?id=4136. This statistic does not refer to the whole population of subprime loan originations. Of that population, banks and thrifts held a significant share. That fact is evident in Table 1 below (http://www.minneapolisfed.org/pubs/cd/09-2/table1.pdf.) from the same article. It shows that, in 2005, 36 percent of higher-priced loans were by depositories or their subsidiaries; in 2006 the figure rose to 41 percent. If you add in bank affiliates, in 2005, banks, their subsidiaries and affiliates made 48 percent of all higher-cost loans, and 54 percent in 2006.Q.5. Mr. Yingling claims that the creation of the CFPA will result in a ``potentially massive new regulatory burden.'' He then goes on to assert ``community banks will have greatly increased fees to fund a system that falls disproportionately on them.'' How do you respond?A.5. We believe that the Federal regulatory structure for consumer protection needs fundamental reform. We have proposed to consolidate rule-writing, supervision, and enforcement authority under one agency, with marketwide coverage over both nonbanks and banks that provide consumer financial products and services. With this consolidated authority and marketwide coverage, the CFPA will be able to regulate in a manner that is more streamlined and effective, not more burdensome. The authorities for rulemaking, supervision, and enforcement for consumer financial products and services are presently scattered among seven different Federal agencies, sometimes with overlapping authority. For example, the Federal Reserve Board (FRB) has jurisdiction over required mortgage disclosures under the Truth in Lending Act (TILA), while the Department of Housing and Urban Development has authority to require mortgage disclosure under the Real Estate and Settlement Protection Act (RESPA). As another example, the Federal Trade Commission (FTC) has authority to issue rules relating to mortgage loans in the nonbank sector, while the Federal Reserve has similar authority under the Home Ownership and Equity Protection Act to issue rules regarding the entire mortgage market. Such balkanization and overlap of regulatory authority does not make sense. With consolidated authority, the CFPA will, for example, be able to integrate the mortgage disclosures required under TILA and RESPA into one, integrated form. This simplification--and others like it--would decrease, not increase, the compliance burden, while improving protections for consumers. Moreover, with respect to regulations, the CFPA will be statutorily required to consider the potential costs and benefits to consumers and institutions, including the potential reduction in consumer access to financial products and services. The CFPA will be required to consult with safety and soundness regulators before issuing rules. As a result, the CFPA's rules and supervisory approach will be balanced and effective. It is simply not true under our proposal that community banks will pay higher fees to fund the CFPA. The Administration proposes to provide by statute that community banks will pay no more for Federal consumer protection supervision after the CFPA is created than they do today. Moreover, we believe that community banks will benefit from the CFPA in several ways. First, today, community banks have to compete against nonbank entities like mortgage brokers and mortgage companies, which, unlike banks, are not subject to Federal oversight. In recent years, nonbank firms won market share by lowering lending standards and offering irresponsible--and often deceptive--loans. Community banks were forced either to lower their own standards or to become uncompetitive. The CFPA will provide a level playing field, extending the reach of Federal oversight to all providers of consumer financial products and services, banks and nonbanks alike, for the first time. The CFPA will put an end to community banks' competitive disadvantage. Second, CFPA's marketwide coverage and consolidated authority for rule writing, supervision, and enforcement will enable it to choose the least-cost, most-effective tools. For example, it will be able to use ``supervisory guidance'' in place of new regulations. Supervisory guidance is less burdensome for financial institutions, but is not an effective consumer protection tool today because it requires coordination between numerous Federal and State agencies. With one Federal agency in charge, supervisory guidance can more often be used in place of new regulations. Finally, the CFPA will have a mandate to allocate more resources to those companies that pose more risks to consumers when providing consumer financial products and services. Community banks are close to their customers and have often provided simpler, easier-to-understand products with greater care and transparency than other segments of the market. Such banks will receive proportionally less oversight from the CFPA.Q.6. Mr. Yingling asserts that the CFPA is ``instructed to create its own products and mandate that banks offer them. . . . Community banks whether it fits their business model or not, would be required to offer Government-designed products, which would be given preference over their own products.'' This raises two questions: Would the Administration's proposal require the CFPA to create its own products? In the area of mortgages, for example, are the kinds of ``plain-vanilla'' mortgages that the plan would encourage similar to products that community banks currently offer, or do community banks tend to offer more exotic mortgages that might attract the additional scrutiny contemplated by the proposal? What about nonmortgage products such as credit cards, auto loans, and the like?A.6. The Administration's proposal would not require the CFPA to design products. The proposal would permit the CFPA only to identify a standard product that is commonly provided in the marketplace already, and that is proven, simple, and poses less risk to consumers. In the mortgage context, such standard products would likely include both 30-year, fixed rate mortgages and adjustable rate mortgage (ARM) products. Most community banks that offer residential mortgages, offer 30-year fixed rate and conventional ARM mortgage products. These loans would generally meet the definition of standard products. Some community banks certainly offered more exotic mortgages such as payment option ARMs or subprime loans with nontraditional features, but those institutions likely offered conventional loans too. The mortgage market has known standard products for years. The Agency would have the authority to determine if the concept would also apply in other contexts, such as credit cards and auto loans. Recently at least one major card issuer has offered a ``plain-vanilla'' credit card and it is possible that this practice would spread.Q.7. Had lenders been required to offer ``plain-vanilla'' mortgage products such as fixed-rate mortgages or traditional ARMs during the significant growth in subprime lending starting in 2003, what impact do you think it might have had on the crisis?A.7. Subprime mortgages grew extremely rapidly, reaching $600 billion in originations and 20 percent of the market by 2005. It is clear today that the rapid development of this segment of the market was disastrous; a Federal Reserve economist has projected that approximately 45 percent of subprime loans originated in 2006 and 2007 will end in foreclosure. A substantial proportion of subprime borrowers qualified for much safer conventional, standard mortgages, which had lower interest rates, stable payments, escrows for taxes and insurance, no barriers to exit such as prepayment penalties, and substantially lower default rates. The financial incentives for originators, however, were to steer borrowers into subprime loans even if borrowers qualified for conventional loans. A requirement to provide the consumer a comparison between these more complex products and simpler products might have made a difference. The banking agencies ultimately required lenders to disclose these comparisons, but the agencies took so long to agree on the disclosures that they made little difference.Q.8. Chairman Bernanke appeared before the Committee on July 23 to discuss monetary policy. At that hearing, he was asked about the requirement that consumers be offered ``plain-vanilla'' choices. Bernanke said ``there is some economic analysis which suggests that there might be benefits in some cases of having a basic product available, so-called `vanilla product'.'' He goes on to say, however, that the regulators would have to take care not to ``roll back all of the innovation in financial markets that has taken place over the past three decades or so.'' Do you have any observations to make regarding these comments by Chairman Bernanke?A.8. Chairman Bernanke's comments are well taken. Our specific proposal on ``plain vanilla'' is lighter touch regulation. A vanilla product would serve to provide a standard of comparison for borrowers, so they can make more informed choices about what loan product would be best for them. It is another tool besides disclosure, but less intrusive than outright banning contract terms that harm consumers (as Congress just did on credit cards). Our proposal would not dictate business plans or decide for consumers what products are right for them. The goal is to make it easier for consumers who want to choose simple products to make that choice, and to make sure consumers who choose more complicated products understand the risks they are taking. Here's an example. When the regulators put out a model disclosure on subprime mortgages in 2008, it required mortgage lenders to compare the payment schedule of a subprime mortgage--with a big jump in interest rates in the third or fourth year--to the payment schedule on a fixed-rate, 30-year mortgage. That's the sort of action this agency would take. Only, it would be able to act much faster--the regulators' disclosure came out after the subprime mortgage market had imploded. I also agree with Chairman Bernanke on innovation. Our proposals are designed to preserve the incentives and opportunities for innovation. Many of the consumer lending practices that led to this crisis gave innovation a bad name and served simply to hide costs in a deceptive manner. We need to create an agency that restores confidence of consumers in innovation. We also need to restore confidence of the financial investors who would fund innovation but have become wary of it. This is why preserving innovation and promoting access are key objectives of the agency. The agency will be required to measure every proposal against these objectives. Innovation has to be sustainable and respond to consumer preferences. That requires transparency and fairness. We are equipping the agency with the authority to ensure transparency and fairness so that sustainable innovations can thrive.Q.9. Mr. Wallison argued at the hearing that the Administration's proposal would require lenders to determine the ability of a potential customer to understand various products, which, he goes on to assert will lead to limitations on what they offer. How do you respond?A.9. The intent of the standard products provision is to provide a standard of comparison for borrowers, so they can make more informed choices about what loan product would be best for them. The Agency will also improve disclosures so that it will be easier for consumers to understand the loan products they are getting. It will remain the consumer's right and responsibility to make the choice.Q.10. Mr. Wallison said during the hearing that the liability faced by lenders for offering more complex products would effectively eliminate those options for consumers. How do you respond?A.10. A standard product would serve to provide a standard of comparison for borrowers, so they can make more informed choices about what loan product would be best for them. It's another tool besides disclosure, but less intrusive than outright banning complex contract terms (as Congress just did on credit cards). Since borrowers would be entirely free to select alternative, more complex products and many would do so, lenders would have substantial incentives to offer them.Q.11. Title X, section 1022(b)(2)(A) of the Administration's proposal describes special rulemaking requirements applicable to the Consumer Financial Products Agency (CFPA). These requirements state that when engaged in a rulemaking, the CFPA must ``consider the potential benefits and costs to consumers and covered persons, including the potential reduction of consumers' access to consumer financial products or services, resulting from such rule.'' Please explain the rationale for requiring the CFPA to conduct additional analysis beyond the typical notice and comment procedures required of agencies engaged in a rulemaking under the Administrative Procedures Act.A.11. The goal of the CFPA is not more regulation, but smarter regulation. There is no question that existing consumer protection statutes and rules were not protective enough of consumers, and we are all paying a price for that failure. Better rules are needed. An essential part of the solution is one agency, with marketwide reach, and consolidated authorities of rule writing, supervision, and enforcement. These rules must be balanced. Supervising and, when necessary, enforcing against banks and nonbanks will provide the new agency with essential information about which problems to address, as well as market realities in banks and credit unions that need to be respected. CFPA will consult with prudential supervisors before writing rules, and the national bank supervisor will be on the CFPA board. The CFPA proposal requires that the Agency weigh costs in addition to benefits, and consider impact on businesses as well as access to credit, in order to ensure that it is a balanced agency that acts in the most effective, prudent way possible. This requirement is consistent with the Agency's mission of not removing all risk from consumer financial products and services, but rather providing consumers with clear and unbiased information that permits them to make their own decisions and weigh their own costs and benefits in a reasoned manner. It is also the practice the Federal Reserve has followed in implementing the consumer financial protection statutes. ------ fcic_final_report_full--88 Residential Mortgage-Backed Securities Financial institutions packaged subprime, Alt-A and other mortgages into securities. As long as the housing market continued to boom, these securities would perform. But when the economy faltered and the mortgages defaulted, lower-rated tranches were left worthless. 1 Originate Lenders extend mortgages, including subprime and Alt-A loans. Pool of RMBS TRANCHES Low risk, low yield 2 Pool Securities firms Mortgages AAA SENIOR TRANCHES purchase these loans and pool them. First claim to cash flow from principal & interest payments… 3 Tranche Residential mortgage-backed securities are sold to investors, giving them the right to the principal and interest from the mortgages. These securities are sold in tranches, or slices. The flow of cash determines the rating of the securities, with AAA tranches getting the first cut of principal and interest payments, then AA, then A, and so on. next claim… next… etc. A AA MEZZANINE TRANCHES These tranches were often purchased by CDOs. See page 128 for an explanation. BBB BB EQUITY TRANCHES High risk, high yield Collateralized Debt Obligation Figure . CHRG-110hhrg46591--65 Mrs. Maloney," Thank you. What I am hearing from my constituents is they are not getting access to credit still, even though it was reported Monday that the credit markets are easing. And these are established businesses, small and large, that are paying their loans on time, yet some banks are pulling their loans. This could be a downward spiral forcing them into bankruptcy, hurting our economy. So I would like to ask Ms. Rivlin, would one approach to help the stability in the credit markets be that at the very least, we could guarantee the loaning between the banks and have a blanket guarantee of new short-term loans to one another by the central banks? Would that be helpful in this regard? We have seen, so far, a piecemeal approach, as has been mentioned by the panelists, and not only in America, but in Europe and Asia as well. This obviously requires a high degree of international cooperation. I welcome your remarks and other panelists on this idea. Would that ease the credit? Would that help us get the credit out to the substantial businesses that are employing paying taxes part of our economy? Ms. Rivlin. I am sorry, a guarantee of interbank lending? Well, that has been discussed. I think we may not need that. It does look as though interbank lending is coming back. And the international cooperation doing the same thing in different financial markets has been actually I think quite impressive that the central banks and treasuries have been working together. So I am not sure that we actually need at this point a guarantee of interbank lending. The interbank lending rates are coming down and the capital injection, it seems to me, is probably going to be enough to do that. " CHRG-110shrg50369--118 Chairman Dodd," Thank you very much. Senator Corker. Senator Corker. Mr. Chairman, thank you, and I thank you for your testimony. I listened carefully to what you had to say because I know you choose your words carefully. You need to because everybody in the world is listening to what you have to say. But I did notice that, you know, you mentioned that in every other sector of our economy, we are doing well except in the financial area. And I noticed that you have mentioned not to make--we shouldn't make decisions for the short term, that as it related to the housing issue itself, that you knew of no good additional measures, that you are focused on GSE reform and FHA reform. And I know the Senator from Indiana talked about on our side being aggressive. I would say that what we do ends up being a law that cannot be changed. What you do can be changed at the very next meeting, and so you have a great deal more flexibility to really look at indicators and make changes than we do. Our changes usually stay there for a long time. I was up at the New York Stock Exchange last week and noticed that they are trying to put in place the ability for people to know quickly what the value of their credit instruments are, that there is not the transparency there that we have in the equity markets. And my sense is because there is no transparency today, that even if we did not have the subprime issue, because people are making money packaging things and selling them off to the next person, that even if the subprime market had not tanked the way that it had, we still would have had writedowns because people were making so much money off of fees. Is that a fair assessment? " CHRG-111shrg57321--79 Mr. Raiter," Well, we had some preliminary results in early 2004. I left in April 2005, and I believe the model was delivered in September 2006. And I do not know if it was ever implemented. Senator Levin. All right. Now, some of the subprime loans also used stated income loans in which the lender just accepted a borrower's oral presentation of his income and did not verify it. In your judgments, would that make loans riskier to have unverified income in these loan applications? " CHRG-111hhrg48674--69 Mrs. Biggert," Thank you, Mr. Chairman. Mr. Chairman, my constituents have the same problem and are questioning, when are we going to return to normalcy so consumers and small businesses and everybody would be able to get loans? But can you describe in more detail why banks are parking their excess reserves at the Fed instead of using those excess reserves to facilitate interbank lending as well as private and consumer and small business lending? " FOMC20070918meeting--324 322,MR. KOHN.," Thank you, Mr. Chairman. I think this is aimed at addressing a serious problem that I’m afraid we’re losing sight of a bit. The piling-up of financing in very short term vehicles is an issue for financial stability. Partly this is, yes, the term rates are elevated, and if this were just a risk premium on certain counterparties, I don’t think that would be a big deal. But I do feel that there has been a malfunctioning in the markets: As is typical in a financial crisis or panic, people have fled toward liquidity and safety in Treasury bills and overnight lending, and the normal arbitrage that happens across markets just isn’t happening. It’s great that the markets seem to be getting better, but if they continue to malfunction or if it gets worse again, I think there’s a serious problem. The problem is that all these banks are being financed in the one-day to four-day area, and it leaves them open to huge rollover risk and huge liquidity risk. In turn, because they have this risk, they’re more reluctant to lend. They’re more reluctant to use all that capital that you saw in the chart the other day. So it is having a potential macroeconomic effect, and I completely agree with President Stern. We would do it because there’s a macroeconomic effect and because there is a financial stability effect. But I think there is an issue here that we can’t shrug off. I agree that the facility would attract those banks that need it most. That’s what auctions do, right? That’s why they’re designed that way, and I think that’s fine. For the most part, with one exception, that’s the way it would have the maximum effect of relieving some of these issues. You bring in the folks who need it the most, and it relieves some of their problems. That is a problem regarding the borderline institutions that people have been talking about, and if an institution is in transition from being sound to being not sound, this is an issue. It’s an issue for two reasons. One is that it could facilitate the runoff of uninsured liability holders, and the Congress has told us not to do that, and we shouldn’t do it. That’s a moral hazard problem. The second is that it might allow the banks that aren’t being run well to make that last bet—to do some other things that would put them at greater risk. But I think those would be very, very rare institutions that are in that kind of spot where they’re just placing the final bet before going out of business. So the borderline institution is a bit of a problem, but I’m not sure it’s as big a problem as others have said. I think this would have a chance of success. There are no guarantees. I absolute agree. When arbitrage isn’t working, you have very strong preferred habitats. People want to lend short, and other people want to borrow long, and the Fed would be stepping into that breach in some sense where the markets aren’t working. We would be supplying Treasury bills and, to a certain extent, doing matched sale-purchases or reverse RPs or whatever they call them these days, borrowing from the public at the very short term, and we would be extending the term credit. In a sense, we would be stepping in for the arbitrage that’s not happening, and that would relieve pressures on these markets at least a little. It has a chance of having some second-round effects of helping those banks that want to use their capital do so more than they are already. So no guarantees. I don’t know that it would remove the stigma. As I said, I think the auction process, making it a totally separate discount window, and having the long period over which it has to happen makes it look very, very different from a discount rate loan. On the moral hazard issue, of course, this isn’t doing anything really to relieve people who made subprime loans. It’s not going to change the price of those assets, so it’s not really affecting that in any moral hazard way. It’s not aimed at individual institutions. It’s more like open market operations than it is like the old form of discount window lending. Even when normal functioning is restored to markets, banks will be paying for the liquidity insurance that they wrote. There’s no relief on the credit side. They’ll still have to tie up capital, making good on the liquidity insurance, forgoing more-profitable opportunities. It would reduce, perhaps at least a little around the edges, the extra cost of financing this liquidity insurance that they sold that comes from the disruption of the markets, from the fire sale aspect. I think that, if we thought that the markets weren’t improving and it would have a feedback effect on financial stability, stepping in would be worthwhile. That’s the classic central bank thing to do—to step in and relieve some of the extra panicky pressures on the markets to get them functioning again. So I guess I don’t see an important moral hazard issue or, to the extent that there is a moral hazard issue, I think it would be more than offset by the benefits to the macroeconomy of the functioning of financial markets, should we decide that this were needed if those markets weren’t working. Thank you, Mr. Chairman." fcic_final_report_full--511 In a key memo dated June 27, 2005 (the “Crossroads” memo), Tom Lund, Executive Vice President for Single Family Business, addressed the question of Fannie’s loss of market share and how this share position could be regained. The date of this memo is important. It shows that even in the middle of 2005 there was still a debate going on within Fannie about whether to compete for market share with Countrywide and the other subprime issuers. No such competition had actually begun. Lund starts the discussion in the memo by saying “We are at a strategic crossroad…[his ellipses] We face two stark choices: 1. Stay the Course [or] 2. Meet the Market Where the Market Is”. “Staying the course” meant trying to maintain the mortgage quality standards that Fannie had generally followed up to that point (except as necessary to meet HUD’s AH goals). “Meeting the market” meant competing with Countrywide and others not only by acquiring substantially more NTMs than the AH goals required, but also by acquiring much riskier mortgages than Fannie—which specialized in fixed rate mortgages—had been buying up to that time. These riskier potential acquisitions would have included much larger numbers of Option ARMs (involving negative amortization) and other loans involving multiple (or “layered”) risks with which Fannie had no prior experience. Thus, Lund noted that to compete in this business Fannie lacked “capabilities and infrastructure…knowledge… willingness to compete on price..[and] a value proposition for subprime.” His conclusion was as stark as the choice: “Realistically, we are not in a position to ‘Meet the Market’ today.” “Therefore,” Lund continued, “we recommend that we: Pursue a ‘Stay the Course’ strategy and test whether market changes are cyclical vs secular.” 108 [emphasis supplied] In the balance of the Crossroads memo, Lund notes that subprime and Alt-A loans are driving the “leakage” of “goals rich” products to PMBS issuers. He points out the severity of the loss of market share, but never suggests that this changes his view that Fannie was unequipped to compete with Countrywide and others at that time. According to an internal FCIC staff investigation, dated March 31, 2010, other senior offi cials—Robert Levin (Executive Vice President and Chief Business Offi cer), Kenneth Bacon (Executive Vice President for Housing and Community Development), and Pamela Johnson (Senior Vice President for Single Family Business)—all concurred that Fannie should follow Lund’s recommendation to “stay the course.” There is no indication in any of Fannie’s documents after June 2005 that Lund’s “Stay the Course” recommendation was ever changed or challenged during 2005 or 2006—the period when Fannie and Freddie were supposed to have begun to acquire large numbers of NTMs (beyond what was required to meet the AH goals) in order to compete with Countrywide or (in some telling) Wall Street. Thus, in June 2006, one year after the Lund Crossroads memo, Stephen B. Ashley, then the chairman of the board, told Fannie’s senior executives: “2006 is a 108 Tom Lund, “Single Family Guarantee Business: Facing Strategic Crossroads” June 27, 2005. 507 transition year. To be sure, there are still issues to resolve. The consent order with OFHEO [among other things, the order raised capital requirements temporarily] is demanding. And from a strategy standpoint, it is clear that until we have eliminated operations and control weaknesses, taking on more risk or opening new lines of business will be viewed dimly by our regulators. ” 109 [emphasis supplied] So, again, we have confirmation that Fannie’s top offi cials did not believe that the firm was in any position—in the middle of 2006—to take on the additional risk that would be necessary s to compete with Countrywide and other subprime lenders that were selling PMBS backed by subprime and other NTMs. CHRG-111shrg57322--819 Mr. Broderick," This was entirely consistent with the strategy that--with the direction provided by David Viniar and other senior managers of the firm that we be less long in our mortgage business generally. Senator Coburn. OK. But as a risk manager, what are the inciting events for them to do that? You are sitting there looking at it as a risk manager. What caused them to make that turn? Was it, as testified in the first panel, we started seeing a deceleration and an increase in housing prices, or we started seeing subprimes not performing? What was it that led to that conclusion within your firm? " CHRG-111shrg57322--47 Mr. Sparks," I do not recall at that time. Senator Levin. You sold about $700 million in subprime residential mortgage-backed securities, helping Fremont do that. Within 10 months, those securities were downgraded and today have junk status. You also bought some of the Fremont securities, immediately bought loss protection through a CDS on those securities. In other words, you were betting against those securities at the same time you were selling those crap pools to your client. Do you know how much money you made on those shorts? Do you remember? " CHRG-110hhrg46595--487 Mr. Cleaver," My final question: Someone unfortunately brought up subprime loans in the automobile industry this morning, which was just unfortunate that someone would do that. The economy is not in trouble because we have had foreclosures on Cadillacs or Chevys. But do any of you see anything wrong with--in any agreement also making sure that to get an automobile loan, your credit score doesn't have to be 700 or 750? I mean, we may need--yes, yes, Mr. Lester, I am sure you can respond to this. " CHRG-110shrg50414--26 STATEMENT OF SENATOR SHERROD BROWN Senator Brown. Thank you, Senator Dodd, for calling today's hearing. Thanks to the witnesses for joining us. They have had many long nights lately and this may be a long morning. I make no apologies for that. I doubt they seek any. Like my colleagues, my phones have been ringing off the hook. The sentiment from Ohioans about this proposal is universally negative. I count myself among the Ohioans who are angry. Had the Federal Government acted to contain the epidemic in subprime lending, I do not think we would be sitting here today. The time we spend this morning will be time well spent, not just for our own benefit but for the benefit of the people we represent. I am not sure they will be convinced, but they sure deserve a better explanation than they have received to date. A man from Westerville, Ohio was so concerned he took a day off work and drove to Washington this week--a 7 hour drive--to share his views with me. He quite rightly asked why we are rushing to bail out companies whose leaders got rich by gambling with other people's money? Here is another communication, and I quote, ``The Federal Government must not prolong necessary corrections in the housing market, bail out lenders, or subsidize irresponsible borrowing and lending at the expense of hard-working people who have played by the rules.'' Except that statement did not come from Ohio. It came from the Office of Management and Budget three short months ago. Throughout this sorry chapter in our Nation's financial history, the Administration has shown extraordinary attention to the problems of Wall Street while at times showing hostility to rebuilding Main Streets across the country. The statement I quoted above was from the Administration's veto threat of the housing bill. Congress had the audacity to include $4 billion to rebuild neighborhoods devastated by the foreclosure crisis but the Administration did not want to reward irresponsible borrowing and lending. Now it does. But before we agree, there are many, many unanswered questions that Congress and the American people have a right to ask that the Administration needs to answer. As Chairman Bernanke knows, the bank panic of 1933 started in Detroit and in 2 weeks spread to Cleveland. Two of the city's largest banks were shuttered and never reopened. One had ties to my predecessor in this seat, Republican Marcus Hanna. Rumors flew that the bank's closure was a political decision. If we do not know the rules now, these types of rumors will be reborn. Secretary Paulson, as much as I respect your judgment, you will not be making the hundreds of individual decisions that this effort will require. And as your colleague, Secretary Kempthorne has found, a lack of close supervision and adherence to rules can lead to disastrous results. Many of the people who will be making these decisions as to the purchase of these troubled assets have come from Wall Street, and they may be returning to Wall Street. The notion that they can operate without clear guidelines is not just unfair to taxpayers, I think it is unfair to them. So I hope this morning we go into considerably greater detail. I hope we can give Main Street a good bit more help and attention than we have to date. I think the taxpayers need to be protected. And I think the leadership of these companies have to be held accountable. If any CEO hesitates to participate because of his or her narrow self-interest, his or her compensation, I would say it is time to get a new CEO. It is fine to say that people's 401(k) accounts may be affected. They will be if we do not act. But for most people, their home is their 401(k). We need to help them, as well. Mr. Chairman, gas is expensive. I want that man from Westerville, Ohio to know that his time and his money were well spent. " CHRG-111hhrg53245--228 Mr. Mahoney," I completely agree with that point. I would also just note that in the crisis, what you saw is that institutions that had a lot of exposure to subprime did very badly. Some of those were stand-alone investment banks like Lehman. Some of them were more or less stand-alone commercial banks like Countrywide. Some were combined investment and commercial banks like Citigroup. So I do not think that that is a strong piece of evidence that we need to reestablish Glass-Steagall. " FinancialCrisisReport--419 Mr. Montag in turn reported to Goldman CEO Lloyd Blankfein: “Covered another 1.2 billion in shorts in mortgages–almost flat–now need to reduce risk.” 1706 That same day, March 14, 2007, in response to his request, the Mortgage Department sent Mr. Ruzika a detailed breakdown of its subprime mortgage holdings. 1707 It disclosed that, despite offsetting short and long positions in a number of areas , the SPG Desk still held three sizeable net short positions involving about $2.6 billion in ABX assets, $2.2 billion in single name CDS contracts, and $2 billion in mezzanine CDOs. 1708 Goldman personnel prepared the following chart tracking the SPG Trading Desk’s efforts to cover its BBB and BBB- net short position from February through mid-May 2007. 1709 [SEE CHART NEXT PAGE: Notionals (ABX convention) , prepared by Goldman Sachs, reformatted by the Permanent Subcommittee on Investigations to be readable in black and white print, GS MBS-E- 012890600.] AAA Disaster Insurance. Despite all the attention paid to the Mortgage Department’s subprime mortgage holdings beginning in December 2006, one large short position seemed to have escaped the directives of senior management in the first quarter of 2007 to cover the Department’s shorts. It consisted of a massive $9 billion net short position made up of CDS contracts referencing an ABX index that tracked a basket of 20 AAA rated subprime RMBS securities. 1710 Goldman representatives could not recall when that short position was acquired, who acquired it, or whether proprietary funds were used, 1711 but the CDS contracts appear to have been held at a relatively constant level of $9 billion from some time in 2006 until July 2007. 1712 Mr. Sparks told the Subcommittee that the net short position served as a form of low cost “disaster insurance” that would pay off only in a “worst case” scenario – when even the top tier AAA rated RMBS securities, among the safest of all subprime mortgage investments, lost value. 1713 1705 1706 3/17/2007 email from Daniel Sparks and Tom Montag, “Cactus Delivers,” GS MBS-E-009632839. Id. Mr. Montag ’s comment suggests that he may have wanted the Mortgage Department to reduce the size of both its longs and shorts to reduce its overall risk, or to reduce its basis risk, the risk that arises when two different types of assets are used to offset one another, and the assets are imperfectly matched. 1707 1708 1709 3/14/2007 email from David Lehman, “ABS Trading - Subprime risk,” GS MBS-E-010397102. Id. See “Notionals (ABX convention), ” chart attached to 5/23/2007 email from Kevin Kao to Joshua Birnbaum, “RM BS Subprime risk history as of 18May07, ” GS MBS-E-012890599. 1710 See, e.g., 3/8/2007 email from Mr. Sparks, “Mortgage Risk,” GS MBS-E-002206279, Hearing Exhibit 4/27-75 (noting Mortgage Department ’s $9 billion short position on the AAA ABX index). 1711 Subcommittee interview of Daniel Sparks (4/15/2010), David Lehman (4/12/2010), Joshua Birnbaum (4/22/2010), and Michael Swenson (4/16/2010). 1712 See chart entitled “Goldman Sachs Mortgage Department Total Net Short Position, February-December 2007 in $ Billions,” prepared by the Subcommittee, April 2010, updated January 2011, derived from Goldman Mortgage Strategies and Mortgage Department Top Sheets. 1713 Subcommittee interview of Daniel Sparks (10/3/2010). 10,000,000,000 8,000,000,000 6,000,000,000 105 100 95 90 4,000,000,000 85 2,000,000,000 80 0 19-Jan18-Feb20-Mar19-Apr19-May18-Jun18-Jul17-Aug16-Sep16-Oct15-Nov15-Dec14-Jan13-Feb15-Mar14-Apr14-May13-Jun 75 CHRG-110hhrg38392--104 Mr. Sires," I know the lending rate seems to have stabilized. Do you see any changes downward for the future? " CHRG-110hhrg46593--153 Mr. Bernanke," Only that our programs are mostly short-term lending and well collateralized. " FOMC20070321meeting--3 1,MR. DUDLEY.,"1 Thank you, Mr. Chairman. Financial markets have become much more turbulent since the last meeting—especially in subprime mortgages and associated securities, in U.S. and global equities, and in foreign exchange markets. The good news is that markets have generally remained liquid and well functioning, with a minor exception on the New York Stock Exchange on February 27. Moreover, there are few signs of significant contagion from the subprime mortgage market into the rest of the mortgage market or from subprime mortgage credit spreads to corporate credit spreads more generally. In general, the debt markets have been mostly unruffled by recent developments. I plan to focus my attention on four major market developments. First, the substantial turmoil in the subprime mortgage market—I talked about the risk that this market might unravel at the January FOMC meeting; that certainly occurred more quickly and more forcefully than I anticipated. Second, I want to talk a little about the decline in U.S. equity prices and the accompanying rise in actual and implied price volatility. Third is the sharp correction in the so-called “carry trade” in foreign exchange markets. The low interest rate currencies such as the yen and the Swiss franc have appreciated, with the greatest moves coming against their higher-yielding counterparts. Finally, I’ll talk a bit about the sharp downward shift in market expectations about the path of the federal funds rate target over the next year and a half. Two key questions motivate my comments. First, is the market turbulence driven mainly by fundamental developments, or does it reflect mainly a shift in the risk appetite of investors? Second, what is the ongoing risk of contagion from the market area that has experienced the most stress—the subprime mortgage market—to other markets? Regarding the subprime mortgage market, the deterioration appears driven mostly by fundamental developments. As you know, the delinquency rates for subprime adjustable-rate mortgages have risen sharply. In contrast, as shown in exhibit 1 of the handout, there has been little change in delinquency rates for fixed-rate mortgages. Most significantly, delinquency rates for the 2006 vintage of subprime adjustable-rate mortgages have climbed unusually quickly. As shown in exhibit 2, the last vintage that went this bad so fast was the 2001 vintage, and that had a much different economic environment—one characterized by a mild recession and a rising unemployment rate. The deterioration in the quality of subprime mortgage credit has led to a sharp widening in credit spreads for the ABX indexes. The ABX indexes 1 Material used by Mr. Dudley is appended to this transcript (appendix 1). represent the cost of default protection on a basket of collateralized debt obligations that are backstopped mainly by subprime mortgages. As shown in exhibit 3, although this widening has been most pronounced at the bottom end of the credit quality spectrum (BBB-minus and BBB), it has rippled upward to the higher-rated tranches that are better protected. Exhibit 4 shows how the credit deterioration initially registered in the ABX indexes as market participants sought to buy protection. In milder form, this deterioration also registered in the underlying collateralized debt obligations and asset-backed securities. The widening of the credit spread in the ABX indexes was probably exaggerated by the fact that there was an asymmetry between the many that were seeking loss protection and the few that were willing to write protection. This can be seen in two ways. First, as shown in exhibit 4, the spread widening was more pronounced in the ABX index than in either underlying collateralized debt obligations or asset-backed securities. Second, as shown in exhibit 3, the ABX spreads have come down a bit from their peaks even as the underlying market for subprime mortgages, as reflected in the ongoing viability of many mortgage originators, has continued to deteriorate. The deterioration in the subprime market has undermined the economics of subprime mortgage origination and securitization. This is especially true for those mortgage originators with poorer underwriting track records. Their loans can no longer be sold at a sufficient premium to par value to cover their origination costs. In addition, the costs that they must incur to replace loans that have defaulted early have increased sharply. In several cases, these difficulties have caused banks to pull their warehouse lines of credit. Several of the large monoline originators are bankrupt, distressed, or up for sale—they are highlighted in red in exhibit 5. Moreover, several of the diversified lenders, such as HSBC, have indicated that they are tightening credit standards and pulling back from this sector. The result is that the volume of subprime mortgage originations is likely to fall sharply this year—perhaps dropping one-third or more from the 2006 rate of slightly more than $600 billion. This tightening of credit availability to subprime borrowers is likely to manifest itself through a number of channels. These channels include (1) a drop in housing demand, as borrowers who would have been able to get credit in 2006 no longer qualify under now toughened underwriting standards; (2) an increase in housing supply, as the rate of housing foreclosures increases (notably, the Mortgage Bankers Association reported last week that the rate of loans entering the foreclosure process in the fourth quarter of 2006 reached a record level of 0.54 percent, the highest level in the history of the thirty-seven-year-old survey); and (3) additional downward pressure on home prices, which in turn threatens to increase the magnitude of credit problems, delinquencies, and foreclosures. In considering these channels, it is important to emphasize that the credit strains in the subprime sector are unlikely to have peaked yet. The reset risk on the adjustable-rate portion of the subprime loans originated in 2005 and 2006 will be felt mainly over the remainder of 2007 and 2008. Most of the adjustable-rate loans are fixed for two years at low “teaser” rates. When yields adjust upward once the teaser rate period is over, some borrowers may have insufficient resources to service these debts. The good news—at least to date—is that spillover into the alt-A mortgage and conforming mortgage areas is very mild, both in terms of credit spreads and in terms of loan performance. Although there has been some rise in delinquency and foreclosure rates for higher-quality residential mortgages, these rates are still low both qualitatively and historically. Moreover, there is little evidence that the subprime problems have hurt mortgage loan volumes. For example, the Mortgage Bankers Association index of mortgage applications for purchase has increased in the past three weeks. Turning next to the U.S. equity market, it is less clear-cut whether the decline in prices and the rise in volatility are fundamentally based. As several observers have noted, equity valuations do not appear to be excessive. If that is the case, then why have equities been more turbulent than corporate and emerging-market debt, for which spreads remain unusually narrow? Although this point is legitimate, two fundamental developments that make U.S. equity prices less attractive deserve mention. First, equity analysts have been reducing their earnings forecasts for 2007. Although the top-down view of the equity strategists for the S&P 500 index has not changed much, on a bottom-up basis, earnings expectations have dropped sharply. As shown in exhibit 6, the aggregate forecasts of the individual sector analysts now indicate a growth rate in S&P 500 earnings for 2007 of about 6 percent, down from about 9 percent at the beginning of the year. In contrast, S&P 500 earnings have grown at an annual rate of more than 10 percent for four consecutive years. It should be no surprise that falling earnings expectations could weigh on equity prices. Second, uncertainty about the growth outlook has increased. This shows up clearly, for example, in our most recent primary dealer survey. Because greater uncertainty about the growth outlook presumably implies greater risk, the rise in uncertainty should—all else being equal—result in lower share prices. In contrast, it is easier to explain the modest widening of corporate credit spreads. In theory, lower share prices and higher volatility imply a greater risk of default, which should imply wider credit spreads. Corporate credit spreads have behaved in a manner consistent with this. Josh Rosenberg from the research group at the Federal Reserve Bank of New York recently investigated this issue. He found that the spread widening in the high- yield corporate debt sector was consistent with past periods in which the implied volatility for equities rose sharply. Exhibit 7 summarizes one key result. The widening in the BB-rated corporate spreads in the week after the February 27 retrenchment was of a magnitude similar to that of other instances in which implied equity-price volatility as measured by the VIX index rose sharply. In the most recent episode, the VIX index rose 848 basis points, and the BB corporate spread rose 27 basis points. This rise compares with an average rise of 21 basis points in the BB spread in the ten cases in which the VIX rose most sharply. The rise in the most recent episode is well within the range of historical experience. In many other areas in which asset prices have moved sharply, risk-reduction efforts appear to have played the biggest role. For example, in the foreign exchange markets, the biggest currency moves were in the currency pairs associated with so- called carry trades, such as the yen and Swiss franc for the low-yielding currencies and the Australian and New Zealand dollar for the high yielders. Exhibit 8 indicates the change in the yen versus the Australian dollar, the New Zealand dollar, the euro, the British pound, and the U.S. dollar during three separate periods—the week before the February 27 stock market selloff, the week of the stock market selloff, and the past two weeks. The high-yielding currencies appreciated the most during the run-up to the February 27 selloff, fell the most during the February 27 week, and have recovered the most against the yen over the past two weeks. The changes in speculative positioning in foreign exchange future markets tell a similar story. Exhibit 9 shows the change in the share of the open interest position held by participants in the noncommercial futures market. Over the past few weeks, net short positions as a percentage of the overall open interest in the yen have dropped, and long positions in the British pound and Australian dollar have dropped. An examination of how Treasury yields, stock prices, exchange rates, and credit spreads have moved also indicates that risk-reduction efforts have been important. Exhibit 10 shows the correlation of daily price and yield movements in 2007 before February 27. As one can see, the correlations were quite low. In contrast, the correlation matrix in exhibit 11 shows the correlation of daily price moves for the period beginning on February 27. Most of the correlations have climbed sharply, suggesting that risk positioning is driving price and yield movements. Finally, short-term interest rate expectations have shifted substantially since the last FOMC meeting. As shown in exhibit 12, near-term expectations have shifted, with market participants now expecting a modest reduction in the federal funds rate target by late summer. However, the federal funds rate futures curve is still above the curve at the time of the December FOMC meeting. In contrast, longer-term expectations have shifted more sharply, with a larger move toward easing. As shown in exhibit 13, the June 2008/June 2007 Eurodollar calendar spread is now inverted by about 60 basis points. This calendar spread is more inverted than it was at the time of the December 2006 FOMC meeting. Compared with the shift in market expectations, the forecasts of primary dealers have not changed much. Exhibits 14 and 15 compare dealer expectations with market expectations before the January FOMC meeting and before this meeting. The horizontal bold lines represent market expectations. The blue circles represent the different dealer forecasts. The green circles represent the average dealer forecast for each period. The two exhibits illustrate several noteworthy points. First, the average dealer forecast has not changed much since the January FOMC meeting—the green circles in the two charts are in virtually the same position. Second, the amount of dispersion among the dealers’ forecasts has not changed much—in fact, the range of the blue circles is slightly narrower currently. Although many dealers now mention that their uncertainty about the growth outlook has increased, that does not appear to have been reflected in their modal forecasts. Third, there is now a substantial gap between the dealers’ average forecast and market expectations—the gap between the horizontal bold lines, which represent market expectations, and the green circles, which represent the average dealer’s view, has increased. Why is there a large gap between the dealers’ forecasts and market expectations? I think there are three major explanations. First, the dealers’ forecasts are modal forecasts and do not reflect the downside risks that many dealers now believe have emerged in the growth outlook. Second, dealer forecasts often lag behind economic and market developments. Only when “downside risks” grow big enough to pass some threshold are dealers likely to alter their modal forecasts. Third, some of the downward shift in market expectations may represent risk-reduction efforts. An investor with speculative risk positions that would be vulnerable to economic weakness might hedge these risks by buying Eurodollar futures contracts. This hedging could push the implied yields on Eurodollar futures contracts lower than what would be consistent with an unbiased forecast of the likely path of the federal funds rate. Nevertheless, the potential gap between market expectations and the Committee’s interest rate expectations may pose a bit of a conundrum for the Committee. If the Committee were to shift the bias of its statement in the direction of neutral, market expectations with respect to easing would undoubtedly be pulled forward and might become more pronounced. After all, most dealers expect that the Committee will not change the inflation bias of the January FOMC statement. In contrast, keeping the bias unchanged in order to keep market expectations from shifting further in the easing direction might be inconsistent with the Committee’s assessment of the relative risks regarding growth and inflation. If the Committee were to keep the bias unchanged even when its views had changed, the communication process might be impaired. On a housekeeping note, I wish to bring to the Committee’s attention the changes to the “Morning Call” with the Trading Desk. They were discussed in a memo distributed to the Committee last week. Under the new format, which we plan to implement on Thursday, the call will be open to all members of the Committee, and you will have the option of participating in the 9:10 a.m. discussion of reserve management issues, the 9:20 a.m. portion covering recent developments in global markets, or both portions. The March 15 memo outlines the new procedures for joining these calls. Finally, there were no foreign operations during this period. I request a vote to ratify the operations conducted by the System Open Market Account since the January FOMC meeting. Of course, I am very happy to take questions." CHRG-111shrg51303--16 Mr. Dinallo," Thank you, Chairman Dodd, Ranking Member Shelby, and other Senators. I think that to some extent, AIG is a microcosm of our regulatory regime, love it or hate it, and I want to try to explain what I think were the roles of at least the State insurance regulators here and try to clear up any confusion about responsibility that I know existed a couple of days ago, although it sounds like a lot of that has been clarified. I think the State regulators did a very good job on what their main assignment is, which is solvency and policy holder protection. I think that the operating companies of AIG, particularly the property companies, are in excellent condition. The life insurance companies are experiencing a lot of the same stresses that other life insurance companies are experiencing across the country and the world. I think that it is important to put some of these numbers in context, because I disagree with the concept that the securities lending program had much of anything to do with the problems at AIG. We calculate that without the Federal intervention, the life insurance companies are approximately $10 billion solvent, so they were solvent prior to the intervention. The amount that was written, on Senator Shelby's numbers, the amount that was written and put into the securities lending pool wasn't a leveraging, it was a direct undertaking, would be, say, I think $40 billion was invested in RMBS. That would be against $400 billion of assets in the life insurance company. So there was 10 percent invested in AAA-rated RMBS. The loss, as you say, we will adopt the number of $17 billion. So that is less than 5 percent of the losses of the assets at the life insurance companies could be laid at the door of securities lending investing in RMBS, which I submit $17 billion is a big number, but as a percentage basis, I think it is not an overwhelming number. I would say that the securities lending business was used to expose itself to RMBS businesses. But if you look at the entirety of the assets as invested by life insurance companies, it was a modest percentage. I think the Financial Products division had a huge causation on this. I think that Chairman Bernanke was correct a couple days ago when he described that causation. And the amounts of money are staggering. The securities lending business, as I said, you would put somewhere in the $75 billion range. The Financial Products division had notional exposure through CDSs and derivatives of $2.7 trillion. That is larger than the gross national debt of Germany, Great Britain, or Italy. I do agree with both of your statements that what they essentially did was they wrote a form of insurance without anywhere near the capitalization that you would have for such an activity if you were in a regulated insurance company. They are the ones that created the systemic risk, and that systemic risk rolled through the operating companies, including causing the run that you described, Senator, on the securities lending business. The securities lending business, which is something that I am happy to discuss with you, although New York only had about 8 percent exposure to it, is not the purpose or the reason for the Federal bailout. If there had been no Financial Products division involvement, I don't think there would have been any bailout of AIG's operating companies, certainly not the securities lending business. I think it was caused by, A, the run on the bank, and also, of course, the Federal Government had to detangle it in order to sell the operating companies. So they essentially removed the remaining securities from the operating companies in the securities lending business in order to sell the assets. Those assets are the ones that are going to go to pay off the loan. So it is the solvency in the operating companies that are going to go to pay off the Federal loan that is necessary because of what Chairman Bernanke described as essentially a bolted-on hedge fund of Financial Products division. When we came into the department, we did begin to take seriously some of the issues around securities lending, and I can detail that during question and answer. But we began to work it down starting in the beginning of 2007 by 25 percent. We got the holding company to guarantee $5 billion of the losses. And in July, we sent a circular letter to all of our companies saying this is something that you need to start to examine. It does have exposure to the mortgage underwritings and securitization. And indeed, I will just tell you that we have subsequently sent out 25 letters to our regulated entities to look into securities lending businesses. Frankly, they have actually performed pretty well across the board. AIG is the lone securities lending business that has had this kind of problem of the 25 that we looked at, and I would hypothesize that it is because of the run on it and the run on it came directly because of the need for massive collateral and the run on Financial Products division. I think that there are some lessons that we can discuss. I certainly think that one of them is a revisitation of Gramm-Leach-Bliley. We did not completely abrogate Glass-Steagall, thank God, or you would have the operating dollars of policy holders being used for the hedge fund activities. But we have, I think, seen for the first time that the creation of financial supermarkets can have a, what I would almost call a knock-on effect on the operating companies to which they are related. The portions of the company that involves itself in leverage, which securities lending did not do any leverage, has the potential to commit itself so heavily that when there is a financial downturn and there is a need for liquidity which they simply didn't have, the operating companies are looked to as an opportunity for that liquidity, but because they are regulated, fortunately, against that, they can't put up the liquidity and you have a downgrade. You have people asking for collateral which doesn't exist at the holding company level, which the State regulators do not regulate. And you have the systemic effects of basically some of these companies' future being questioned, whereas actually the underlying solvency of them and the quality of them as operating companies, as Chairman Bernanke said 2 days ago, I think are actually--should be unquestioned. Thank you. " fcic_final_report_full--138 B u yers of N on-GSE Mortgage-Ba c ked Se cu rities The GSEs purchased subprime and Alt-A nonagency securities during the 2000s. These purchases peaked in 2004. IN BILLIONS OF DOLLARS S u b pr i m e Secur i t i es Purc h ases A l t - A Secur i t i es Purc h ases $500 400 300 200 100 0 F re ddi e Mac F a nni e Mae O t h er purc h asers ’01 ’02 ’03 ’04 ’05 ’06 ’07 ’08 ’01 ’02 ’03 ’04 ’05 ’06 ’07 ’08 S OURCE S : In s id e M o rtgage Fin a n ce , F a nni e Mae , F re ddi e Mac Figure . several cases, help Fannie meet its subgoals—specific targets requiring the GSEs to purchase or guarantee loans to purchase homes. In , Fannie missed one of these subgoals and would have missed a second without the securities purchases; in , the securities purchases helped Fannie meet those two subgoals. The pattern is the same at Freddie Mac, a larger purchaser of non-agency mort- gage–backed securities.  Estimates by the FCIC show that from  through , Freddie would have met the affordable housing goals without any purchases of Alt-A or subprime securities, but used the securities to help meet subgoals.  Robert Levin, the former chief business officer of Fannie Mae, told the FCIC that buying private-label mortgage–backed securities “was a moneymaking activity—it was all positive economics. . . . [T]here was no trade-off [between making money and hitting goals], it was a very broad-brushed effort” that could be characterized as “win-win-win: money, goals, and share.”  Mark Winer, the head of Fannie’s Busi- ness, Analysis, and Decisions Group, stated that the purchase of triple-A tranches of mortgage-backed securities backed by subprime loans was viewed as an attractive opportunity with good returns. He said that the mortgage-backed securities satisfied housing goals, and that the goals became a factor in the decision to increase pur- chases of private label securities.  FinancialCrisisReport--341 Subcommittee that he “told his views to anyone who would listen” but most CDO investors disagreed with him. 1292 In March 2007, Mr. Lippmann again expressed his view that mortgage related assets were “blowing up”: “I remain firm in my belief that these are blowing up whether people like it or not and that hpa [housing price appreciation] is far less relevant than these bulls think. Can’t blame them because if this blows up lots of people lose their jobs so they must deny in hope that that will help prevent the collapse. At this price I’m nearly just as short as I’ve ever been.” 1293 (b) Building and Cashing in the $5 Billion Short Mr. Lippmann did not just express negative views of RMBS and CDO securities to his colleagues and clients, he also acquired a significant short position on those assets on behalf of Deutsche Bank. Despite the views of virtually all other senior executives at the bank that RMBS and CDO securities would gain in value over time, Mr. Lippmann convinced the bank to allow him to initiate and build a substantial proprietary short position that would pay off only if mortgage related securities lost value. Initiating the Short Position. In 2005, Deutsche Bank was heavily invested in the U.S. mortgage market and, by 2007, had accumulated a long position in mortgage related assets that, according to Deutsche Bank, had a notional or face value of $128 billion and a market value of more than $25 billion. 1294 These positions had been accumulated and were held primarily by the Deutsche Bank mortgage department, the ABS Trading Desk, and a Deutsche Bank affiliated hedge fund, Winchester Capital, which was based in London. 1295 Mr. Lippmann told the Subcommittee that, despite the bank’s positive view of the mortgage market, in the fall of 2005, he requested permission to establish a proprietary trading 1292 Subcommittee interview of Greg Lippmann (10/18/2010). 1293 3/4/2007 email from Greg Lippmann to Harvey Allon at Braddock Financial, DBSI_PSI_EMAIL02041351-53. On June 23, 2007, Mr. Lippmann wrote to a Deutsche Bank colleague, “Yup this is the beginning of phase 2 (the bulls still can’t see it), sales by the longs and how do you think the foreign banks will feel when they see that the true mark for what they have is … this could be the end of the cdo biz.” 6/23/2007 email from Greg Lippmann to Michael George, DBSI_PSI_EMAIL02584591. 1294 According to Deutsche Bank, as of March 31, 2007, it held a total long position in mortgage related securities whose notional or face value totaled $127.8 billion, including $4.3 billion at “ABS Correlation London”; $5 billion at “CDO Primary Issue/New York”; $102 billion at “RMBS/New York”; $7.6 billion at “SPG-Asset Finance/New York”; and $8.9 billion at “Winchester Capital/London.” 3/2/2011 letter from Deutsche Bank’s counsel to the Subcommittee, PSI-DeutscheBank-31-0004-06. The market value of those positions was substantially lower. For example, according to Deutsche Bank, the $102 billion long investment held by its RMBS/New York office had a market value of about $24 billion. 3/21/2011 letter from Deutsche Bank’s counsel to the Subcommittee, PSI- Deutsche_Bank-32-0001-04. 1295 Id. position that would short RMBS securities. 1296 He explained that he made this request after reviewing data he received from a Deutsche Bank quantitative analyst, Eugene Xu. He said that this data showed that, in regions of the United States where housing prices had increased by 13%, the default rates for subprime mortgages had increased to 7%. 1297 At the same time, he said, in other regions where housing prices had increased only 4%, the subprime mortgage default rates had quadrupled to 28%. 1298 Mr. Lippmann explained that he had concluded that even a moderate slow down in rising housing prices would result in significant subprime mortgage defaults, that there was considerable correlation among these subprime mortgages, and that the defaults would affect BBB rated RMBS securities. Mr. Lippmann stressed that his negative view of RMBS securities was based primarily on his view that moderating home prices would cause subprime mortgage defaults and was not dependent upon the quality of the subprime loans. 1299 CHRG-110hhrg46591--358 Mr. Bachus," Absolutely. And they need to base those values on some reasonable expectation. Now, you know, you have mentioned that we continue to have this debate over regulated or nonregulated, what caused the problem. But now I am going to take issue with this idea that most of these institutions weren't regulated. At some level, they were regulated. If you are talking about the investment banks which, you know, if the investment banks hadn't engaged in what they did, I am not sure we would even be here today. And they were regulated by the SEC, by the CSE program. And it was the SEC that in 2004 let them water down their capital ratios that went from 12 to 1 to 40 to 1. And you know AIG, is gone today. I mean not gone, they are the subject of a massive bailout. Now, the reason I bring that up is not to get in a conflict with you, but we still have this idea of licensing and registration of mortgage originators. And you know, you and I, we have been on the opposite sides of that. You all have opposed registration and licensing of mortgage originators. You want to just do it for the mortgage brokers, not for those under the regulated institutions. But, Mr. Bartlett, as you said, or Congressman Bartlett, 40-something percent of the bad actors were working for regulated institutions. We are talking about Golden West, Countrywide, IndyMac, Washington Mutual, a lot of them are at banks. I know you all are continuing to resist my efforts to extend that to all mortgage originators. And I hope you will take a look at this in hindsight--because you all have resisted these efforts for 3 or 4 years in subprime reform--and just say, look, we are there. I am just going to ask you to continue to look at that. Because, look, if you don't, you are going to have 40 percent of the problem, or it could be 60 percent of these folks who go from one institution to another. They make bad loans in one State, they show up in another State, and it is a big loophole. Let me ask you this: When you all endorsed the TARP plan, did you not have the same concerns that I expressed from day one, that why would you want those assets to come into the government, you know, to be managed by the government? Wasn't the expertise with the institutions? Wasn't it far better to use covered bonds or lending or preferred stocks to inject the capital in the institution? " CHRG-111shrg57322--48 Mr. Sparks," Chairman, I do not remember. The one point I would say about this email is it looks like the customer had the chance to evaluate the investment and decided not to invest. Senator Levin. I am just telling you how much you sold of the securities. I just informed you that Goldman--helped Fremont package and sell $700 million in subprime residential mortgage-backed securities. That is what I am telling you when I am asking you that. You also took out a short position. Do you know how much you made? " CHRG-111hhrg56766--264 Mr. Lance," I thank you. A statement, not a question, Mr. Chairman. I think consumer confidence is at the heart of restoring the economy, getting more people working in America since it is such a large percentage of the overall economy, and I am deeply concerned about any bank tax as suggested by the President's proposal because I think it would lead to less lending by banks and what we need in this country is more lending, not less. Thank you. I yield back the balance of my time. " fcic_final_report_full--254 Cayne called Spector into the office and asked him to resign. On Sunday, August , Spector submitted his resignation to the board. RATING AGENCIES: “IT CAN ’T BE . . . ALL OF A SUDDEN ” While BSAM was wrestling with its two ailing flagship hedge funds, the major credit rating agencies finally admitted that subprime mortgage–backed securities would not perform as advertised. On July , , they issued comprehensive rating down- grades and credit watch warnings on an array of residential mortgage–backed securi- ties. These announcements foreshadowed the actual losses to come. S&P announced that it had placed  tranches backed by U.S. subprime collat- eral, or some . billion in securities, on negative watch. S&P promised to review every deal in its ratings database for adverse effects. In the afternoon, Moody’s down- graded  mortgage-backed securities issued in  backed by U.S. subprime col- lateral and put an additional  tranches on watch. These Moody’s downgrades affected about . billion in securities. The following day, Moody’s placed  tranches of CDOs, with original face value of about  billion, on watch for possible downgrade. Two days after its original announcement, S&P downgraded  of the  tranches it had placed on negative watch. Fitch Ratings, the smallest of the three major credit rating agencies, announced similar downgrades.  These actions were meaningful for all who understood their implications. While the specific securities downgraded were only a small fraction of the universe (less than  of mortgage-backed securities issued in ), investors knew that more downgrades might come. Many investors were critical of the rating agencies, lam- basting them for their belated reactions. By July , by one measure, housing prices had already fallen about  nationally from their peak at the spring of .  On a July  conference call with S&P, the hedge fund manager Steve Eisman ques- tioned Tom Warrack, the managing director of S&P’s residential mortgage–backed se- curities group. Eisman asked, “I’d like to know why now. I mean, the news has been out on subprime now for many, many months. The delinquencies have been a disaster now for many, many months. (Your) ratings have been called into question now for many, many months. I’d like to understand why you’re making this move today when you—and why didn’t you do this many, many months ago. . . . I mean, it can’t be that all of a sudden, the performance has reached a level where you’ve woken up.” Warrack responded that S&P “took action as soon as possible given the information at hand.”  The ratings agencies’ downgrades, in tandem with the problems at Bear Stearns’s hedge funds, had a further chilling effect on the markets. The ABX BBB- index fell another  in July, confirming and guaranteeing even more problems for holders of mortgage securities. Enacting the same inexorable dynamic that had taken down the Bear Stearns funds, repo lenders increasingly required other borrowers that had put up mortgage-backed securities as collateral to put up more, because their value was unclear or depressed. Many of these borrowers sold assets to meet these margin calls, and each sale had the potential to further depress prices. If at all possible, the borrow- ers sold other assets in more liquid markets, for which prices were readily available, pushing prices downward in those markets, too. FinancialCrisisReport--66 WaMu’s internal documents indicate that the primary motivation behind its High Risk Lending Strategy was the superior “gain on sale” profits generated by high risk loans. 167 Washington Mutual management had calculated that higher risk loans were more profitable when sold or securitized. Prior to sale, higher risk loans also produced greater short term profits, because the bank typically charged the borrowers a higher rate of interest and higher fees. Higher risk home loans placed for sale were more profitable for WaMu, because of the higher price that Wall Street underwriters and investors were willing to pay for them. The profit that WaMu obtained by selling or securitizing a loan was known as the “gain on sale.” Gain on sale figures for the loans produced by the bank were analyzed and presented to the WaMu Board of Directors. On April 18, 2006, David Schneider, the President of WaMu Home Loans division, provided the Board of Directors a confidential presentation entitled, “Home Loans Discussion.” 168 The third slide in the presentation was entitled, “Home Loans Strategic Positioning,” and stated: “Home Loans is accelerating significant business model changes to achieve consistent, long term financial objectives.” 169 Beneath this heading the first listed objective was: “Shift from low-margin business to high-margin products,” 170 meaning from less profitable to more profitable loan products. The next slide in the presentation was entitled: “Shift to Higher Margin Products,” and elaborated on that objective. The slide listed the actual gain on sale obtained by the bank, in 2005, for each type of loan WaMu offered, providing the “basis points” (bps) that each type of loan fetched on Wall Street: 2005 WaMu Gain on Sale Margin by Product in bps 171 Government 13 Fixed 19 Hybrid/ARM 25 Alt A 40 Option ARM 109 Home Equity 113 Subprime 150 167 1/18/2005 Washington Mutual Inc. Washington Mutual Bank FA Finance Committee Minutes at JPM_WM06293964; see also 1/2005 “Higher Risk Lending Strategy Presentation,” submitted to Washington Mutual Board of Directors, at JPM_WM00302977, Hearing Exhibit 4/13-2a 168 4/18/2006 “Home Loans Discussion Board of Directors Meeting,” WaMu presentation, JPM_WM00690890-901, Hearing Exhibit 4/13-3. 169 Id. at 893 [emphasis in original removed]. 170 Id. 171 Id. at 894 [formatting as in the original]. FinancialCrisisReport--123 This email, which is based upon a 2005 Fitch analysis of Long Beach, shows that, from 1997 to March 2005, due to loan delinquencies and losses, Long Beach securities were among the very worst performing in the entire subprime industry. 442 Long Beach’s performance did not improve after 2005. In April 2006, for example, Nomura Securities issued an analysis of the ABX Index that tracked a basket of 20 subprime RMBS securities and identified Long Beach as the worst performer: “Long Beach Mortgage Loan Trust appears to be the poorest performing issuer, with its three deals averaging 15.67% in 60+ day delinquency and 12.75% in 90+ day delinquency. Unsurprisingly, all three deals issued by LBMLT have exceeded their delinquency trigger limits.” 443 In November 2006, while attending the Asset Backed Securities East Conference for the securitization industry, the head of WaMu’s Capital Markets Division, David Beck, emailed WaMu’s Home Loans President, David Schneider, that with respect to RMBS securities carrying noninvestment grade ratings, “LBMC [Long Beach] paper is among the worst performing paper in the mkt [market] in 2006. Subordinate buyers want answers.” 444 In March 2007, an analysis by JPMorgan Chase again singled out Long Beach securities for having the worst delinquency rates among the subprime securities tracked by the ABX Index: “Washington Mutual Inc.’s subprime bonds are suffering from some of the worst rates of delinquency among securities in benchmark indexes, according to JPMorgan Chase & Co. research. … Delinquencies of 60 days or more on loans supporting WaMu’s Long Beach LBMLT 2006-1 issue jumped … to 19.44 percent … the highest among the 20 441 4/14/2005 email from Steve Blelik to David Henry, “Fitch – LBMC Review,” Hearing Exhibit 4/13-8a. 442 Id. 443 4/19/2006 “ABX Index – The Constituent Breakdown,” prepared by Nomura Securities International Inc., http://www.scribd.com/doc/19606903/Nomura-ABX-Index-The-Constituent-Breakdown. 444 11/7/2006 email from David Beck to David Schneider, Hearing Exhibit 4/13-50. See also 4/19/2006 “ABX Index – The Constituent Breakdown,” prepared by Nomura Securities International Inc., http://www.scribd.com/doc/19606903/Nomura-ABX-Index-The-Constituent-Breakdown. bonds in the widely watched ABX-HE 06-2 index of bonds backed by residential loans to risky borrowers.” 445 CHRG-111hhrg50289--10 Mr. Heacock," Chairwoman Velazquez, Ranking Member Graves, and members of the Committee, thank you so much for the opportunity to testify on behalf of the Credit Union National Association. I am honored to address the impact SBA lending has on our local economy, our credit union, and our members, and to suggest ways to improve SBA programs. Black Hills was first authorized to do SBA lending in January 2003, and we truly value our partnership with the SBA. We wrote more SBA loans than any other financial institution in South Dakota during 2008, 29 loans for a total of $1.6 million. We are looking forward to working with new SBA Administrator Karen Hills and find working with the SBA beneficial to the credit union and our members for several reasons. We have a number of members who started small businesses using SBA loan funds while continuing to work at their primary job as their main source of income. The SBA helped us be there for our members, and this has resulted in additional employment opportunities. There is additional risk to these types of borrowers, and quite frankly, other lenders shy away from helping them because there is not a proven cash flow. We are able to do this type of lending because of the guarantee that SBA provides. The programs allow us to help the borrower who comes in and may not have the equity investment we would generally like to see but has a good business plan. The SBA helps us create an acceptable level of risk, and it is a win-win situation for all of us, the credit union, the SBA, and the borrower. CUNA is a strong supporter of the 7(a) and 504 loan programs, essential tools for achieving our mission to serve the needs of members. However, several important factors discourage more credit unions from participating as SBA lenders. First, the statutory cap on credit union MBLs restricts the ability of credit unions from helping their members even more. Even though the cap does not apply to SBA loans, it is a real barrier, keeping some credit unions from establishing an MBL program at all. Not all loans fit SBA parameters, and credit unions are reluctant to initiate an MBL program when they may reach the cap in a fairly short order. CUNA is also aware that some lenders have not had a positive experience with the SBA, citing the application process, fees, and time of decision making. In that vein, we think there are ways to improve the work that is done by the SBA. As the Committee reviews SBA programs, we encourage Congress to make additional funds available to the agency so that fees can remain low and the guarantees can remain sufficient. We appreciate Congress setting aside $375 million for the temporary elimination of fees and raising the guaranty percentage on some loans to 90 percent as part of the Recovery Act. In closing, credit union business lending represents just over one percent of the depository institution business lending market. Credit unions have about $33 billion in outstanding business loans compared to $3.1 trillion for banking institutions. We are not financing skyscrapers or sports arenas. We are making loans to members who own and operate small businesses. Despite the financial crisis, the chief obstacle for credit union business lending is not the availability of capital. Credit unions are, in general, well capitalized. Rather, the chief obstacle is the statutory limits imposed by Congress in 1998. Under current law, credit unions are restricted from member business lending in excess of 12.25 percent of their total assets. This arbitrary cap has no basis in either actual credit union business lending or safety and soundness considerations. And the U.S. Treasury Department found that delinquencies and charge-offs for credit union business loans were much lower than that for either banks or thrifts. The cap effectively limits entry into the business lending arena on the part of small and medium size credit unions, the vast majority of all credit unions, because the costs and requirements, including the need to hire and retain staff with business lending experience exceed resources of many credit unions. While we support strong regulatory oversight of member business lending, there is no safety and soundness rationale for the cap. There is, however, a significant economic reason to eliminate the cap. America's small business needs access to capital. We estimate that if the cap on credit union business lending were removed, credit unions could safely and soundly provide as much as $10 billion for new loans for small businesses within the first year. This is an economic stimulus that would not cost the taxpayers a dime or increase the size of government. Madam Chairwoman, thank you very much for convening this hearing and inviting me to testify. I look forward to answering the Committee's questions. [The prepared statement of Mr. Heacock is included in the appendix.] " CHRG-111shrg57319--27 Mr. Melby," That is correct. Senator Levin. Then on page 2, the first bullet point, ``Management Control Weaknesses'' were identified by you at that first bullet point, which is about two-thirds of the way down. ``Relaxed credit guidelines, breakdowns in manual underwriting processes, inexperienced subprime personnel, coupled with a push to increase loan volume and the lack of an automated fraud monitoring tool exacerbated the deterioration in loan quality.'' Is that correct? " FinancialCrisisReport--479 On March 8, 2007, in an email to senior management, Mr. Sparks listed a number of “large risks I worry about.” 2021 At the top of the list was “CDO and Residential loan securitization stoppage – either via buyer strike or dramatic rating agency change.” Mr. Sparks was referring to the possibility that Goldman would be unable to securitize and sell its remaining subprime mortgage related inventory by repackaging it into RMBS and CDOs for sale to customers. His concern was either that buyers would refuse to purchase such products (“buyer strike”), or that the ratings agencies might realize the poor quality and high risks associated with these products and downgrade them so they could not be sold with AAA ratings (“dramatic rating agency change”). In essence, Mr. Sparks was worried about Goldman’s being left with a large inventory of unsold and unsaleable subprime mortgage related assets when the market finally collapsed. 2022 At the same time Goldman personnel were expressing these negative views of the securitization business, the Mortgage Department was building its large net short positions in the first and third quarters of the year. (iii) Goldman ’s Securitization Sell Off In response to the December 14, 2006 meeting at which CFO David Viniar ordered the Mortgage Department to offset the risk associated with its mortgage related holdings, the Department initiated an intensive effort to sell off the subprime RMBS and CDO securities and other assets in its inventory and warehouse accounts. 2023 AA. RMBS Sell Off As described earlier, on the same day as the Viniar meeting, December 14, 2006, Kevin Gasvoda, head of the Mortgage Department’s Residential Whole Loan Trading Desk, instructed his staff to undertake an immediate, concerted effort to sell the whole loans and RMBS securities in Goldman’s inventory and warehouse accounts, focusing on RMBS securities from Goldman- originated securitizations. 2024 By February 9, 2007, the Goldman sales force reported a substantial growth and the market are DEAD if that ’s the case. ”) [emphasis in original]. 2021 2022 3/8/2007 email from Daniel Sparks, “Mortgage risk,” Hearing Exhibit 4/27-75. See also emails expressing concerns about the CDO market in particular. 6/27/2007 email from Jonathan Sobel, “Citi feedback on debt mkts,” GS MBS-E-010807091 (reporting a conversation with the head of the mortgage desk at Citibank: “He is very nervous. ... Some Citi people think the CDO market is dead - a potential result of [subprime] contagion. ”); 8/30/2007 email from Daniel Sparks, “RAIT, ” GS MBS-E-010626401 ( “the business model pursued by these guys (taking junior parts of the . . . capital structure and obtaining further leverage via the CDO market) is dead for the foreseeable future. ”). 2023 2024 See also Section C(4)(b) of this chapter, above. 12/14/2007 email from Kevin Gasvoda, “Retained bonds, ” GS MBS-E-010935323, Hearing Exhibit 4/27-72. See also 2/8/2007 email from Kevin Gasvoda to Tom Montag, “Mortgage risk – credit residential,” at 2, GS MBS-E- 010372233, Hearing Exhibit 4/27-74 (seven weeks later, Mr. Gasvoda reported transferring the remaining Goldman- originated RM BS securities to the mortgage trading desk to sell: “moving retained bonds out of primary desk hands and into 2ndry desk. ”). number of sales, 2025 and by the end of February, Goldman’s controllers reported that Goldman’s inventory of whole loans had “decreased from $11bn to $7bn” with “subprime loans decreased from $6.3bn to $1.5bn,” a reduction of more than two-thirds. 2026 CHRG-111shrg57319--491 Mr. Killinger," Even in the middle part of 2007, Secretary Paulson was saying, I think this housing thing is contained and it is not really going to impact the overall economy and lead us into a recession. Chairman Bernanke was saying something similar about the containment of the subprime issues. So it really wasn't until that second half of 2007 when it became pretty obvious to us that things were going to be pretty difficult and we needed to pull in our horns even more. Senator Kaufman. But all these registered security deals, you had to sign them as a CEO, right? " CHRG-111hhrg58044--176 Mr. Snyder," Thank you. Lending scores and insurance scores are very different. We have included some materials in our statement from FICO, which is one of the major modelers, indicating they have not seen an overall pattern of insurance scores declining. It is because of the different make-up of the scores. You have heard no doubt and read newspaper articles about lending scores. That has not been the case with insurance scores. They continue to be very stable over time, and they continue to reflect differences in risk. Insurers also have the ability to adjust their rating tier so that if you have an overall decline in the economy, you can understand that across-the-board, so you have not had the impact on insurance scores that has occurred with regard to lending scores that you might otherwise assume would be occurring. Mrs. McCarthy of New York. Just a follow-up question, so many homes have actually de-valued in their worth, and yet they are continuing with basically--I just thought of this when you were speaking. My homeowner's insurance basically has gone up even though my home value has gone down. Are you seeing a trend like that across the Nation? " CHRG-111shrg62643--122 Chairman Dodd," Senator Bennet. Senator Bennet. Thank you, Mr. Chairman. Thank you for holding this hearing, and to the Ranking Member, thank you, and thank you for being back here, Mr. Chairman. I actually want to pick up right where Senator Tester left off, because the last time we were together, I asked whether or not we might have some metrics where we could start to look at things and be able to distinguish between lending that is not happening because of loan demand, lending that is not happening because of regulators' overreach, lending that is not happening because we are in a different leverage environment, all that stuff, and I was pleased to see that in the addendum you have talked about it a few times. There is a section on research and data, what you are going to start collecting, what you have heard from people that might make it more meaningful, and for the life of me, there are a million things in here that I don't know why we haven't done already, but we haven't. We haven't had the focus on small business lending that we need to have. I don't think the administration has had the focus on it that they need to have. But my question is--and my anecdotal evidence in Colorado continues to be exactly the same as Senator Tester's, which is that small businesses that assert that they can pay on their loans can't get credit, and banks are saying that the reason they can't extend the credit is because the regulators have swung too far over to one side. It is a consistent theme. Every now and then, you hear somebody say, well, there is not really loan demand, or they will say, Michael, look and see if people are actually paying off their letters of credit and they are returning capital to banks. So my question for you is, you talked about the training and the guidance, wanting people to take a balanced approach. In the evidence that you have collected so far that you were just talking about, what is the evidence? What does it tell you about what is happening here? " CHRG-111shrg57319--221 Mr. Schneider," Thank you, Senator. If you look at the gain on sale, there are a number of factors that would have driven what would be the ultimate gain on sale. Fixed tended to have a fairly low gain on sale because it was a highly commoditized product that generally went to Fannie Mae and Freddie Mac. Subprime tended to have a large gain on sale, A, because of the additional credit risk that investors would demand from the product, and B, because it was probably less competitive than---- Senator Levin. Does that mean higher interest rates? " CHRG-111shrg57321--115 Mr. Raiter," Yes. stated income loans were there. They were known as ``liar loans,'' ``NINAs.'' When they started using the stated income loan concept in the late 1990s, it was applied to the highest credit borrowers--doctors, lawyers, self-employed people. As they started developing in the subprime arena, again, you started out with the top of the subprime market with the initial loans that were coming into the bonds. By 2004 and 2005, with the new hybrids and the stated numbers, you were stepping down to much lower FICO scores, much lower credit quality of the borrower, and there was evidence starting to bubble up that brokers were impacting the way stated income was put on the various applications, that there were questions about appraisals, whether they were accurate or not. So when they first started out with the no-income, low-doc kind of loans, we did have modeled in the ratings process higher credit enhancements for those loans, and as we tried to collect data on the new products that were developing and how they performed or were expected to perform, we were factoring that into the models. And, again, I hate to beat a dead horse, but we had a 2.8 million loan set that was used to build the Version 6.0 of the model, and at that time it had the most information we had collected on the hybrid loans. And the next data set that we were trying to collect had almost 10 million loans in it, and it was even more powerful. Senator Kaufman. Right. " CHRG-111hhrg48874--76 Mr. Long," And I can tell you that at the OCC, our examiners are not telling our bankers to not lend to manufacturers. " FOMC20080805meeting--25 23,MR. LACKER.," So if I could just follow up--in these graphs, what would you point to as the effects of our actions or our lending? " FOMC20080916meeting--94 92,MR. FISHER., Could you interpret for us the Bank of China's cut in the bank lending rate? fcic_final_report_full--23 Many people chose poorly. Some people wanted to live beyond their means, and by mid-, nearly one-quarter of all borrowers nationwide were taking out interest- only loans that allowed them to defer the payment of principal.  Some borrowers opted for nontraditional mortgages because that was the only way they could get a foothold in areas such as the sky-high California housing market.  Some speculators saw the chance to snatch up investment properties and flip them for profit—and Florida and Georgia became a particular target for investors who used these loans to acquire real estate.  Some were misled by salespeople who came to their homes and persuaded them to sign loan documents on their kitchen tables. Some borrowers naively trusted mortgage brokers who earned more money placing them in risky loans than in safe ones.  With these loans, buyers were able to bid up the prices of houses even if they didn’t have enough income to qualify for traditional loans. Some of these exotic loans had existed in the past, used by high-income, finan- cially secure people as a cash-management tool. Some had been targeted to borrow- ers with impaired credit, offering them the opportunity to build a stronger payment history before they refinanced. But the instruments began to deluge the larger market in  and . The changed occurred “almost overnight,” Faith Schwartz, then an executive at the subprime lender Option One and later the executive director of Hope Now, a lending-industry foreclosure relief group, told the Federal Reserve’s Con- sumer Advisory Council. “I would suggest most every lender in the country is in it, one way or another.”  At first not a lot of people really understood the potential hazards of these new loans. They were new, they were different, and the consequences were uncertain. But it soon became apparent that what had looked like newfound wealth was a mirage based on borrowed money. Overall mortgage indebtedness in the United States climbed from . trillion in  to . trillion in . The mortgage debt of American households rose almost as much in the six years from  to  as it had over the course of the country’s more than -year history. The amount of mortgage debt per household rose from , in  to , in .  With a simple flourish of a pen on paper, millions of Americans traded away decades of eq- uity tucked away in their homes. Under the radar, the lending and the financial services industry had mutated. In the past, lenders had avoided making unsound loans because they would be stuck with them in their loan portfolios. But because of the growth of securitization, it wasn’t even clear anymore who the lender was. The mortgages would be packaged, sliced, repackaged, insured, and sold as incomprehensibly complicated debt securities to an assortment of hungry investors. Now even the worst loans could find a buyer. More loan sales meant higher profits for everyone in the chain. Business boomed for Christopher Cruise, a Maryland-based corporate educator who trained loan offi- cers for companies that were expanding mortgage originations. He crisscrossed the nation, coaching about , loan originators a year in auditoriums and classrooms. CHRG-111shrg57321--23 Mr. Michalek," No, I did not. I think that we are touching on something that you are likely to hear later in the day, that, in fact, the common perception of what a AAA rating is and means is not necessarily what the definition of a AAA rating is. This is something of a legal distinction, but at the same time, I think it is very important that this is not lost on the Subcommittee. In fact, there is published by Moody's the migration rates and history of the different ratings that are assigned, and those migration rates represent an average migration for a particular rating. But it is simply an average from a population of which there are tails at either end. Some AAAs never get downgraded, and there are others that are downgraded, unfortunately, quite quickly. And I do think that there is an expectation in the market and there is a proper expectation that AAAs are not going to be issued on Monday and on Friday downgraded to anything else. That debate as to whether or not there should be or is a necessary element of stability in the rating, at least at Moody's, was one that was ongoing. Senator Levin. OK, thank you. Let us take a look at another failed rating, this time involving mortgages issued by Fremont. Take a look at Exhibit 93b.\1\ In January 2007, S&P was asked to rate an RMBS with subprime loans issued by Fremont Investment, a subprime lender known for poor-quality loans. At that time an S&P ratings analyst sent an email to a supervisor saying the following: ``I have a Goldman deal with subprime Fremont collateral. Since Fremont collateral has been performing not so good, is there anything special I should be aware of?''--------------------------------------------------------------------------- \1\ See Exhibit No. 93b, which appears in the Appendix on page 589.--------------------------------------------------------------------------- Now, one of the supervisor's response was, ``No, we don't treat their collateral any differently.'' And the other one wrote back, in Exhibit 93c,\1\ that as long as we had current FICO scores for the borrowers, the analyst was ``good to go.''--------------------------------------------------------------------------- \1\ See Exhibit No. 93c, which appears in the Appendix on page 590.--------------------------------------------------------------------------- So we got S&P employees now that know there is a problem with Fremont loans, but treated those loans like any other. In Exhibit 93d,\2\ there is an email in which S&P analysts were circulating an article about--and this is January 29--how Fremont had stopped using 8,000 brokers because of loans with high delinquency--with some of the highest delinquency rates in the industry coming from those brokers.--------------------------------------------------------------------------- \2\ See Exhibit No. 93d, which appears in the Appendix on page 592.--------------------------------------------------------------------------- Now, in March, a couple months later, Fremont announced in an 8-K filing that the court of appeals had found sufficient evidence in a lawsuit filed by the California Insurance Commissioner that the company, among other things, was ``marketing and extending adjustable-rate mortgage products to subprime borrowers in an unsafe and unsound manner that greatly increases the risk that borrowers will default on the loans or otherwise cause losses.'' And the suit then could proceed against the company. Just a few days later, Fremont entered into a publicly available cease-and-desist order with the FDIC regarding fraud and lax underwriting standards. Despite that information, Fremont RMBS securities were rated by both S&P and Moody's in late February and early March. Before the ratings were done, they knew of those facts which I just described. By the end of the year in 2007, both companies began substantially downgrading the Fremont RMBS securities. Does either S&P or Moody's take into account an issuer's reputation for issuing either good loans or bad loans and incorporate that into their credit analyst? Mr. Raiter. " CHRG-111shrg56262--89 PREPARED STATEMENT OF CHAIRMAN JACK REED I want to welcome everyone and thank our witnesses for appearing today. This hearing will examine a key activity within our financial markets--the securitization of mortgages and other assets--and will build on previous hearings this Subcommittee has held to address various aspects of regulatory modernization, including hedge funds, derivatives, corporate governance, SEC enforcement, and risk management at large financial institutions. Securitization is the packaging of individual loans or other debt instruments into marketable securities to be purchased by investors. At its core, this process helps free lenders to make more loans available for families to purchase items like homes and cars and for small businesses to thrive. But we have learned from the financial crisis that securitization, or how it is conducted, can also be extremely harmful to financial markets and families without appropriate diligence and oversight. Arguably, many of the basic requirements needed for effective securitization were not met. Today's panel will discuss how in recent years the securitization process created incentives throughout the chain of participants to emphasize loan volume over loan quality, contributing to the build-up and collapse of the subprime mortgage market and the broader economy. Today we find ourselves in the opposite position from a few years back, with hardly any issuances in key markets that could help return lending to responsible levels. So this afternoon's hearing is about how to strengthen the securitization markets and enact any needed changes to ensure that securitization can be used in ways that expand credit without harming consumers and the capital markets. I have asked today's witnesses to address a number of key issues, including the role securitization played in the financial crisis, the current conditions of these markets, and what changes may be needed to Federal oversight of the securitization process. Unfortunately, a number of the banks who issue these securities could not find anyone in their workforce who was willing to testify today. I welcome you all and look forward to your testimony. ______ fcic_final_report_full--503 Most of what was going on here was under the radar, even for specialists in the housing finance field, but not everyone missed it. In a paper published in 2001, 94 financial analyst Josh Rosner recognized the deterioration in mortgage standards although he did not recognize how many loans were subject to this problem: Over the past decade Fannie Mae and Freddie Mac have reduced required down payments on loans that they purchase in the secondary market. Those requirements have declined from 10% to 5% to 3% and in the past few months Fannie Mae announced that it would follow Freddie Mac’s recent move into the 0% down payment mortgage market. Although they are buying low down payment loans, those loans must be insured with ‘private mortgage insurance’ (PMI). On homes with PMI, even the closing costs can now be borrowed through unsecured loans, gifts or subsidies. This means that not only can the buyer put zero dollars down to purchase a new house but also that the mortgage can finance the closing costs…. [I]t appears a large portion of the housing sector’s growth in the 1990’s came from the easing of the credit underwriting process ….The virtuous cycle of increasing homeownership due to greater leverage has the potential to become a vicious cycle of lower home prices due to an accelerating rate of foreclosures. 95 [emphasis supplied] The last increase in the AH goals occurred in 2004, when HUD raised the LMI goal to 52 percent for 2005, 53 percent for 2006, 55 percent for 2007 and 56 percent for 2008. Again, the percentage increases in the special affordable category outstripped the general LMI goal, putting added pressure on Fannie and Freddie to acquire additional risky NTMs. This category increased from 20 percent to 27 percent over the period. In the release that accompanied the increases, HUD declared: Millions of Americans with less than perfect credit or who cannot meet some of the tougher underwriting requirements of the prime market for reasons such as inadequate income documentation, limited downpayment or cash reserves, or the desire to take more cash out in a refinancing than conventional loans allow, rely on subprime lenders for access to mortgage financing. If the GSEs reach deeper into the subprime market , more borrowers will benefit from the advantages that greater stability and standardization create. 96 [emphasis supplied] Fannie did indeed reach deeper into the subprime market, confirming in a March 2003 presentation to HUD, “Higher goals force us deeper into FHA and subprime.” 97 According to HUD data, as a result of the AH goals Fannie Mae’s acquisitions of goal-qualifying loans (which were primarily subprime and Alt-A) increased (i) for very low income borrowers from 5.2 percent of their acquisitions in 1993 to 12.2 percent in 2007; (ii) for special affordable borrowers from 6.4 percent in 1993 to 15.2 percent in 2007; and (iii) for less than median income borrowers (which includes the other two categories) from 29.2 percent in 1993 to 41.5 percent in 2007. 98 94 Josh Rosner, “Housing in the New Millennium: A Home Without Equity is Just a Rental With Debt,” June, 2001, p.7, available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1162456. 95 96 97 98 Id., p.29. http://fdsys.gpo.gov/fdsys/pkg/FR-2004-11-02/pdf/04-24101.pdf , p.63601. Fannie Mae, “The HUD Housing Goals”, March 2003. HUD, Offi ce of Policy Development and Research, Profiles of GSE Mortgage Purchases, 1992-2000, 2001-2004, and 2005-2007. 499 FinancialCrisisInquiry--21 We have seen, in our view, four crises unfold: a mortgage crisis, a capital markets crisis, a global credit crisis, and a severe global recession. The mortgage crisis originated with the dramatic expansion in the availability of mortgage credit through subprime lending and aggressive mortgage terms even in prime products. This led to a greater debt burden for consumers. Lenders, prompted by lower interest rates, rapidly rising home prices, and large amounts of capital available, made credit available to borrowers who could not previously qualify for a mortgage or extended more credit to a borrower who could or perhaps should—would not be able to handle. The national policy to expand American homeownership was also popular and created tailwinds. No one involved in the housing system—lenders, rating agencies, investors, insurers, consumers, regulators, and policy makers, foresaw a dramatic and rapid depreciation of home prices. When the nation did experience this rapid depreciation in home prices, the first that had been experienced since the Great Depression, many of these loans became very unfavorable and the option of refinancing disappeared leading to defaults. The second crisis came in investment banks in the capital markets area. Investment banks not only had underwritten mortgages, but they had retained significant amounts of the risk by holding interest and providing backup liquidity for mortgage-related securities they had sold. Investment banks created products based on these mortgage assets. The risk of these assets spread. This happened when a monoline insurer guaranteed the mortgages or a structured investment vehicle brought the mortgage securities and having the money- market funds to purchase that commercial paper from those vehicles. Third, the stress of the financial crisis began to spread beyond the investment banks and mortgages to other fixed income products and to more market participants. This destabilized the financial institutions and non-financial institutions that had little to do with the U.S. or the mortgage market. This contagion was, in fact, global. Without government intervention to restore liquidity to capital markets, the risk of global economic collapse was very real. CHRG-111hhrg48674--121 Mr. Bernanke," For example, the so-called TALF, the assets-backed securities program, was slated for $200 billion to support new lending in credit cards, student loans, auto loans and small business lending. As part of the plan announced this morning by Secretary Geithner, the Treasury and the Federal Reserve would collaborate to bring that amount up to $1 trillion, which would be another $800 billion of credit made available to broad categories of consumers and businesses. " CHRG-111shrg54789--160 Mr. Plunkett," Well, Senator, I hope that when we heard discussion today about choices, we were not hearing about choices like the large number of minority consumers who were steered into high-cost mortgage loans when they could have afforded and would have qualified for a lower-cost loan. I hope we are not talking about choices like what Congress has just eliminated in the credit card bill, not just double-cycle billing but interest rate increases on existing balances for no apparent reason. I mean, that is called ``negative financial engineering.'' That is not legitimate innovation. And that is the kind of, unfortunately, choice in many credit areas that has driven out positive credit, credit offered by some of the small banks you mentioned or credit unions. Senator Menendez. Well, Mr. Chairman, I hope that we will--you know, I do have concerns about how we structure this in a way that affects community banks that clearly have not been at the forefront of our economic challenges. We need to look at that. I do get concerned about how we harmonize the State regulator process with these efforts. And, third, I do want to see--I think Mr. Yingling does make a very valid comment that we have to apply--if we are going to have this consumer protection agency, which I generally support, it has to be applied across the spectrum of financial service entities; otherwise, we would do a disservice to the consumer, to the Nation, and certainly to the industry as well. So I look forward to working toward those goals. Senator Reed. Thank you, Senator Menendez. Senator Shelby, you have a comment? Senator Shelby. I have got a couple of scenarios here that I think we ought to consider. In case one, a borrower obtains a subprime loan, the only loan he could qualify for, and uses it to buy property and then realizes a 75-percent gain on the property 3 years later. This goes on. In case two, a borrower obtains a subprime loan in another market. This borrower has all the same credit and income characteristics at the time he received the loan as the borrower in the first scenario, but later loses his job, sees the real estate market collapse, and then defaults. I believe we need a system where we can accommodate both. How do we do that? In other words, the first guy--and this goes on--took a subprime loan and he made money out of it. Good for him, good probably for the market. The second one, he had the same qualifications, but things turned sour on him. He lost his job, and then he could not make the payments and so forth. How do we do this? Mr. Wallison, do you have any--how do we balance this, I guess? " CHRG-111shrg51290--56 Chairman Dodd," In fact, I think that--I forget which publication it was, it may have been the Wall Street Journal, and I may be a little bit off on this--somewhere around 60 percent of the subprime loans to borrowers actually would have qualified for conventional mortgages. Ms. Seidman. That is right. Governor Kroszner, former Fed Governor Kroszner, has cited a study by Glenn Canner at the Fed that only 6 percent of the high-cost loans to low-income people were made by CRA-regulated institutions in their assessment areas. " CHRG-111hhrg51591--105 Mr. Webel," You know, we can't insure the future. But in looking--I have specifically in the past looked at the securities lending aspect of AIG, and into the sort of other insurance companies and what their securities lendings look like. And from what I have found, there wasn't anybody else who was approaching it nearly to the level that AIG did. And this was definitely a big way that they failed. So it doesn't look like this explosive failure is coming from that direction. Ms. Guinn. I would agree with Mr. Webel that in terms of participation in the credit default swap market and securities lending, coupled with the scope of AIG's operations, the complexity of it, the number of coverages it wrote, the number of legal entities, it is pretty unique in the industry. That is if there are other large companies and each company bears its own risks. So if there were--you know, the big quake came to California tomorrow, could other insurance companies, perhaps large ones, be impacted-- " CHRG-111hhrg48873--65 Mr. Bachus," Okay. And these were credit default swaps, securities lending, things of that nature, which you can lose money on. " fcic_final_report_full--524 This does not solve all the major problems with the AH goals. In the sense that the goals enable the government to direct where a private company extends credit, they are inherently a form of government credit allocation. More significantly, the competition among the GSEs, FHA and the banks that are required under the CRA to find and acquire the same kind of loans will continue to cause the same underpricing of risk on these loans that eventually brought about the mortgage meltdown and the financial crisis. This is discussed in the next section and the section on the CRA. 4. Competition Between the GSEs and FHA for Subprime and Alt-A Mortgages One of the important facts about HUD’s management of the AH goals was that it placed Fannie and Freddie in direct competition with FHA, an agency within HUD. This was already noted in some of the Fannie documents cited above. Fannie treated this as a conflict of interest at HUD, but there is a strong case that this competition is exactly what HUD and Congress wanted. It is important to recall the context in which the GSE Act was enacted in 1992. In 1990, Congress had enacted the Federal Credit Reform Act. 138 One of its purposes was to capture in the government’s budget the risks to the government associated with loan guarantees, and in effect it placed a loose budgetary limit on FHA guarantees. For those in Congress and at HUD who favored increased mortgage lending to low income borrowers and underserved communities, this consequence of the FCRA may have been troubling. What had previously been a free way to extend support to groups who were not otherwise eligible for conventional mortgages—which generally required a 20 percent downpayment and the indicia of willingness and ability to pay—now appeared to be potentially restricted. Requiring the GSEs to take up the mantle of affordable housing would have looked at the time like a solution, since Fannie and Freddie had unlimited access to funds in the private markets and were off-budget entities. Looked at from this perspective, it would make sense for Congress and HUD to place the GSEs and FHA in competition, just as it made sense to put Fannie and Freddie in competition with one another for affordable loans. With all three entities competing for the same kinds of loans, and with HUD’s control of both FHA’s lending standards and the GSEs’ affordable housing requirements, underwriting requirements would inevitably be reduced. HUD’s explicit and frequently expressed interest in reducing mortgage underwriting standards, as a means of making mortgage credit available to low income borrowers, provides ample evidence of HUD’s motives for creating this competition. 137 Federal Housing Finance Agency, 2010-2011 Enterprise Housing Goals; Enterprise Book-Entry Procedures; Final Rule, 12 CFR Parts 1249 and 1282, Federal Register , September 14, 2010, p.55892. 138 Title V of the Congressional Budget Act of 1990. Under the FCRA, HUD must estimate the annual cost of FHA’s credit subsidy for budget purposes. The credit subsidy is the net of its estimated receipts reduced by its estimated payments. CHRG-111shrg56262--90 PREPARED STATEMENT OF PATRICIA A. McCOY George J. and Helen M. England Professor of Law, and Director, Insurance Law Center, University of Connecticut School of Law October 7, 2009 During the housing bubble, private-label securitization financed the majority of subprime and nontraditional mortgages. \1\ This system proceeded on the assumption that housing prices would keep going up. When housing prices fell and people could not refinance out of unaffordable loans, investors lost confidence in private-label mortgage securitization and the system collapsed in August 2007.--------------------------------------------------------------------------- \1\ I use the term ``nonprime'' to refer to subprime loans plus other nontraditional mortgages. Subprime mortgages carry higher interest rates and fees and are designed for borrowers with impaired credit. Nontraditional mortgages encompass a variety of risky mortgage products, including option payment ARMs, interest-only mortgages, and reduced documentation loans. Originally, these nontraditional products were offered primarily in the ``Alt-A'' market to people with near-prime credit scores but intermittent or undocumented income sources. Eventually, interest-only ARMs and reduced documentation loans penetrated the subprime market as well.--------------------------------------------------------------------------- This statement begins with a thumbnail sketch of securitization. Then I describe the role played by securitization in the financial crisis. Following that, I analyze the inherent flaws in private-label mortgage securitization. The statement goes on to describe current conditions in that market. I close by describing needed reforms.I. An Introduction to Securitization Back in the 1970s, banks had to hold home mortgages in portfolio until those loans were paid off. This destabilized banks that made mortgages because they got their financing from demand deposits, but invested those deposits in illiquid mortgages. This ``term mismatch'' between assets and liabilities was a direct cause of the 1980s savings and loan crisis. Starting in the late 1970s, securitization burst on the scene and eliminated the need for lenders to hold their mortgages in portfolio. The idea behind securitization is ingenious: bundle a lender's loans, sell them to a bankruptcy-remote trust, repackage the monthly loan payments into bonds rated by rating agencies, back the bonds with the underlying mortgages as collateral, and sell those bonds to investors.[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] Investment banks ``structured'' these securitization deals by dividing the bonds into ``tranches'' (French for ``slice''). The best tranche, with the lowest expected default rate, carried an AAA rating, was paid off first, and offered the lowest rate of return. The lower tranches were rated AA, A, etc., on down to the junior-most tranche, known as the equity tranche. The equity tranche was paid off last and was the first to absorb any losses from the loans. Securitization was prized for accomplishing four things. First, lenders were able to get their mortgages off their books. Second, securitization appeared to manage the risks of mortgages by slicing and dicing those risks and spreading them among millions of investors with assorted tolerances for risk. Third, securitization opened up huge new pools of capital to finance home mortgages. Finally, securitization freed lenders from relying principally on insured deposits in order to make loans. Instead, in a continuous cycle, lenders could make loans, sell those loans through securitization, and then plow the proceeds into a new batch of loans, which in turn would be securitized. This paved the way for a new breed of nonbank subprime lenders, who had little in the way of capital reserves, were free from Federal banking regulation, and were inured to the reputational constraints of banks and thrifts. At first, securitization was limited to prime loans, which were mostly securitized through the two Government-sponsored entities (GSEs) Fannie Mae and Freddie Mac. Once the market gained confidence about its ability to price subprime mortgages, securitization expanded to the subprime market in the early 1990s. Although the GSEs made limited forays into the subprime market and later expanded those forays around 2005, most subprime securitizations did not take place through the GSEs, but rather through the ``private-label'' securitization market. The private-label market lacked the same degree of public accountability that was expected of Fannie Mae and Freddie Mac as GSEs. By 2006, two-thirds or more of subprime mortgages were being securitized through the private-label market.II. The Role of Securitization in the Financial CrisisA. How Private-Label Securitization Increased the Risk of Mortgage Lending Before securitization, lenders usually did it all: they solicited loan applicants, underwrote and funded the loans, serviced the loans, and held the loans in portfolio. Lenders earned profits on loans from interest payments as well as from upfront fees. If the loans went into default, the lenders bore the losses. Default was such a serious financial event that lenders took care when underwriting loans. All that changed with private-label securitization. Securitization allowed lenders to offload most of the default risk associated with nonprime loans. Under the ``originate-to-distribute'' model, lenders could make loans intending to sell them to investors, knowing that investors would bear the financial brunt if the loans went belly-up. Similarly, securitization altered the compensation structure of nonprime lenders. Lenders made their money on upfront fees collected from borrowers and the cash proceeds from securitization offerings, not on the interest payments on loans. Lenders liked the security of being paid in advance, instead of having to wait for uncertain monthly payments over the life of loans. And, because they could pass the lion's share of the default risk onto faceless investors, lenders had less reason to care about how well their loans performed. In my examinations of internal records of major nonprime lenders, including Federal thrift institutions and national banks, too often I found two sets of underwriting standards: high standards for the loans they kept on their books and lax standards for the loans that they securitized. At their peak, investment grade, \2\ nonprime residential mortgage-backed securities (RMBS) were considered excellent investments because they supposedly posed minimal default risk while offering high returns. Investors clamored for these bonds, creating demand for ever-riskier loans.--------------------------------------------------------------------------- \2\ The top four ratings issued by a rating agency are ``investment grade'' ratings. For Standard & Poor's, these are ratings of AAA, AA, A, and BBB; for Moody's, Aaa, Aa, A, and Baa. Any rating below investment grade is considered junk bond status.--------------------------------------------------------------------------- Lenders were not the only players in the chain between borrowers and investors. Investment banks played significant roles as underwriters of nonprime securitizations. Lehman Brothers, Bear Stearns, Merrill Lynch, JPMorgan, Morgan Stanley, Citigroup, and Goldman Sachs underwrote numerous private-label nonprime securitizations. From 2000 through 2002, when IPO offerings dried up during the 3-year bear market, RMBS and CDO deals stepped into the breach and became one of the hottest profit centers for investment banks. Investment banks profited from nonprime underwriting by collecting a percentage of the sales proceeds, either in the form of discounts, concessions, or commissions. Once an offering was fully distributed, the underwriter collected its fee in full. This compensation system for the underwriters of subprime offerings caused Donna Tanoue, the former Chairman of the Federal Deposit Insurance Corporation, to warn: ``[T]he underwriter's motivation appears to be to receive the highest price . . . on behalf of the issuer--not to help curb predatory loans.'' Tanoue's warning proved prophetic. In February 2008, Fitch Ratings projected that fully 48 percent of the subprime loans securitized by Wall Street in 2006 would go into default. Despite that dismal performance, 2006 produced record net earnings for Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers, and Bear Stearns. That year, manager pay reflected the bottom-line importance that investment banks placed on private-label RMBS, with managing directors in the mortgage divisions of investment banks earning more on average in 2006 than their counterparts in other divisions.B. How Securitization Fueled Contagion Ultimately, private-label mortgage securitization turned out to be an edifice built on a rotting foundation. Once that foundation gave way, rising nonprime delinquencies mushroomed into international contagion for a number of reasons. For example, the same loan often served as collateral for multiple bonds, including an RMBS, a CDO, and a CDO of CDOs. If the loan went into default, it would jeopardize repayment for all three bonds. In addition, if defaults led to downgrades on those bonds, those assets were highly correlated. If rating agencies downgraded one issue, other issues came into question as well. Collateral is another reason why nonprime loans infected other markets. Many large institutional investors bought nonprime bonds that they later pledged as security for other types of loans. Banks, for instance, pledged their nonprime bonds as security for short-term loans from other banks on the market for interbank credit. Major corporations borrowed money from other corporations on the short-term commercial paper market by issuing paper backed by nonprime bonds. As the value of nonprime bonds fell, lenders began calling loans and ultimately the interbank lending and asset-backed commercial paper markets slowed to a crawl. Banks also reinfected themselves with subprime risks by buying private-label RMBS and CDOs and effectively taking those risks back on their books. When they sustained major losses on those bonds, they reined in their lending, adding fuel to the recession. General investor panic is the final reason for contagion. Even in transactions involving no nonprime collateral, concerns about the nonprime crisis had a ripple effect, making it hard for companies and cities across-the-board to secure financing. Banks did not want to lend to other banks out of fear that undisclosed nonprime losses might be lurking on their books. Investors did not want to buy other types of securitized bonds, such as those backed by student loans or car loans, because they lost faith in ratings and could not assess the quality of the underlying collateral. Stocks in commercial banks, insurance companies, and Wall Street firms took a beating because investors did not know where nonprime assets were hidden and feared more nonprime write-downs. Because they did not know exactly who was tainted by nonprime, investors stopped trusting practically everyone.III. Inherent Flaws in Private-Label Mortgage SecuritizationA. The Lemons Problem In hindsight, private-label mortgage securitization turned out to resemble the used car business in one respect. Both businesses have motivations to sell ``lemons.'' In other words, they have structural incentives to sell products carrying hidden defects and a heightened risk of failure. There are two main reasons for this lemons problem. First, securitization resulted in a misalignment of compensation and risk. Each company in the securitization process was able to collect upfront fees, while shifting default risk to downstream purchasers. Although investors tried to protect themselves through recourse clauses and structures making lenders retain the equity tranches, those contractual safeguards often broke down. Lenders were able to hedge their equity tranches or shed them by resecuritizing them as CDOs. Similarly, too many originators lacked the capital to honor their recourse obligations in full. Second, securitization fueled a relentless demand for volume and volume-based commissions. In the process, the quest for volume pushed lending standards steadily downward in order to maintain market share. This became a challenge in 2003, when interest rates began rising again, ending the refinancing boom. Securitizers needed another source of mortgages in order to increase the rate of securitization and the fees it generated. The ``solution'' was to expand the market through nontraditional mortgages, especially interest-only loans and option payment ARMs offering negative amortization. Lenders also relaxed their underwriting standards on traditional products to qualify more borrowers. This expansion of credit swept a larger portion of the population into the potential homeowner pool, driving up housing demand and prices, and consumer indebtedness. Many big investment banks, including Lehman Brothers and Bear Stearns, went so far as to buy subprime lenders in order to have an assured pipeline of mortgages to securitize. In short, the incentive structure of securitization caused the lemons problem to grow worse over time. Not only did private-label securitization sell lemons, those lemons grew more rotten as the housing bubble grew. In the process, securitization actors played the ends against the middle, injuring borrowers and investors alike.B. Harm to Borrowers Private-label securitization hurt numerous borrowers. First, investor appetite for high-yield RMBS caused originators to peddle risky mortgages, to the exclusion of safer loans. Second, compensation methods such as yield spread premiums saddled many borrowers with costlier mortgages than they qualified for. Third, borrowers whose loans were securitized lost important legal rights without their consent. On the first point: As mentioned above, in order to maintain volume while satisfying investor demand for high-yield bonds, investment banks and lenders had to continually tap new groups of borrowers with lower credit scores and less disposable income. For many of these cash-strapped borrowers, low monthly payments were a primary consideration. In order to offer the lure of lower initial payments, lenders concocted bafflingly complex loans combining a host of risky features, including adjustable-rate terms, teaser rates, high margins, stiff prepayment penalties, and no amortization or even negative amortization. Evidence is now coming to light that investment banks or large investors in many cases dictated those underwriting guidelines to originators. The front-end payments of these hazardous mortgages were attractive to unsuspecting borrowers and usually lower than the payments on a plain vanilla fixed-rate mortgage. But the back-end risks of those mortgages were daunting, yet difficult or impossible for borrowers to discern. Worse yet, to qualify individual borrowers, lenders often threw full income verification out the window. There was a second way in which investor demand for higher yield hurt many borrowers. Because investors paid more for higher yields, lenders offered mortgage brokers higher compensation in the form of yield spread premiums to convince borrowers who probably qualified for cheaper loans to unwittingly pay higher interest rates. The Wall Street Journal estimated that by year-end 2006, 61 percent of subprime mortgages went to borrowers with high enough credit scores to qualify for cheaper prime loans. \3\ Yield spread premiums artificially inflated the interest rates that borrowers had to pay, substantially increasing the likelihood that nonprime loans would default and go into foreclosure. Economists have estimated the size of this risk. For every 1 percent increase in the initial interest rate of a home mortgage, the chance that a household will lose its home rises by 16 percent a year.--------------------------------------------------------------------------- \3\ Rick Brooks and Ruth Simon, ``Subprime Debacle Traps Even Very Creditworthy'', Wall St. J., Dec. 3, 2007, at A1.--------------------------------------------------------------------------- Finally, under the Uniform Commercial Code in many States, borrowers whose loans are securitized lose valuable legal rights without their consent or financial compensation. This doctrine, known as the ``holder-in-due-course rule,'' prohibits borrowers whose loans are securitized from raising common types of fraud or other misconduct in the making of their loans against all subsequent purchasers of their loan notes. In many case, this shields investment banks, rating agencies, and investors from borrower suits for fraud. Although borrowers can still raise fraud as a claim or defense against their mortgage brokers and lenders, many of those entities are bankrupt today and thus judgment-proof. More importantly, once a loan is securitized, any suit for foreclosure will be brought by the investor or securitized trust, not the mortgage broker or lender. In those cases, the holder-in-due course rule prevents borrowers who were defrauded from even raising the fraud as a defense to foreclosure.C. Harm to Investors The lack of transparency in securitization also hurt investors. The securities disclosures for private-label RMBS lacked crucial information to investors. In addition, product complexity made it difficult or impossible for investors to grasp the risks associated with many offerings. Finally, both problems caused investors to place undue reliance on credit ratings, which proved to be badly inflated. 1. Inadequate Securities Disclosures--For most of the housing bubble, the Securities and Exchange Commission (SEC) had no rule requiring disclosures specifically tailored to RMBS or CDOs. The SEC adopted Regulation AB in an attempt to redress that gap, but the rule did not go into effect until January 1, 2006, too late to cover earlier private-label offerings. Once the rule went into effect, it was riddled with holes. First, Reg AB only applies to public offerings of asset-backed securities. An investment bank could simply bypass Reg AB by structuring the offering as a private offering limited to big institutional investors. In private offerings, SEC disclosures are lighter or left to private negotiation, based on the idea that institutional investors have clout to demand the information they need. Wall Street took full advantage of this loophole, meaning that CDOs were almost always sold through private offerings with seriously deficient disclosures. Even when Reg AB did apply--i.e., in public offerings of asset-backed securities--the disclosures were too skimpy to be of use. The SEC modeled many of Reg AB's disclosures on the reporting requirements for corporate issuers. Corporations usually have track records to speak of, so securities disclosures for those issuers focus on recent past performance. But past performance was irrelevant for most offerings of RMBS and CDOs, which involved relatively new mortgages. In essence, Reg AB puts the wrong information under the microscope. Instead, investors in nonprime bonds needed standardized information on the risk characteristics of the individual loans in the loan pool. But Reg AB does not require that level of detail. While the rule encouraged investment banks to make tapes with loan level data available to investors online, it did not force them to do so. Instead, Reg AB simply mandates a summary of the aggregate characteristics of the loan pool. That made it difficult to discern whether the riskiest loans were going to the strongest borrowers or to the worst borrowers in the loan pool. Similarly, too many prospectuses and offering memoranda for private-label offerings stated that the lenders reserved the right to make exceptions to their underwriting standards in individual cases. In 2006 and 2007, there were offerings in which the exceptions--in other words, loans that flunked the lender's underwriting standards--outweighed the number of loans that conformed to the lender's stated standards. The exact (and often high) percentage of exceptions was not disclosed to investors. Nor does Reg AB make investment banks disclose the due diligence reports they commissioned from outside firms, even when those reports contained evidence of deteriorating lending standards. Too often, investment banks withheld those reports from investors and ratings agencies. Reg AB is also deficient regarding the performance of individual loans. While Reg AB requires some reporting on loan performance, it is only for the first year following the offering, not for the life of the loans. All told, there was a dearth of useful publicly available information on the loan pools underlying private-label RMBS and CDOs. The SEC disclosure scheme for nonprime RMBS and CDOs was so misbegotten and riddled with exceptions that those securities operated in a fact-free zone. Investors and analysts who wanted to do serious due diligence could not get the facts they needed to figure out the true risk presented by the loans. Without those facts, investors often overpaid for those securities. Furthermore, the dearth of key public information also impeded the development of a healthy resale market in those bonds, which became a big problem later on when banks tried to unload toxic subprime assets off their books. 2. Complex Products--Many private-label RMBS and CDOs were so complex that due diligence was too costly or impossible for investors. CDOs are a good example. Typically, a CDO consisted of junior tranches of RMBS from different offerings, sometimes paired with other types of asset-backed securities involving receivables from things like credit cards or auto loans. At best, the investor received data on the quality of the underlying bonds. But it was impossible for the investor to x-ray the offering in order to analyze the underlying home mortgages, credit card borrowers, or auto loans themselves. That was even more impossible when the CDO was a ``synthetic CDO'' made up of credit default swaps on RMBS and asset-backed securities. Even in regular RMBS, complexity was a big problem. One issue was the sheer number of tranches. Another was the fact that many private-label RMBS offerings featured complex credit enhancement rules about who would receive cash flows from the mortgages in what amounts, depending on changes in the amount of subordination or overcollateralization. This meant that investors could not just stop with estimating expected losses from the mortgages. They also had to analyze who would get what cash flows when, based on a changing kaleidoscope of scenarios. \4\ In addition, too many offerings were made on a ``to be announced'' or ``TBA'' basis, which meant that investors could not scrutinize the underlying loans because the loans had not yet been put in the loan pool. Finally, many securitization deals involved custom features that undermined standardization.--------------------------------------------------------------------------- \4\ Ingo Fender and Janet Mitchell, ``The Future of Securitization: How To Align Incentives?'', Bis. Quarterly Review 27, 30, 32 (Sept. 2009).--------------------------------------------------------------------------- Of course, this discussion begs the question whether investors would have done adequate investigation in any case when the housing bubble was at its height and euphoria prevailed. But back then, even investors who wanted to do serious due diligence would have met insuperable obstacles. More recently, lack of transparency and complexity have blocked the formation of an active, liquid resale market that would enable banks to remove impaired RMBS and CDOs from their books. 3. Overreliance on Credit Ratings--Poor disclosures and overly complex deals caused investors to over rely on credit ratings. Meanwhile, the rating agencies had financial incentives to understate the risks of nonprime RMBS and CDOs. The investment banks that underwrote nonprime securitizations paid the rating agencies to provide them with investment-grade ratings. The rating agencies touted the top-rated nonprime bonds--ranging from AAA down to A--as hardly ever defaulting. Under banking and insurance laws, banks and insurance companies can only invest in types of bonds permitted by law. Private-label RMBS and CDOs carrying investment grade ratings are on the permissible list, so long as those ratings are rendered by rating agencies designated Nationally Recognized Statistical Rating Organizations (NRSROs) by the SEC. These regulatory rules encouraged institutional investors in search of higher yields to buy the top-rated nonprime RMBS and CDOs. During the housing bubble, rating fees on private-label RMBS and CDOs were the fastest-growing sector of the rating agency business. Issuers paid the rating agencies handsome fees from these deals, spurring the rating agencies to rate offerings for which there was scant historical default data. Similarly, the rating agencies used flawed models which assumed never-ending housing price appreciation and were not updated with new default data. Nor did most investors realize that an AAA rating for an RMBS offering was different than, and inferior to, an AAA rating for a corporate bond. \5\--------------------------------------------------------------------------- \5\ In large part, and in contrast with corporate bonds, this is because downgrades of a tranched RMBS tend to make downgrades of other RMBS tranches more likely. Fender and Mitchell, supra note 4, at 33.---------------------------------------------------------------------------D. Impediments to Loan Modifications Deal provisions in private-label securitizations have also paralyzed constructive workouts of many distressed home loans. Today, securitized trusts, not lenders, hold the vast majority of those loans. The complexity of the securitized deals often pits servicers against investors and investors against each other. Too often, the servicers opt for foreclosing on property, instead of arranging workouts that would allow homeowners to stay in their homes. The irony of this approach is that, in many cases, workouts in the form of loan forbearance or loan modifications would result in a higher recovery. There are several explanations for this seemingly irrational behavior, including inadequate staffing levels and compensation clauses that cause servicers to earn more money from foreclosures than workouts. But the main reason why more workouts do not occur is that many pooling and servicing agreements place constraints on servicers' ability to negotiate loan workouts. Some limit the percent of the loan pool that can be modified. Others have vague prohibitions allowing modifications only to the extent they are in the best interests of the investors. Even when those agreements give servicers latitude to modify loans, servicers are reluctant to modify loans because they fear lawsuits by warring trancheholders for breach of fiduciary duty. This hold-up problem has stymied Federal regulators' attempts to speed up loan modifications and halt the vicious cycle of falling home prices. With no Federal legislation to force modifications, regulators have only had limited success. Meanwhile, loan workouts are crawling at a snail's pace, leading foreclosed homes to be dumped on the market in record numbers and pushing home prices further down in the process.IV. Current Conditions in the Private-Label Securitization Markets Due to the problems just described, the markets for private-label RMBS and CDOs are essentially dead. The securitization markets for auto loans, credit cards, and student loans are open, but their volume has dropped sharply due to general concerns about the soundness of the securitization process. For all intents and purposes, the Federal Government has become the financier of first resort for residential mortgages. In 2008, agency mortgage-backed securities--in other words, RMBS issued by Fannie Mae, Freddie Mac, and Ginnie Mae (FHA loans)--accounted for over 96 percent of the U.S. RMBS market. Private-label mortgage-backed securitization accounted for less than 4 percent of the market that year.[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] This disparity widened in the first 6 months of 2009, when the relative market shares of agency and private-label mortgage-backed securitization were 99 percent and 1 percent. \6\ In second quarter 2009, moreover, 38.4 percent of private-label RMBS transactions were re-REMICs of old loans that were repackaged into tranches of good and bad loans. According to the Securities Industry and Financial Markets Association (SIFMA), the ``private label market remains dormant due to reduced lending, lack of investor demand, low liquidity,'' and rising delinquencies and foreclosures. \7\--------------------------------------------------------------------------- \6\ I use the term ``agency'' to refer to GNMA, Fannie Mae and Freddie Mac mortgage-backed securities and collateralized mortgage obligations. The term ``private-label'' includes RMBS and CMOs. \7\ Securities Industry and Financial Markets Association, Research Report 2009 Q2 (August 2009), at 2, 9.--------------------------------------------------------------------------- As these numbers suggest, private investors are largely shunning the private-label mortgage securitization market in favor of other investments, including agency RMBS. In the meantime, the Federal Reserve has become a major investor in agency RMBS, having begun purchases in this market in December 2008. The Fed has pledged to buying up to $1.25 trillion in agency RMBS before the end of this year, in an effort to help lower home mortgage interest rates. Other securitization markets associated by investors with mortgages are also dormant. SIFMA reports that the private-label commercial MBS primary market ``remains closed.'' \8\ Similarly, global issuance of CDOs has essentially come to a halt.--------------------------------------------------------------------------- \8\ Id. at 9. [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] CHRG-111shrg57709--153 Mr. Volcker," It is an interesting idea. I have not thought of it, I must confess. It is the reverse of many other ideas that you withdraw support if they do not lend enough. The Deputy Secretary mentioned some things that kind of discourage growth and would encourage, I hope, lending. But I would have to think pretty hard about the suggestion of removing, in effect, the safety net from banks that did not act like banks. Senator Reed. Well, food for thought. " Mr. Volcker," OK. We will look at it. Senator Reed. Secretary Wolin, do you have any comments? " CHRG-111shrg54675--79 PREPARED STATEMENT OF SENATOR MIKE CRAPO Many community banks and credit unions have tried to fill the lending gap in rural communities caused by the credit crisis. Even with these efforts, it is apparent that many consumers and businesses are not receiving the lending they need to refinance their home loan, extend their business line of credit, or receive capital for new business opportunities. Today's hearing will assist us in identifying these obstacles. As we began to explore options to modernize our financial regulatory structure, we need to make sure our new structure allows financial institutions to play an essential role in the U.S. economy by providing a means for consumers and businesses to save for the future, to protect and hedge against risk, and promote lending opportunities. These institutions and the markets in which they act support economic activity through the intermediation of funds between providers and users of capital. One of the more difficult challenges will be to find the right balance between protecting consumers from abusive products and practices while promoting responsible lending to spur economic growth and help get our economy moving again. Although it is clear that more must be done to protect consumers, it is not clear that bifurcating consumer protection from the safety and soundness oversight is the best option. If that is not the best option, what is and why? It is my intention to explore this topic in more detail with our witnesses. Again, I thank the Chairman for holding this hearing and I look forward to working with him on these and other issues. ______ CHRG-111hhrg53245--130 Mr. Wallison," Yes. I have a comment on the question of bubbles. I think we have to distinguish this bubble from every other bubble. We will always have them. We are human beings. We tend to believe that when things are going in one direction, they will continue to go in one direction. That is both up and down. This bubble was completely different. In this bubble, we had 25 million subprime and non-traditional loans that are failing at rates that we have never seen before. The question we have to answer is, why did that happen? That is one of the major reasons that this particular bubble turned into a worldwide financial crisis. " CHRG-111hhrg56241--147 Mr. Green," It is not the right thing to do. All right. I will help you. It is irresponsible. Friends, we at some point have to become adults about what we are dealing with. We are talking about perverse incentives that create systemic failure. Give me an example, please, ma'am, of a perverse incentive that creates systemic failure, please. Ms. Minow. Certainly. In the subprime industry, the individuals were paid on the number of transactions rather than the quality of transactions. So they had a perverse incentive to create as many transactions as possible. " CHRG-111hhrg55811--337 Mr. Hill," It was misunderstood. People assumed that borrowers disclosed their incomes correctly, people assumed lenders checked, people assumed the real estate appraisals were done accurately. And it turned out that a lot of those things weren't the case. So I have always felt the focus should be less so on the derivative and more so on what is the derivative on and is that market performing correctly. And I think in this case of the subprime, it clearly wasn't. In the case of the corporate bond market and the corporate CDS market, it certainly was. " FinancialCrisisReport--477 On February 14, 2007, Mr. Sparks wrote some notes to himself: “Bad week in subprime collateral performance on loans was poor – we took a write-down on second lien deals and on the scratch and dent book last week ... Synthetics market got hammered – around 150 [basis points] wider ... Originators are really in a bad spot. Thinly capitalized, highly levered, dealing with significant loan putbacks, some with retained credit risk positions, now having trouble selling loans above par when it cost them 2 points to produce. What is the next area of contagion.” 2013 That same day, February 14, 2007, Mr. Sparks exchanged emails with Goldman’s Co- President Jon Winkelried about the deterioration in the subprime market: Mr. Winkelried: “Another downdraft?” Mr. Sparks: “Very large – it’s getting messy. ... Bad news everywhere. Novastar bad earnings and 1/3 of market cap gone immediately. Wells [Fargo] laying off 300 subprime staff and home price appreciation data showed for first time lower prices on homes over year broad based.” 2014 On February 26, 2007, when Mr. Montag asked him about two CDO 2 transactions being assembled by the CDO Origination Desk, Timberwolf and Point Pleasant, Mr. Sparks expressed his concern about both: Mr. Montag: cdo squared–how big and how dangerous Mr. Sparks: Roughly 2bb, and they are the deals to worry about. 2015 2012 2013 2014 2/8/2007 email from Daniel Sparks, “Post,” Hearing Exhibit 4/27-7. 2/14/2007 email from Daniel Sparks to himself, “Risk,” GS MBS-E-002203268. 2/21/2007 email exchange between Daniel Sparks and Jon W inkelried, “Mortgages today,” GS MBS-E- 010381094, Hearing Exhibit 4/27-10. 2015 2/26/2007 emails between Tom Montag and Daniel Sparks, “Questions you had asked,” GS MBS-E-019164799. fcic_final_report_full--283 One week later, Cassano called Sherwood in Goldman’s London office and de- manded reimbursement of . billion. He told both AIG and Goldman executives that independent third-party pricing for  of the , securities underlying the CDOs on which AIG FP had written CDS and AIG’s own valuation for the other  indicated that Goldman’s demand was unsupported—therefore Goldman should re- turn the money.  Goldman refused, and instead demanded more.  By late November, there was relative agreement within AIG and with its auditor that the Moody’s model incorporated into AIG’s valuation system was inadequate for valuing the super-senior book.  But there was no consensus on how that book should be valued. Inputting generic CDO collateral data into the Moody’s model would result in a . billion valuation loss; using Goldman’s marks would result in a  billion valuation loss, which would wipe out the quarter’s profits.  On November , PwC auditors met with senior executives from AIG and the Financial Products subsidiary to discuss the whole situation. According to PwC meeting notes, AIG re- ported that disagreements with Goldman continued, and AIG did not have data to dispute Goldman’s marks. Forster recalled that Sullivan said that he was going to have a heart attack when he learned that using Goldman’s marks would eliminate the quarter’s profits.  Sullivan told FCIC staff that he did not remember this part of the meeting.  AIG adjusted the number, and in doing so it chose not to rely on dealer quotes. James Bridgewater, the Financial Products executive vice president in charge of mod- els, came up with a solution. Convinced that there was a calculable difference be- tween the value of the underlying bonds and the value of the swap protection AIG had written on those bonds, Bridgewater suggested using a “negative basis adjust- ment,” which would reduce the unrealized loss estimate from . billion (Goldman’s figure) to about . billion. With their auditor’s knowledge, Cassano and others agreed that the negative basis adjustment was the way to go. Several documents given to the FCIC by PwC, AIG, and Cassano reflect discus- sions during and after the November  meeting. During a second meeting at which only the auditor and parent company executives were present (Financial Products ex- ecutives, including Cassano and Forster, did not attend), PwC expressed significant concerns about risk management, specifically related to the valuation of the credit default swap portfolio, as well as to the company’s procedures in posting collateral. AIG Financial Products had paid out  billion without active involvement from the parent company’s Enterprise Risk Management group. Another issue was “the way in which AIGFP [had] been ‘managing’ the SS [super senior] valuation process—saying PwC will not get any more information until after the investor day presentation.”  The auditors laid out their concerns about conflicting strategies pursued by AIG subsidiaries. Notably, the securities-lending subsidiary had been purchasing mort- gage-backed securities, using cash raised by lending securities that AIG held on behalf of its insurance subsidiaries. From the end of  through September , its holdings rose from  billion to  billion. Meanwhile, Financial Products, act- ing on its own analysis, had decided in  to begin pulling back on writing credit default swaps on CDOs. In PwC’s view, in allowing one subsidiary to increase expo- sure to subprime while another subsidiary worked to exit the market entirely, the parent company’s risk management failed. PwC also said that the company’s second quarter of  financial disclosures would have been changed if the exposure of the securities-lending business had been known. The auditors concluded that “these items together raised control concerns around risk management which could be a material weakness.”  Kevin McGinn, AIG’s chief credit officer, shared these con- cerns about the conflicting strategies. In a November , , email, McGinn wrote: “All units were apprised regularly of our concerns about the housing market. Some listened and responded; others simply chose not to listen and then, to add insult to injury, not to spot the manifest signs.” He concluded that this was akin to “Nero play- ing the fiddle while Rome burns.”  On the opposite side, Sullivan insisted to the FCIC that the conflicting strategies in the securities-lending business and at AIG Fi- nancial Products simply revealed that the two subsidiaries adopted different business models, and did not constitute a risk management failure.  CHRG-111hhrg50289--33 Mr. Heacock," Thank you. We have not backed off at all. As I said before, we wrote more SBA loans than any other lender in South Dakota last year, and it is continuing this year. As far as non-SBA loans, we had a record year last year and it is continuing very, very strong. Credit unions nationwide, for the most part, have plenty of capital to lend, and we have had, I know, locally some financial institutions that are not willing to lend to some small businesses. Also, they are changing some terms and conditions. They are coming to us. Oftentimes we can help them. Sometimes we cannot, but we are there and available and have the funding. " FOMC20070810confcall--26 24,VICE CHAIRMAN GEITHNER.," Richard, we’ve been talking to these people several times a day, and we’ll do so again today. But I guess I don’t feel that at this point we can do anything appropriate that is more powerful than this statement, and I’m not sure that it makes any sense for us to try to persuade these people to lend to a bunch of institutions that they’re not comfortable lending to now. I don’t really feel as though there’s an effective way for us to condition this. You know, we have no indication that people are going to come to the window on any significant scale. If we think that there’s a liquidity problem that could be effectively relaxed by encouraging people to come to the window and that would make them more likely to help meet that constraint, then we can get to that point. But at this stage I don’t think it’s helpful or necessary for us to try to induce these people to on-lend what they may come to us later in the day for at the window. We may get to that point, but I don’t think that makes sense now." CHRG-111shrg52619--122 Chairman Dodd," We are going back around. Chairman Bair, let me ask you to comment on this as well. Ms. Bair. Well, I think John is right. These practices became far too pervasive. For the most part, the smaller State-chartered banks we regulate did not do this type of lending they do more traditional lending, and then obviously they do commercial real estate lending, which had a separate set of issues. We had one specialty lender who we ordered out of the business in February of 2007. There have been a few others. We have had some other actions, and I would have to go back to the examination staff to get the details for you. But I was also concerned that even after the guidance on the nontraditional mortgages, which quite specifically said you are not going to do low-doc and no-doc anymore, that we still had very weak underwriting in 2007. So I think that is a problem that all of us should look back on and try to figure out, because clearly by 2007 we knew this was epidemic in proportion, and the underwriting standards did not improve as well as you would have thought they should have, and the performance of those loans had been very poor as well. I do think we need to do a lot more---- " CHRG-110hhrg34673--229 Mr. Bernanke," There have been a few small companies that have gone out of business, and others that have lost money. Nowadays, mortgages are not just made and held by individual firms, they are then securitized and sold into the general financial markets. And so we can look at financial market prices and see what the market more broadly thinks is happening in this area. And the value of subprime-mortgage-backed securities has dropped pretty significantly, suggesting that financial market investors are concerned about the loss probabilities in this area. " CHRG-111hhrg49968--87 Mr. Bishop," Understood. One of the policy issues before us over the next several months will be to deal with the President's recommendations with respect to higher education policy. One of his recommendations is to move away from what is referred to as FFEL lending to 100 percent direct lending, monies provided by the Treasury. There are arguments for doing that, and there are arguments that would suggest we should not do that. One of the arguments raised that suggest that we should not do it is that the increased borrowing would be detrimental to our both short and long-term fiscal stability. What is your assessment of that argument? " FOMC20080310confcall--90 88,MR. ALVAREZ., That's correct. This is securities lending by the New York Reserve Bank out of the SOMA. FOMC20080724confcall--77 75,MR. LACKER., So you don't think refusing to lend would have forced the FDIC to accelerate closure? FOMC20081216meeting--434 432,MR. LACKER.," You said that investors who bought this and put this and got the lending would have the haircut at risk, right? " CHRG-111hhrg55814--143 Secretary Geithner," Congresswoman, this is a very important issue. Small businesses are much more reliant on credit from banks, including small banks. For again, to get that credit, banks have to have the capital they need to lend. The President proposed last week two important new initiatives to make sure small banks can get that capital, as well as community development and finance institutions as well. And I think Congress needs to work with us to help make those banks more comfortable, coming to get capital from the government. If they do that, then they'll have a better capacity to provide credit to small businesses. And we think that's a very important thing to do. The Congress also passed in the Recovery Act some important changes to help encourage small business lending by the SBA. Lending by the SBA since those actions were taken has increased very dramatically. But I think you're absolutely right that for many small businesses across the country, they're still not getting the credit they need to grow and expand. And we need to work with you to try to fix that problem. " CHRG-111shrg57321--243 Mr. McDaniel," No, I was not. Ms. Corbet. I was no longer with the company. Senator Levin. OK. And the press release from your firm--and I will just address this to you, Mr. McDaniel--when you rated the Citibank deal stated that you expected heightened losses and had accounted for that in the structure of the deal, but there was a 37 percent loss. That is the actual losses as of today. They exceeded any expected loss, obviously, when you rated the deal. But does it surprise you that you were still rating those subprime RMBSes in December 2007, after what happened in July? Does that come as any surprise to you? " FOMC20070918meeting--155 153,MR. POOLE.," Thank you, Mr. Chairman. I favor a cut of 50 basis points, and I think that the alternative B language does what we need it to do. It’s very much in our interest that the markets settle down sooner rather than later. I also think that the moral hazard argument in this context is simply wrong. It’s wrong because if you take an insurance company context, there the issue is that the policyholder takes action that is adverse to the interest of the insurance company. It’s in our interest and it’s in the economy’s interest that the markets settle down sooner rather than later. We want subprime paper to trade. If it’s 30 cents on the dollar, okay. Nobody is talking about subprime paper trading at 100 cents on the dollar or 98 cents on the dollar. We want the market to function so that the positions can be adjusted and so that we can go back to a normal situation in which the paper trades for what it’s really worth. If the data and the anecdotal information justify going down 50 and going down only 50, our best chance to make that stick is actually to do it all at once because, if we can leave rates unchanged in our October meeting, that sets the default option for the following meeting also to be no change rather than further action. So it seems to me our best chance of avoiding an overreaction is to do 50 now and then make the case that we’re waiting to see how all of that works and we don’t think that as time goes on it will probably be necessary to do anything more. Thank you." CHRG-110shrg50416--37 Mr. Kashkari," Chairman, we share your view. It is a very important point. We want our financial institutions lending in our communities. It is essential. And so if you look at some of the details--terms around the preferred stock purchase agreement, there are specific contractual provisions on how they can and cannot use the capital. As an example, we are preventing increases in dividends because we do not think it is appropriate to take Government capital, the taxpayers' money, and then increase dividends. That does not increase capital in the financial system, so that is prohibited. Second, share repurchases are also prohibited. We do not want to put Government capital in and then boost the stock price by buying back a bunch of shares. That is contractually prohibited. In addition, we have got other language in there focusing on commitments around increasing lending, working hard to help homeowners. Some of them are contractual provisions. Others are more guidance in nature. But we share your view 100 percent. We want these institutions in our communities lending. " CHRG-111hhrg56776--28 Mr. Volcker," I think this is an example of why we need some pretty thorough reform, so that an institution of that size would have some official oversight. I would also hope that if we have the kind of reform that is being talked about, the issue of the Federal Reserve lending to those institutions, non-bank institutions, would not be relevant because if push came to shove and they were failing, it would come under the so-called ``resolution authority'' that would have the power and resources to provide a suitable liquidation or merger of that institution. The Federal Reserve would not have to get directly involved as a lending organization. " FOMC20081216meeting--445 443,MR. DUDLEY.," No, I don't think that is quite right. We are in basically a market disequilibrium, where the traditional buyers of these securities have vanished. In a normal market environment, it would be completely reasonable to lend against these securities on a leveraged basis. But the people who would do that lending--banks and dealers--are balance sheet constrained, and that is why they are not willing to make those loans. If we had a normal banking and dealer situation today in which they were willing to extend loans to their counterparties, they would be providing the leverage. But that is just not happening. " CHRG-111shrg57319--487 Mr. Killinger," Well, again, market conditions changed very dramatically with housing prices coming down and there are a number of things that we changed. As you heard this morning, we tightened underwriting. We changed loan products. We ceased offering some of the subprime products. We ceased offering Option ARMs. We started to go back to more documentation on the loans. And there were just a number of things that became more appropriate because the housing conditions changed so dramatically. Senator Kaufman. So it was just right then when you really found out how bad stated loans were? " CHRG-110shrg50414--194 Secretary Paulson," Senator, I will give a quick view and I am sure the Chairman will. From a policy perspective, you have heard me express disapproval. I think that that is--although many people have considered it and advocate it, I very respectfully think it is a mistake, and when I look at what we are trying to do here, is to get lending going again and increase lending, I think this really mitigates against that and it is in contradiction with what we are trying to do, is to get lenders to do more if we do these bankruptcy modifications or cram-downs. But I understand there are differences of opinion and I respect the other view. I just think it is a mistake. Senator Casey. Chairman Bernanke. " CHRG-111shrg54675--19 Mr. Skillern," Thank you, Senator Johnson, for the opportunity to testify today on lenders, consumers, and the economy in rural areas. I am Peter Skillern, Executive Director of the Community Reinvestment Association of North Carolina. We are a nonprofit community advocacy and development agency. North Carolina has strong rural and banking sectors. Eighty-five of our 100 counties are rural and 50 percent of our population live in them. We have 106 credit unions and 106 banks, ranging from the largest in the country, Bank of America, down to Mount Gilead Savings and Loan at $9.8 million. The current economic stresses for our rural communities and small financial institutions are significant, and they are best understood in the context of two long-term trends: one is a decline in the rural economy, and two is the consolidation of the financial sector. And our policy recommendations focus on two issues: one is the financial regulatory reform to provide greater consumer protections and stability; and two is the investment needed in our rural communities for recovery and growth--in particular, through the Neighborhood Stabilization Program. Rural Economies are in long-term decline. In North Carolina, the unemployment rate is the fifth highest in the country, but our rural communities are taking it even harder. The rates in 19 counties range between 14 and 17 percent. But these rates are years in the making. Rural North Carolina did not recover from the 2001 recession. From 2002 to 2008, rural counties lost more than 100,000 jobs in the manufacturing sector of textiles, apparel, furniture, and automobiles. Changes in tobacco and the agricultural sector have reduced the number of small farms. Tobacco farms have dropped by 70 percent since 2002. Forty of our rural counties lost population. These long-term trends, in combination with the credit crisis and recession, have contributed to an estimate 31,000 foreclosures in rural North Carolina. That is more than in the urban areas. Small banks also face challenges in the consolidation of the financial sector. During this crisis, a number of small banks across the Nation have failed, but far more have been lost through consolidation. Nationally, the number of banks with under $100 million in assets dropped by more than 5,000 from 1992 to 2008. In North Carolina, rural counties hold 50 percent of the population and 50 percent of bank branches, and only 16 percent of the deposit base. Nationally, approximately 4,000 small banks accounted for less than 2 percent of the national mortgage activity. By contrast, the consolidation of assets and market share of megabanks has increased. In 1995, the top five banks had 11 percent of the deposit share; today, they have nearly 40 percent. In the first quarter of 2009, 56 percent of mortgage activity was conducted by just four lenders. Small banks are at a competitive disadvantage in terms of efficiencies, pricing products, and geographical service areas, and consolidation will continue in the foreseeable future. This is a problem. As a rule, small banks and credit unions avoided subprime credit and provided stability and diversification in the financial sector. Without smaller institutions, many areas would go completely unserved. Banking policy and regulatory oversight should proactively support small banks and credit unions as essential to the local economic ecology of credit and commerce. Financial reform will help consumers, lenders, and the rural communities. Consumers in rural and urban areas face similar lending abuses. Rural areas had a higher percentage of subprime high-cost loans than urban areas. Rural areas have a high rate of refund anticipation loans, and payday lenders are prevalent in the rural areas of the 35 States that allow this usurious type of lending. Consumers need better protections from unsound and unscrupulous lending practices, and if so provided, our economy would be safer as well. Our financial sector would be better. Our agency is supportive of President Obama's recommendation for the Consumer Financial Protection Agency Act. We support the CRA Modernization Act, H.B. 1492. And faced with a rising tide of foreclosures and insufficient loan modification programs, we ask the Senate to reconsider and favorably pass a loan judicial modification bill. We support reforms for greater oversight and capital requirements to mitigate the risk of megabanks. Finally, please invest in our rural communities. Although the problems created by the financial crisis and recession are felt by every community and the solutions needed are national in scope, it would be a mistake to assume that urban and rural communities will shake off the recession with the same speed. The long-term challenges for small banks and rural communities are systemic as well as cyclical. Unless we invest in rebuilding these communities, no banks of any size will thrive. Please expand the Neighborhood Stabilization Program both in scale of funding and in scope to include rural areas. NSP funds are to revitalize foreclosed properties and to rebuild distressed communities. But no rural areas receive NSP funds because the needs test emphasizes concentration. Yet in 23 States, such as North Carolina, in the aggregate there are more foreclosures in rural area than urban areas. More funding is needed given the need in both urban and rural areas. The future for rural communities and banks is brighter if we recognize and act on the need for financial regulatory reform and investment in our communities. Thank you very much for your attention. " CHRG-111hhrg53240--129 Mr. Carr," Yes. First of all, I am on the executive committee of Americans for Financial Reform. It is the official position of the organization that CRA should and must be included in the new consumer protection agency. Second of all, I will go back to something I said in my opening comments. The goal of that agency is to ensure access to safe and sound products, and it can't do so to minority communities if it is only looking at individuals, because the financial system doesn't treat individuals the same in minority communities. They treat them as markets. And so getting at systemic issues of failing to lend--failing to lend, as opposed to using exploitive products--the Community Reinvestment Act is the only real act that really promotes and holds banks and other financial institutions--well, banks now, hopefully other financial institutions--accountable for proactively lending in communities and not ignoring the legitimate credit needs. So if it is not in that agency, we have left a major piece of support for minority communities out. The second thing is that we should understand that that agency will have that accumulated knowledge and expertise of researchers, data--how will it in any way enhance their jobs to have the people who look at things at a geographic and at a market's level--systemic market level not part of those daily conversations, sharing of information and, ultimately, the creation of products and the enforcement of the law? It must be in order for that agency to work as it is designed. It must be able to look at broad-based community lending. " FOMC20080724confcall--71 69,MS. YELLEN.," Well, I guess we would have had that. Had they taken the loan out earlier, when they were still rated 2 or 3, I think it would have substituted for borrowings that they could have had at that time from the Federal Home Loan Bank. They might have had a motive to take out a long-term loan from us rather than to tap their Federal Home Loan Bank access. They would have pledged a huge amount of collateral to the Federal Home Loan Bank, which was not accessible to us, had we wanted to lend more because the Federal Home Loan Bank has blanket authority over a large class of collateral. So if we had, in fact, extended that loan, we could have called it in; but that would have precipitated a failure. And we wouldn't have had the ability to augment the collateral. So our hands would have been tied when the FDIC came to us and said, ""Please assist us in lending. This institution is experiencing deposit outruns. We want to get it through to a close that we think will be least-cost, and it is going to take us another week and a half."" There would have been no more collateral to be had. We would have been, then, up against the limit of what we could lend. " CHRG-111hhrg53244--119 Mr. Bernanke," We are continuing to look at floor plan lending, and there are several possibilities. One in particular is we are doing a review right now of the credit rating agencies, the nationally recognized rating agencies, whose ratings we will accept and the criteria on which we will accept those ratings. Depending on what that list is and what views they have about floor plan lending, it may be that some floor plan deals can get the AAA rating that they need to be eligible for the TALF. But we will be putting out rules very soon on the criteria for choosing the rating agencies. " FOMC20070628meeting--105 103,MS. YELLEN.," Thank you, Mr. Chairman. Data relating to both economic activity and inflation during the intermeeting period have been encouraging. Economic indicators have strengthened considerably, and recent readings on core inflation have been quite tame. Although a portion of the recent deceleration of core prices likely reflects transitory influences, the underlying trend in core inflation is still quite favorable. I view the conditions for growth going forward as being reasonably solid. The main negative factors are tied to housing. The latest data don’t point to an imminent recovery in this sector, and I fear that the recent run-up in mortgage rates will only make matters worse. In addition, housing prices are unlikely to rise over the next few years and, indeed, may well fall, and the absence of the housing wealth gains realized in the past should damp consumption spending. I agree with the Greenbook that the recent run-up in bond and mortgage rates reflects primarily a shift in market expectations for the path of policy and, therefore, implies only a small subtraction to my forecast for growth in 2008. In my view, the stance of monetary policy over the next few years should be chosen to help move labor and product markets from being somewhat tight today to exhibiting a modest degree of slack in order to help bring about a further gradual reduction in inflation toward a level consistent with price stability. The stance of monetary policy will need to remain modestly restrictive, along the lines assumed in the Greenbook and by markets, in order to achieve that goal. My forecast is for growth to be around 2½ percent in the second half of this year and in 2008, slightly below my estimate of potential growth, and for the unemployment rate to edge up gradually, reaching nearly 5 percent by the end of next year. Under these conditions, core inflation should continue to recede gradually, with the core PCE price index increasing 2 percent this year and 1.9 percent in 2008. This forecast is predicated on continued well-anchored inflation expectations and the eventual appearance of a small amount of labor market slack. In addition, special factors such as rising energy prices and the sustained run-up in owners’ equivalent rent that have boosted inflation should ebb over time, contributing a bit to the expected decline in core inflation. In terms of risks to the outlook for growth, I still feel the presence of a 600-pound gorilla in the room, and that is the housing sector. The risk for further significant deterioration in the housing market, with house prices falling and mortgage delinquencies rising further, causes me appreciable angst. Indeed, the repercussions of falling house prices are already playing out in some areas where past price rises were especially rapid and subprime lending soared. For example, in the Sacramento metropolitan area east of San Francisco, house prices shot up at an annual rate of more than 20 percent from 2002 to 2005. Since then, however, they have been falling at an annual rate of 3½ percent. Delinquencies on subprime mortgages rose sharply last year, putting Sacramento at the top of the list of MSAs in terms of the changes in the rate of subprime delinquencies. Research by my staff examining metropolitan areas across the country indicates that the experience of Sacramento reflects a more general pattern. They found that low rates of house price appreciation, and especially house price decelerations, are associated with increases in delinquency rates even after controlling for local economic conditions such as employment growth and the unemployment rate. One possible explanation for these findings is that subprime borrowers, especially those with very low equity stakes, have less incentive to keep their mortgages current when housing no longer seems an attractive investment, either because prices have decelerated sharply or interest rates have risen. These results highlight the potential risks that rising defaults in subprime could spread to other sectors of the mortgage market and could trigger a vicious cycle in which a further deceleration in house prices increases foreclosures, in turn exacerbating downside price movements. The risks to inflation are also significant. In addition to the upside risks associated with continued tight labor markets, a slowdown in productivity growth could add to cost pressures. Although recent productivity data have been disappointing, I expressed some optimism at the last meeting about productivity growth on the grounds that at least some of the slowdown appeared to reflect labor hoarding and lags in the adjustment of employment to output, especially in the construction industry. Data since that meeting have reinforced my optimism concerning trend productivity growth. In particular, new data in the recently released Business Employment Dynamics report suggest that productivity growth may have been stronger than we have been thinking. This report, which includes data that will be used in the rebenchmarking of the payroll survey in January, shows a much smaller increase in employment in the third quarter of 2006 than is reported in the payroll survey; it, therefore, implies a larger increase in output per worker. A second risk to inflation is slippage in the market’s perceptions of our inflation objective. Although inflation compensation over the next five years is essentially unchanged since our last meeting, long-run breakeven inflation rates implied by the difference between nominal and indexed Treasury securities are up about 20 basis points. However, our analysis suggests that this increase reflects in good part an elevation in risk premiums or the influence of various—let me call them “idiosyncratic”—factors of the type that Bill Dudley mentioned, such as a possible shift in the demand by foreign central banks for Treasuries or special factors affecting the demand for inflation-indexed securities and not an increase in long-run inflation expectations. We base this conclusion on the fact that long-run breakeven inflation rates have also climbed in the United Kingdom—a country where inflation expectations have been remarkably well anchored over the past decade and where inflation has been trending downward. The fact that breakeven inflation rates rose in both countries, despite their different monetary policy regimes, suggests that a common explanation is needed rather than one specific to the United States. I think this conclusion is supported by the Board staff model that attributes about half of the movement in breakeven inflation to risk premiums. That said, our understanding and estimates of risk premiums are imprecise, so we must continue to monitor inflation expectations very carefully—of course, along with everything else. [Laughter]" CHRG-111shrg57319--105 Mr. Vanasek," I think they were very much a part of the problem. If you read Michael Lewis's book, as I understand you have, you will understand exactly how that worked. They sold, or they rated securities based on average FICO scores, credit scores. Everyone in the business knows that you can barbell a securitization in such a fashion to put 50 percent good loans and 50 percent higher-risk subprime loans in and you are still going to take an unbelievable beating. Senator Coburn. Mr. Cathcart, your comments on that? " CHRG-111hhrg53021Oth--52 Mr. Posey," You know better than me how cyclical they are--anyway, the next question is, we know, even in our districts, banks have money to lend, but they are not lending it. People have money to buy a new car, but they are not buying them. People have money to take a vacation, but they are not taking them. Consumer confidence isn't what we would like it to be, and the money is not getting spent. And, personally, I think it is because they don't know what is coming. The banks are afraid to loan it. They don't know what the next issue is going to be, and we are looking, really, kind of, for a plan. " CHRG-111hhrg53248--40 Mr. Bachus," And let me ask another question, but I think you have Fannie and the car companies are our biggest loss, looking to me, maybe AIG. You know, you are talking about the Capital Purchase Plan. The idea there was we put the money in the banks. They will lend it. You get a multiplier effect, and then it will pass through the economy, and I think a velocity is the economic term there. Of course they are holding on to it, but that is because of the capital requirements. They are restocking their capital. Some of them are lending it. But tell me why we didn't really see that multiplier effect? " CHRG-111hhrg53021--52 Mr. Posey," You know better than me how cyclical they are--anyway, the next question is, we know, even in our districts, banks have money to lend, but they are not lending it. People have money to buy a new car, but they are not buying them. People have money to take a vacation, but they are not taking them. Consumer confidence isn't what we would like it to be, and the money is not getting spent. And, personally, I think it is because they don't know what is coming. The banks are afraid to loan it. They don't know what the next issue is going to be, and we are looking, really, kind of, for a plan. " CHRG-110shrg50414--80 Secretary Paulson," I would say, regrettably, there is not every homeowner that is going to save their home. As you well know, even in normal times, in good times, there are many foreclosures. There are some people that cannot afford to stay in their home. But there is a huge effort being made so that everyone that can afford to stay in the home and want to stay in the home stays in the home. But what this plan will do is make financing available. And I do not think there is anything more important. Lenders have got to keep lending. If they are not lending and there is not capital available, homeowners are not going to be able to stay in the home. " CHRG-111hhrg52407--38 Mr. Hensarling," But it doesn't trouble you that this particular commission could have that power without any review. So you would be trusting that simply wouldn't happen. How about with respect to payday lending, which is controversial within a number of areas and communities? It seems among some disadvantaged and low-income communities, some believe they serve a valuable purpose; other people, frankly, would like to see them banned. I don't know what the position of La Raza is. But would it trouble you if this particular panel decided to ban all payday lending as inherently ``unfair'' or ``anti-consumer?'' " FinancialCrisisInquiry--478 BASS: When you look back—Mr. Mayo talked about loan growth doubling that of GDP growth. When you look back at the housing market—and you can go back through OFHEO’s raw data, all the way back to about I think it’s 1971, you look, you can go back and plot the housing price appreciation x inflation and chart that against median income. January 13, 2010 It only makes sense that as income moves up, housing prices should be able to move up in a perfectly parallel fashion—you make a little bit more money, you can afford a little bit more house. Those lines were parallel for the good part of 40 years. And what happened in 2001, when Dr. Greenspan traded the dot.com bust for the housing boom, he lowered rates down to 1 percent. He made money free, and encouraged all of the lending possible to try to restart the economy after the dot.com bust. I simply think he did a bad job. Other people think he did a great job. But I think that he enabled this housing market. So when you started seeing rates—rates started—they started raising rates in 2004? When rates started to be—started an increasing path, you saw prime mortgage origination in 2004 drop 50 percent. That just makes sense. Everybody refinanced their homes that could. Everyone got reset and settled, but subprime origination in 2004 doubled. And then it doubled again in ‘05, as prime originations fell off a cliff because rates were moving up. So what happened is Wall Street had these machines built to manufacture mortgages. We wanted affordable housing, so they could lower rates with exotic mortgages. And what you saw from 2001 on is you saw those two parallel lines, home price—median home price and median income—diverge. And not only did they diverge by—for those of you that are statisticians, it was an eight standard deviation divergence. OK? That doesn’t happen very often. I know we talk about once-in-a- lifetime calamities every 10 years, that one just hasn’t happened. FOMC20081216meeting--438 436,MR. LACKER.," So if spreads close in the marketplace, then they get the upside--so we are essentially lending to them to make a leveraged bet on the securities. " CHRG-111shrg57321--161 Mr. McDaniel," Thank you, Mr. Chairman and Senator Kaufman. I am Ray McDaniel, Chairman and CEO of Moody's Corporation, the parent of the credit rating agency Moody's Investor Service. I want to thank you for the opportunity to contribute Moody's views today.--------------------------------------------------------------------------- \1\ The joint prepared statement of Mr. McDaniel and Ms. Yoshizawa appears in the Appendix on page 186.--------------------------------------------------------------------------- The global financial crisis has sparked a necessary debate about the role and performance of numerous participants in the financial markets. With respect to credit rating agencies, many market observers have expressed concerns that ratings did not better predict the deteriorating conditions in the subprime mortgage market. Let me assure you that Moody's is not satisfied, and I am not satisfied, with the performance of our ratings during the unprecedented market downturn of the past 2 years. We did not anticipate the extraordinary confluence of forces that drove the unusually poor performance of subprime mortgages. We were not alone in this regard, but I believe that we should be at the leading edge for predictive opinions about credit risk. Some key issues influencing the unanticipated performance included the steep and sudden nationwide decline in home prices and the sharp contraction that followed in credit available from banks for mortgage refinancing. Moody's did observe a trend of loosening mortgage underwriting and escalating home prices. We highlighted that trend in our reports and incorporated it into our analysis of mortgage-backed securities. And, as conditions in the U.S. housing market began to deteriorate beyond our expectations, we took the rating actions that we believed at the time were appropriate based on the information we had. Let me summarize our actions during the 2003 to 2007 time frame. First, starting in 2003, we identified and began commenting on the loosening of underwriting standards and escalating housing prices through our sector publications. Second, we tightened our ratings criteria in response to these loosening standards. In fact, between 2003 and 2006, we steadily increased our loss expectations and the levels of credit protection required for a given rating level. In practical terms, this meant that by 2006, half the mortgages in a pool would have to default and provide a recovery of just half the appraised value of the home before a subprime RMBS bond rated AAA by Moody's would suffer its first dollar of loss. This is a level of anticipated loss that far exceeded the losses that actually occurred in the past four real estate recessions. But even these conservative assumptions proved insufficient. Third, we took steps to watch and analyze the unprecedented market conditions and the behavior of various market participants as the crisis continued to unfold. For example, one question before the market was how borrowers, servicers, and banks would respond to the resetting of mortgage interest rates and how that behavior would affect default rates. Faced with extraordinary conditions, we saw market participants, including borrowers, mortgage servicers, mortgage originators, and the Federal Government, behave in historically unprecedented ways. Fourth, we took rating actions when the mortgage performance data warranted. Moody's monitors the actual performance of the mortgages and the securities that we rate throughout the life of the security. The early performance of the 2006 loans was, in fact, comparable to the performance of similar subprime loans during the 2000 and 2001 recession. And not until performance data from the second quarter of 2007 was available did it become clear that many of the 2006 vintage bonds might perform worse than those from the prior recession. In short, Moody's did see the loosening of some prime lending standards. We reported our observations to the market and we incorporated our increasingly unfavorable views into the ratings we assigned. However, let me emphasize again that we, like most other market participants, did not anticipate the severity or the speed of deterioration that occurred in the U.S. housing market, nor did we anticipate the behavior of market participants in response to the housing downturn, including the speed of credit tightening by financial institutions that followed and exacerbated the situation. The unprecedented events of the last few years provide critical lessons to all market participants, certainly including us. At Moody's over the past 2 years, we have undertaken a wide range of initiatives to strengthen the quality, transparency, and independence of our ratings. Some of these measures include establishing common macroeconomic scenarios for rating committees, publishing volatility scores and sensitivity analysis on structured finance securities, consolidating surveillance activities and structured finance under one leadership, and further bolstering the independence of and resources for our credit policy function. Moody's is firmly committed to meeting the highest standards of integrity in our rating practices. We wholeheartedly support constructive reforms and we are eager to work with Congress, regulators, and other market participants to that end. I am happy to respond to your questions. Senator Levin. Thank you very much, Mr. McDaniel. Ms. Corbet. TESTIMONY OF KATHLEEN A. CORBET,\1\ FORMER PRESIDENT (2004- 2007), STANDARD AND POOR'S Ms. Corbet. Thank you, Mr. Chairman and Senator Kaufman.--------------------------------------------------------------------------- \1\ The prepared statement of Ms. Corbet appears in the Appendix on page 210.--------------------------------------------------------------------------- My name is Kathleen Corbet and my career spans over 25 years of experience within the financial services industry. For a 3-year period during my career, I served as President as Standard and Poor's, a division of the McGraw-Hill Companies, from April 2004 until my voluntary departure in September 2007. Before turning to the substantive issues raised by the Subcommittee's investigation, I would like to acknowledge the important work of the Subcommittee and Congress more broadly in its examination of the causes and consequences of the financial crisis. It is difficult not to feel personally touched by the pain experienced by many as a result of the turmoil in the subprime market and the financial crisis that followed. Many people feel anger, and in my view, that anger is understandable. Accordingly, I believe strongly that we should collectively use the lessons from this crisis to focus on effective reforms, stronger investor protections, better industry practices, and accountability. As background, I was recruited to join the McGraw-Hill Companies as an Executive Vice President of its Financial Services Division in April 2004 and served as President of Standard and Poor's until my successor, Deven Sharma, took over that position in September 2007. During my 3-year tenure, I led an organization of 8,000 employees based in 23 countries which provided financial information and market analysis to its customers and the broader market as a whole. The company was organized across four primary business units, including Rating Services, Equity Research Services, Index Services, and Data and Information Services. Each business unit was led by a seasoned executive having direct operating responsibility in the respective area and reporting directly to me. One of those units was Rating Services, which issued credit ratings on hundreds of thousands of securities across the globe, including corporate securities, government securities, and structured finance securities. Rating Services was led by an Executive Vice President for Ratings, an executive with over 30 years of experience in the ratings business, who had day-to-day operational responsibility for that business. Among her direct reports was the Executive Managing Director of Structured Finance Ratings, who was responsible for the day-to-day operations of the Structured Finance Ratings Group, the group that issued the ratings that are the subject of this Subcommittee's focus. Consistent with S&P's longstanding and publicly disclosed practice, ratings decisions were and are solely the province of committees comprised of experienced analysts in the relevant area. This practice is based on the principle that the highest quality analysis comes from the exercise of independent analytical judgment free from both undue external or internal pressure. Accordingly, during my tenure, I did not participate in any rating or analytical criteria committee meetings regarding ratings on any type of security, including mortgage-backed securities. All that said, I do hope to be able to provide a business perspective that is helpful to the Subcommittee, and in my view, it is clear that many of the ratings S&P issued on securities backed by subprime mortgages have performed extremely poorly. S&P has publicly stated its profound disappointment with that performance, and I deeply share that sentiment. From my personal perspective, I believe the primary reason for these downgrades is that, despite its efforts to get the rating right and despite rooting its analysis in historical data, S&P's assumptions did not capture the unprecedented and unexpected outcomes that later occurred with respect to the housing market, borrower behavior and credit correlations. S&P, along with others, has been criticized for its failure to predict what happened in the subprime market, and in many ways, that criticism is justifiable. Moreover, the subsequent outcome of the severe economic downturn and downgrades of securities backed by subprime mortgages highlight the challenges inherent in the nature of ratings. At their core, ratings are opinions about what may happen in the future, specifically, the likelihood that a particular security may default. I think that most people agree that predicting the future is always challenging and outcomes can often turn out very differently than even the most carefully derived predictions anticipate. The key from my perspective is to learn from these experiences and to take specific actions to improve. The credit rating industry has begun to respond in a constructive fashion, but there is much more to be done. Through the course of history and through many market cycles, the credit rating industry has played an important role in the financial system for nearly a century, and I do believe that it has the opportunity to continue to do so through the commitment to continual improvements and from appropriate regulatory reform. Again, I appreciate the goals of the Subcommittee's work and would be glad to answer any questions that you have. Senator Levin. Thank you, Ms. Corbet. Thank you both. Before we start with questions, let me put into the record a statement of the Attorney General of the State of Connecticut, Richard Blumenthal. He has made a very powerful statement about the topic of the hearing today, which is ``Wall Street and the Financial Crisis: The Role of Credit Rating Agencies,'' and that will be made part of the record at an appropriate place.\1\--------------------------------------------------------------------------- \1\ The prepared statement of Mr. Blumenthal appears in the Appendix as Exhibit 109, on page 1201.--------------------------------------------------------------------------- Were you both here earlier? Ms. Corbet. Yes, I was. Senator Levin. Mr. McDaniel, were you here, too? " CHRG-111hhrg74090--38 Mrs. Matsui," Thank you, Mr. Chairman, and thank you for calling today's hearing. I applaud your leadership in addressing this important issue. I would also like to thank the witnesses for joining us today. In today's economic recession, many families in home district of Sacramento are struggling to make ends meet. I have heard countless stories of people struggling to keep their homes, their jobs and their way of life. California and in particular my constituents in Sacramento have been greatly impacted by the economic crisis. Many of my constituents were and continue to be victims of predatory home loan lending, unfair credit card practices, payday loans and other forms of unscrupulous business practices. Just recently, the President signed into law credit card reform legislation to regulate unfair credit card practices. The ink is hardly dry. The companies are already trying to find ways to arbitrarily raise credit card interest rates and fees on consumers. Struggling homeowners are also seeking assistance to keep their homes but continue to be tricked into contacting scam artists who just so happen to be the same crowd that initially steered homeowners into subprime loans. This is also occurring as job losses mount, foreclosures continue to rise and Americans are increasingly turning to other forms of credit to make ends meet. It is clear that consumers are not being properly protected from unfair and deceptive financial practices. When is enough enough? The President's proposal to create a new financial consumer protection agency could be the answer that American consumers are seeking but it must be done in a thoughtful way to ensure consumers are protected from fraudulent activity. We must make sure any new agency has real authority and just as much bite as it has bark. Consumers need to feel protected and have confidence in our financial system. Right now it is clear that they do not. I thank you, Mr. Chairman, for holding this important hearing today and I look forward to working with you and the committee on this issue moving forward. I yield back the balance of my time. " FinancialCrisisInquiry--658 VICE CHAIRMAN THOMAS: Ms. Gordon, in terms of your Center for Responsible Lending, do you deal with folks with credit cards as well? CHRG-111hhrg56766--45 Mr. Bernanke," I think one set of tools that we have that we continue to work on as regulators is to try to get credit flowing again. We know that small business lending is closely tied to job creation. We know there are problems with bank lending to small businesses. I do not know if you want me to take your time to go through some of these things, but we are collecting more information. We are doing more consulting. We are trying to train our examiners. We are trying to do everything we can to make sure that creditworthy small businesses can get credit and banks would be willing to take a second look at small businesses to make sure they have access to credit. " FOMC20070321meeting--51 49,MR. DUDLEY.," It’s hard to know how connected the subprime market and the stock market have been in the past month or two. Clearly, people are nervous about the positive feedback loops of less mortgage origination leading to less housing demand leading to lower home prices leading to a weaker economy—and then that feeding into corporate earnings and disappointments on the corporate earnings side. I don’t think any of us knows exactly how powerful those linkages are, but that’s probably at least one element that equity investors are worried about." FinancialCrisisReport--155 When WaMu failed, shareholders lost all of their investments. Yet in the waning days of the company, top executives were still well taken care of. On September 8, 2008, Mr. Killinger walked away with $25 million, including $15 million in severance pay. His replacement, Allen Fishman, received a $7.5 million signing bonus for taking over the reins from Mr. Killinger in September 2008. 579 Eighteen days later, WaMu failed, and Mr. Fishman was out of a job. According to his contract, he was eligible for about $11 million in severance pay when the bank failed. 580 It is unclear how much of the severance he received. G. Preventing High Risk Lending Washington Mutual was a $300 billion, 120-year-old financial institution that was destroyed by high risk lending practices. By 2007, stated income loans – loans in which Washington Mutual made no effort to verify the borrower’s income or assets – made up 50% of its subprime loans, 73% of its Option ARMs, and 90% of its home equity loans. Nearly half of its loans were Option ARMs of which 95% of the borrowers were making minimum payments and 84% were negatively amortizing. Numerous loans had loan-to-value ratios of over 80%, and some provided 100% financing. Loans issued by two high volume loan offices in the Los Angeles area were found to have loan fraud rates of 58, 62, and even 83%. Loan officer sales assistants were manufacturing borrower documentation. The bank’s issuance of hundreds of billions of dollars in high risk, poor quality loans not only destroyed confidence in the bank, but also undermined the U.S. financial system. The consequences of WaMu’s High Risk Lending Strategy and the proliferation of its RMBS structured finance products incorporating high risk, poor quality loans provide critical lessons that need to be learned to protect the U.S. financial system from similar financial disasters. A number of developments over the past two years hold promise in helping to address many of the problems identified in the Washington Mutual case history. (1) New Developments The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), P.L. 111-203, which the President signed into law on July 21, 2010, contains a number of changes in law that will be implemented over the course of 2011. The Dodd-Frank Act changes 577 7/16/2008 email from Kerry Killinger, JPM_WM01240144, Hearing Exhibit 4/13-66. 578 See, e.g., “Shareholders Score at WaMu,” Bloomberg BusinessWeek (4/15/2008) (“And perhaps most notable: WaMu reversed a much-criticized decision to leave out the company’s mortgage related losses when calculating profits that determine executive bonuses for the year ahead.”). 579 “WaMu Creditors could Challenge Payments to Killinger, Others,” Seattle Times (10/1/2008), Hearing Exhibit 4/13-68. 580 “WaMu CEO: 3 Weeks Work, $18M,” CNNMoney.com (9/26/2008). include banning stated income loans; restricting negative amortization loans; requiring lenders to retain an interest in high risk loan pools that they sell or securitize; prohibiting lenders from steering borrowers to poor quality, high risk loans; and re-evaluating the role of high risk, structured finance products in bank portfolios. fcic_final_report_full--569 Chapter 5 1. Gail Burks, written testimony for the FCIC, Hearing on the Impact of the Financial Crisis—State of Nevada, session 3: The Impact of the Financial Crisis on Nevada Real Estate, September 8, 2010, p. 3. 2. Tom C. Putnam, president, Putnam Housing Finance Consulting, written testimony for the FCIC, Hearing on the Impact of the Financial Crisis—Sacramento, session 2: Mortgage Origination, Mortgage Fraud and Predatory Lending in the Sacramento Region, September 23, 2010, pp. 3–4. 3. Board of Governors of the Federal Reserve System, Federal Reserve Statistical Release Z.1: Flow of Funds Accounts of the United States, release date, December 9, 2010, Table L.1: Credit Market Debt Out- standing, and Table L.126: Issuers of Asset-Backed Securities (ABS) 4. Jim Callahan, interview by FCIC, October 18, 2010. 5. Lewis Ranieri, former vice chairman of Salomon Brothers, interview by FCIC, July 30, 2010. 6. Federal Deposit Insurance Corporation, “Managing the Crisis: The FDIC and RTC Experience” (August 1998), pp. 29, 6–7, 407–8, 38. 7. Ibid., 417. 8. Ibid., pp. 9, 32, 36, 48 9. The figures throughout this discussion of CMLTI 2006-NC2 are FCIC staff calculations, based on analysis of loan-level data from Blackbox Inc. and Standard & Poor’s; Moody’s PDS database; Moody’s CDO EMS database; and Citigroup, Fannie Mae Term Sheet, CMLTI 2006-NC2, September 7, 2006, pp. 1, 3. See also Brad S. Karp, counsel for Citigroup, letter to FCIC, November 4, 2010, p. 1, pp. 2–3. All rat- ings of its tranches are as given by Standard & Poor’s. 10. Technically, this deal had two unrated tranches below the equity tranche, also held by Citigroup and the hedge fund. 11. Fed Chairman Ben S. Bernanke, “The Community Reinvestment Act: Its Evolution and New Challenges,” speech at the Community Affairs Research Conference, Washington, D.C., March 30, 2007. 12. Ibid. 13. See Glenn Canner and Wayne Passmore, “The Community Reinvestment Act and the Profitability of Mortgage-Oriented Banks,” Working Paper, Federal Reserve Board, March 3, 1997. Under the Com- munity Reinvestment Act, low- and moderate-income borrowers have income that is at most 80% of area median income. 14. Fed Chairman Alan Greenspan, “Economic Development in Low- and Moderate-Income Com- munities,” speech at Community Forum on Community Reinvestment and Access to Credit: California’s Challenge, in Los Angeles, January 12, 1998. 15. John Dugan, interview by FCIC, March 12, 2010. 16. Lawrence B. Lindsey, interview by FCIC, September 20, 2010. 17. Souphala Chomsisengphet and Anthony Pennington-Cross, “The Evolution of the Subprime Mortgage Market,” Federal Reserve Bank of St. Louis Review 88, no. 1 (January/February 2006): 40 18. Southern Pacific Funding Corp, Form 8-K, September 14, 1998 19. The top 10 list is as of 1996, according to FCIC staff calculations using data from the following sources: Inside Mortgage Finance, The 2009 Mortgage Market Statistical Annual, vol. 1, The Primary Mar- ket (Bethesda, Md.: Inside Mortgage Finance Publications, 2009), p. 214, “Top 25 B&C Lenders in 1996”; Thomas E. Foley, “Alternative Financial Ratios for the Effects of Securitization: Tools for Analysis,” Moody’s Investor Services, September 19, 1997, p. 5; and Moody’s Investor Service, “Subprime Home Eq- uity Industry Outlook—The Party’s Over,” Moody’s Global Credit Research, October 1998. 20. “FDIC Announces Receivership of First National Bank of Keystone, Keystone, West Virginia,” Federal Deposit Insurance Corporation and Office of the Comptroller of the Currency joint press release, September 1, 1999. 21. FCIC staff calculations using data from Inside MBS & ABS . 22. See Marc Savitt, interview by FCIC, November 17, 2010. 23. Henry Cisneros, interview by FCIC, October 13, 2010. 24. Glenn Loney, interview by FCIC, April 1, 2010. 25. Senate Committee on Banking, Housing, and Urban Affairs, The Community Development, Credit Enhancement, and Regulatory Improvement Act of 1993, 103rd Cong., 1st sess., October 28, 1993, S. Rep. 103–169, p. 18. 26. Ibid., p. 19. 27. 15 U.S.C. § 1639(h) 2006. 28. Loans were subject to HOEPA only if they hit the interest rate trigger or fee trigger: i.e., if the an- nual percentage rate for the loan was more than 10 percentage points above the yield on Treasury securi- ties having a comparable maturity or if the total charges paid by the borrower at or before closing exceeded $400 or 8% of the loan amount, whichever was greater. See Senate Committee on Banking, Housing, and Urban Affairs, S. Rep. 103–169, p. 54. 29. Ibid., p. 24. 30. Board of Governors of the Federal Reserve System and Department of Housing and Urban Devel- opment, “Joint Report Concerning Reform to the Truth in Lending Act and the Real Estate Settlement Procedures Act” (July 1998), p. 56. 31. Griffith L. Garwood, director, Division of Consumer and Community Affairs, Board of Gover- nors of the Federal Reserve System, “To the Officers and Managers in Charge of Consumer Affairs Ex- amination and Consumer Complaint Programs,” Consumer Affairs Letter CA 98–1, January 20, 1998 32. GAO, “Large Bank Mergers: Fair Lending Review Could Be Enhanced with Better Coordination,” GAO/GGD-00–16 (Report to the Honorable Maxine Waters and the Honorable Bernard Sanders, House of Representatives), November 1999, p. 20. 33. Fed and HUD, “Joint Report,” pp. I–XXVII. 34. Griffith L. Garwood, director, Division of Consumer and Community Affairs, Board of Gover- nors of the Federal Reserve System, memorandum to the Committee on Consumer and Community Af- fairs, “Memorandum concerning the Board’s Report to the Congress on the Truth in Lending and Real Estate Settlement Procedures Acts,” April 8, 1998, p. 42. 35. Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, Office of the Comptroller of the Currency, and Office of Thrift Supervision, “Interagency Guidance on Sub- prime Lending” (March 1, 1999), p. 1 36. Ibid., pp. 1–7; quotation, p. 5. 37. U.S. Department of the Treasury and U.S. Department of Housing and Urban Development, “Curbing Predatory Home Lending” (June 1, 2000), pp. 13–14, 1–2, 81 (quotations, 2, 1–2). 38. Gail Burks, president and chief executive officer, Nevada Fair Housing Center, Inc., testimony be- fore the FCIC, Hearing on the Impact of the Financial Crisis—State of Nevada, session 3: The Impact of the Financial Crisis on Nevada Real Estate, September 8, 2010, transcript, p. 242–43.See also Kevin Stein, associate director, California Reinvestment Coalition, written testimony for the FCIC, Hearing on the Impact of the Financial Crisis—Sacramento, session 2: Mortgage Origination, Mortgage Fraud and Predatory Lending in the Sacramento Region, September 23, 2010, pp. 8–9. See also his testimony at the same hearing, transcript, pp. 73–74. See Diane E. Thompson, of counsel, National Consumer Law Cen- ter, Inc., and Margot F. Saunders, of counsel, National Consumer Law Center, Inc., interview by FCIC, September 10, 2010. 39. Diane E. Thompson and Margot F. Saunders, both of counsel, National Consumer Law Center, in- terview by FCIC, September 10, 2010. 40. Gary Gensler, interview by FCIC, May 14, 2010. 41. Sheila Bair, testimony before the FCIC, First Public Hearing of the FCIC, day 2, panel 1: Current Investigations into the Financial Crisis—Federal Officials, January 14, 2010, transcript, p. 97. 42. Sheila Bair, interview by FCIC, March 29, 2010. 43. Sandra F. Braunstein, interview by FCIC, April 1, 2010, pp. 31–34. 44. Bair, interview. 45. Treasury and HUD, “Curbing Predatory Home Lending,” p. 31. CHRG-111hhrg50289--90 Chairwoman Velazquez," Thank you, Mr. Bofill. I just would like to address my first question to all the members of the panel. You were sitting there and you were listening to the previous witnesses, basically those representing financial services, banks and the credit unions, and what they are saying is that they have money to lend, and that by some metrics have actually increased their loans. And what I hear from you today, from this panel, is that that is not the experience that you have had. My question is do you think that the SBA should play a more direct role in small business lending either by refinancing non-SBA loans or making direct loans that could be sold to lenders? Any of the members of the panel, for any of the witnesses. Yes, Mr. Watters. " fcic_final_report_full--491 There were subprime loans and subprime lenders, but in the early 1990s subprime lenders were generally niche players that made loans to people who could not get traditional mortgage loans; the number of loans they generated was relatively small and bore higher than normal interest rates to compensate for the risks of default. In addition, mortgage bankers and others relied on FHA insurance for loans with low downpayments, impaired credit and high debt ratios. Until the 1990s, these NTMs were never more than a fraction of the total number of mortgages outstanding. The reason that low underwriting standards were not generally used is simple. Low standards would result in large losses when these mortgages defaulted, and very few lenders wanted to hold such mortgages. In addition, Fannie and Freddie were the buyers for most middle class mortgages in the United States, and they were conservative in their approach. Unless an originator made a traditional mortgage it was unlikely that Fannie or Freddie or another secondary market buyer could be found for it. This is common sense. If you produce an inferior product—whether it’s a household cleaner, an automobile, or a loan—people soon recognize the lack of quality and you are out of business. This was not the experience with mortgages, which became weaker and riskier as the 1990s and 2000s progressed. Why did this happen? In its report, the Commission majority seemed to assume that originators of mortgages controlled the quality of mortgages. Much is made in the majority’s report of the so-called “originate to distribute” idea, where an originator is not supposed to care about the quality of the mortgages because they would eventually be sold off. The originator, it is said, has no “skin in the game.” The motivation for making poor quality mortgages in this telling is to earn fees, not only on the origination but in each of the subsequent steps in the securitization process. This theory turns the mortgage market upside down. Mortgage originators could make all the low quality mortgages they wanted, but they wouldn’t earn a dime unless there was a buyer . The real question, then, is why there were buyers for inferior mortgages and this, as it turns out, is the same as asking why mortgage underwriting standards, beginning in the early 1990s, deteriorated so badly. As Professor Raghuram Rajan notes in Fault Lines , “[A]s brokers came to know that someone out there was willing to buy subprime mortgage-backed securities without asking too many questions, they rushed to originate loans without checking the borrowers’ creditworthiness, and credit quality deteriorated. But for a while, the problems were hidden by growing house prices and low defaults—easy credit masked the problems caused by easy credit—until house prices stopped rising and the flood of defaults burst forth.” 60 Who were these buyers? Table 1, reporting the number of NTMs outstanding on June 30, 2008, identified government agencies and private organizations required by the government to acquire, hold or securitize NTMs as responsible for two-thirds 60 Raghuram G. Rajan, Fault Lines , p.44. 487 of these mortgages, about 19 million. The table also identifies the private sector as the securitizer of the remaining one-third, about 7.8 million loans. In other words, if we are looking for the buyer of the NTMs that were being created by originators at the local level, the government’s policies would seem to be the most likely culprit. The private sector certainly played a role, but it was a subordinate one. Moreover, what the private sector did was respond to demand—that’s what the private sector does—but the government’s role involved deliberate policy, an entirely different matter. Of its own volition, it created a demand that would not otherwise have been there. CHRG-111shrg57319--502 Mr. Killinger," Well, again, I don't have all the intimate knowledge, but I do know, because I followed what the bulk of the FICO scores were for our portfolios, and, for example, our Option ARM portfolio had an average FICO score slightly above 700. Our home equity was slightly above 730. And our other--prime residential, I think, was about 718 or so in that range. And I think in the case of Long Beach or the subprime portfolio we held in portfolio, it was somewhere in the mid-600s. Senator Kaufman. Now, you understand the problem with using averages, right? " CHRG-111shrg57322--729 Mr. Viniar," For most of that year, there was a lot of bullishness still in the market---- Senator Kaufman. Right. Mr. Viniar [continuing]. Other than the subprime mortgage market. Senator Kaufman. Right. But you could have sold the long, dealt with it that way, without going short. And the reason I think we all keep coming back to this is because it really is hard for me to see--I mean, there is a clear conflict of interest, right, when you have a client out there in a position that you put him in and you are at the same time selling that position short. I am not saying it is bad. I am just saying it is a conflict of interest, isn't it? " CHRG-111hhrg54872--36 The Chairman," Next, we will hear from Janice Bowdler, who is the senior policy analyst at the National Council of La Raza. STATEMENT OF JANIS BOWDLER, DEPUTY DIRECTOR, WEALTH-BUILDING POLICY PROJECT, NATIONAL COUNCIL OF LA RAZA (NCLR) Ms. Bowdler. Good morning. Thank you. I would like to thank Chairman Frank and Ranking Member Bachus for inviting NCLR to share perspective on this issue. Latino families have been particularly hard hit by the implosion of our credit markets. Lax oversight allowed deceptive practices to run rampant, driving Latino families into risky products and ultimately cyclical debt. In fact, Federal regulators routinely missed opportunities to correct the worst practices. Congress must plug holes in a broken financial system that allowed household wealth to evaporate and debt to skyrocket. Today, I will describe the chief ways our current regulatory system falls short, and I will follow with a few comments on the CFPA. Most Americans share a fundamental goal of achieving economic security they can share with their children. To do so, they rely on financial products--mortgages, credit cards, car loans, insurance, and retirement accounts. Unfortunately, market forces have created real barriers to accessing the most favorable products, even when families are well-qualified. Subprime creditors frequently targeted minority communities as fertile ground for expansion. Subprime lending often served as a replacement of prime credit, rather than a complement. With much of the damage coming at the hands of underregulated entities, gaming of the system became widespread. Despite the evidence, Federal regulators failed to act. This inaction hurt the Latino community in three distinct ways. Access to prime products was restricted, even when borrowers had good credit and high incomes. This most often occurred because short-term profits were prioritized over long-term gains. Lenders actually steered borrowers into costly and risky loans, because that is what earned the highest profits. Disparate impact trends were not acted upon. Numerous reports have documented this trend. In fact, a study conducted by HUD in 2000 found that high-income African Americans, living in predominantly black neighborhoods, were 3 times more likely to receive subprime home loans than low-income white borrowers. Regulators failed to act, even when Federal reports made the case. And shopping for credit is nearly impossible. Financial products have become increasingly complex, and many consumers lack reliable information. Many chose to pay a broker to help them shop. Meanwhile, those brokers have little or no legal or ethical obligation to actually work on behalf of the borrower. Regulators dragged their feet on reforms that could have improved shopping opportunities. If our goal is to truly avoid the bad outcomes in the future, the high rates of foreclosure and household debt, little or no savings and the erosion of wealth, we have to change the Federal oversight system. Lawmakers must ensure that borrowers have the opportunity to bank and borrow at fair and affordable terms. We need greater accountability and the ability to spot damaging trends before they escalate. Some have argued that it is the borrower's responsibility to look out for deception. However, it is unreasonable to expect the average family to regulate the market and in effect to do what the Federal Reserve did not. The proposed CFPA is a strong vehicle that could plug the gaps in our regulatory scheme. In particular, we commend the committee for including enforcement of fair lending laws in the mission of the agency. This, along with the creation of the Office of Fair Lending and Equal Opportunity, will ensure that the agency also investigates harmful trends in minority communities. This is a critical addition that will help Latino families. We also applaud the committee for granting the CFPA strong rule-writing authority. This capability is fundamental to achieving its mission. Also, we were pleased to see that stronger laws are not preempted. This will ensure that no one loses protection as a result of CFPA action. As the committee moves forward, these provisions should not be weakened. And I will close just by offering a few recommendations of where we think it could be strengthened. A major goal of CFPA should be to improve access to simple prime products. Obtaining the most favorable credit terms for which you qualify is important to building wealth. This includes fostering product innovation to meet the needs of underserved communities. We need to eliminate loopholes for those that broker financing, and for credit bureaus. Real estate agents, brokers, auto dealers, and credit bureaus should not escape greater accountability. And we need to reinstate a community-level assessment. Without it, good products may be developed but will remain unavailable in entire neighborhoods. Including CRA in the CFPA will give the agency the authority necessary to make such an assessment. Thank you. And I would be happy to answer any questions. [The prepared statement of Ms. Bowdler can be found on page 66 of the appendix.] Ms. Waters. [presiding] Ms. Burger is recognized for 5 minutes. STATEMENT OF ANNA BURGER, SECRETARY-TREASURER, SERVICE EMPLOYEES INTERNATIONAL UNION (SEIU) Ms. Burger. On behalf of the 2.1 million members of SEIU and as a coalition member of the Americans for Financial Reform, I want to thank Chairman Frank, Ranking Member Bachus, and the committee members for their continued work to reform our broken financial system. It has been a year since the financial world collapsed, showing us that the action of a few greedy players on Wall Street can take down the entire global economy. As we continue to dig out of this crisis, we have an historic opportunity and a responsibility to reform the causes of our continued financial instability, and protect consumers from harmful and often predatory practices employed by banks to rake in billions and drive consumers into debt. The nurses, the childcare providers, janitors, and other members of SEIU continue to experience the devastating effects of the financial crisis firsthand. Our members and their families are losing their jobs, homes, health care coverage, and retirement savings. As State and local governments face record budget crises, public employees are losing their jobs and communities are losing vital services. And we see companies forced to shut their doors as banks refuse to expand lending and call on lines of credit. At the same time, banks and credit card companies continue to raise fees and interest rates and refuse to modify mortgages and other loans. We know the cause of our current economic crisis. Wall Street, big banks, and corporate CEOs created exotic financial deals, and took on too much risk and debt in search of outrageous bonuses, fees, and unsustainable returns. The deals collapsed and taxpayers stepped in to bail them out. According to a recent report released by SEIU, once all crisis-related programs are factored in, taxpayers will be on the hook for up to $17.9 trillion. And I would like to submit the report for the record. The proliferation of inappropriate and unsustainable lending practices that has sent our economy into a tailspin could and should have been prevented. The regulators' failure to act, despite abundance of evidence of the need, highlights the inadequacies of our current regulatory system in which none of the many financial regulators regard consumer protection as a priority. We strongly support the creation of a single Consumer Financial Protection Agency to consolidate authority in one place, with the sole mission of watching out for consumers across all financial services. I want to thank Chairman Frank for his work to strengthen the Proposed Consumer Financial Protection Agency language, particularly the strong whistle-blower protections. We believe to be successful, the CFPA legislation must include a scope that includes all consumer financial products and services; sovereign rulemaking and primary enforcement authority; independent examination authority; Federal rules that function as a floor, not a ceiling; the Community and Reinvestment Act funding that is stable and does not undermine the agency's independence from the industry; and strong whistle-blower and compensation protections. We believe independence, consolidated authority, and adequate power to stop unfair, deceptive, and abusive practices are key features to enable the CFPA to serve as a building block of comprehensive financial reforms. Over the past year, we have also heard directly from frontline financial service workers about their working conditions and industry practices. We know from our conversations that existing industry practices incentivize frontline financial workers to push unneeded and often harmful financial products on consumers. We need to ban the use of commissions and quotas that incentivize rank-and-file personnel to act against the interest of consumers in order to make ends meet or simply keep their job. The CFPA is an agency that can create this industry change. Imagine if these workers were able to speak out about practices they thought were deceptive and hurting consumers, the mortgage broker forced to meet a certain quota of subprime mortgages, or the credit card call center worker forced to encourage Americans to take on debt that they cannot afford and then they threaten and harass them when they can no longer make their payments, or the personal banker forced to open up accounts of people without their knowledge. Including protection and a voice for bank workers will help rebuild our economy today and ensure our financial systems remain stable in the future. Thank you for the opportunity to speak this morning. The American people are counting on this committee to hold financial firms accountable and put in place regulations that prevent crises in the future. Thank you. Ms. Waters. Thank you very much. [The prepared statement of Ms. Burger can be found on page 74 of the appendix.] Ms. Waters. I will recognize myself for 5 minutes. And I would like to address a question to Mr. David C. John, senior research follow, Thomas A. Roe Institute for Economic Policy Studies, The Heritage Foundation. I thank you for participating and for the recommendation that you have given, an alternative to the Consumer Financial Protection Agency. You speak of the consumer protection agency as a huge bureaucracy that would be set up, that would harm consumers, rather than help consumers, and you talk about your council as a better way to approach this with lots of coordination and outside input. It sounds as if you are kind of rearranging the chairs. Basically, what you want to do is leave the same regulatory agencies in place who had responsibility for consumer protection but did not exercise that responsibility. Why should the American public trust that, given this meltdown that we have had, this crisis that has been created, that the same people who had the responsibility are now going to see the light and they are going to do a better job than starting anew with an agency whose direct responsibility is consumer protection? " FinancialCrisisReport--113 So we come down to the basic question, is this the time to expand beyond the ’05 Plan and/or to expand into new categories of higher risk assets? For my part I think not. We still need to complete EDE [Enterprise Decision Engine, an automated underwriting system], reduce policy exception levels, improve the pricing models, build our sub-prime collection capability, improve our modeling etc. We need to listen to our instincts about the overheated housing market and the likely outcome in our primary markets. We need to build further credibility with the regulators about the control exercised over our SFR underwriting and sub-prime underwriting particularly in LBMC.” 393 Mr. Vanasek retired in December 2005, in part, because the management support for his risk policies and culture was lacking. 394 When Mr. Vanasek left WaMu, the company lost one of the few senior officers urging caution regarding the high risk lending that came to dominate the bank. After his departure, many of his risk management policies were ignored or discarded. For example, by the end of 2007, stated income loans represented 73% of WaMu’s Option ARMs, 50% of its subprime loans, and 90% of its home equity loans. 395 Ronald Cathcart was hired in December 2005 to replace Mr. Vanasek, and became the Chief Enterprise Risk Officer. He had most recently been the Chief Risk Officer for Canadian Imperial Bank of Commerce’s retail bank. 396 Although the High Risk Lending Strategy was well underway, after Mr. Vanasek’s departure, risk management was in turmoil. Mr. Cathcart testified at the Subcommittee hearing: “When I arrived at WaMu, I inherited a Risk Department that was isolated from the rest of the bank and was struggling to be effective at a time when the mortgage industry was experiencing unprecedented demand for residential mortgage assets.” In early 2006, the bank reorganized WaMu’s risk management. 397 Under the new system, much of the risk management was subordinated to the WaMu business divisions, with each business division’s Chief Risk Officer reporting to two bosses, Mr. Cathcart and the head of the business unit to which the division’s Chief Risk Officer was assigned. WaMu referred to this system of reporting as a “Double-Double.” 398 393 2/24/2005 Washington Mutual memorandum from Jim Vanasek to the Executive Committee, “Critical Pending Decisions,” JPM_WM01265462-64. 394 Subcommittee interview of Jim Vanasek (12/18/2009 and 1/19/2010). 395 4/2010 IG Report, at 10, Hearing Exhibit 4/16-82. 396 Subcommittee interview of Ronald Cathcart (2/23/2010). 397 Id. 398 Id.; Subcommittee interviews of David Schneider (2/17/2010) and Cheryl Feltgen (2/6/2010). CHRG-111hhrg48674--72 Mr. Bernanke," Well, I think at this point the reason the banks and the credit markets are frozen is no longer the legacy subprime mortgages and those things. It is more concern about where the economy is going. So I think we need strong action to stabilize the economy and the financial system. If we can do that, we will get a virtuous circle rather than a vicious circle that will get the economy back to a more normal state. But I have to say that this has been an extraordinary episode. This is the most severe financial crisis since the 1930's, and in all honesty, I have to tell you, we can't expect immediate results. We have to be patient and keep working with it. " FinancialCrisisInquiry--153 It only makes sense that as income moves up, housing prices should be able to move up in a perfectly parallel fashion—you make a little bit more money, you can afford a little bit more house. Those lines were parallel for the good part of 40 years. And what happened in 2001, when Dr. Greenspan traded the dot.com bust for the housing boom, he lowered rates down to 1 percent. He made money free, and encouraged all of the lending possible to try to restart the economy after the dot.com bust. I simply think he did a bad job. Other people think he did a great job. But I think that he enabled this housing market. So when you started seeing rates—rates started—they started raising rates in 2004? When rates started to be—started an increasing path, you saw prime mortgage origination in 2004 drop 50 percent. That just makes sense. Everybody refinanced their homes that could. Everyone got reset and settled, but subprime origination in 2004 doubled. And then it doubled again in ‘05, as prime originations fell off a cliff because rates were moving up. So what happened is Wall Street had these machines built to manufacture mortgages. We wanted affordable housing, so they could lower rates with exotic mortgages. And what you saw from 2001 on is you saw those two parallel lines, home price—median home price and median income—diverge. And not only did they diverge by—for those of you that are statisticians, it was an eight standard deviation divergence. OK? That doesn’t happen very often. I know we talk about once-in-a- lifetime calamities every 10 years, that one just hasn’t happened. THOMPSON: The Fed would have certainly seen that. Why, in your opinion was there no action taken there? BASS: You know, I mean, why—why do politicians not want to take the punch bowl away when things are going well is kind of what you’re asking me. It’s just a difficult decision. And, politically—even appointments at the Fed, right? Everyone’s on somewhat of a re- election cycle. If you make that difficult decision when things are good, you’re the bad guy. You’d rather be the guy that helps clean it up once it breaks. So you get into more of a—an ideological question when you ask. CHRG-111hhrg53240--114 Mr. Carr," It is a frivolous argument, the idea that somehow every single consumer is different from one another. There is a difference to offering one product to every single consumer in the market as opposed to having standard products that are based on individuals' income, their wealth, and certain other types of financial circumstances to create classes of standard products. And one can be very nimble, very innovative, with standard products. In fact, there are a lot of them that actually exist. The problem was they could not compete with the reckless subprime loans that were actually priced at a much higher premium by the investment banks. So the idea that somehow you lose innovation because you introduce standards is a frivolous argument. " CHRG-111hhrg48674--307 Mr. Green," Mr. Bernanke, I would like to discuss with you very briefly the efficacy of mark-to-market and a possible modification. My concern with mark-to-market is when we value assets and we write them down as credit losses, which means that we assume that they are losses because the borrower cannot perform or is not performing, as opposed to liquidity losses, which assumes that performance does not necessitate a writing-down of the asset at the current time. My concern is this: If we buy these assets, we do have to assign some value. If we utilize mark-to-market to assign the value, we can create an even greater problem because there is no real market. We write down the assets. When we write down the assets, we find ourselves having to introduce more capitalization. By introducing more capitalization, we find ourselves--also the banks have a liquidity problem in the sense that they don't use that capitalization to lend money. They use the money that they have--they are making on loans to lend money, or they come to your discount window and they borrow to lend money. Now, having said all of that--and I hope it made sense to you--if it did make sense, would you kindly acknowledge so that I know-- " FinancialCrisisReport--468 In November 2007, in another letter to the SEC, Goldman explained further: “During most of 2007, we maintained a net short subprime position with the use of derivatives, including ABX index contracts and single name CDS which hedged [our] long cash exposure.” 1976 Also in November 2007, in talking points prepared for a meeting with the Tri-Lateral Review Group, which included the Federal Reserve Bank, the SEC, and the United Kingdom’s Financial Services Authority, Goldman wrote: “[W]e were able to maintain a short throughout the year.” 1977 Goldman also wrote: “The press and others have discussed an anticipated Q4 [2007 fourth quarter] write-down for GS. Our remaining long subprime exposure totals $695 million, inclusive of whole loans and CDO positions. However, we’re net short – as we have been throughout 2007. Accordingly, we have nothing to write down.” 1978 Public Statements. Goldman also discussed its net short and related profits in public settings. In November 2007, the Bloomberg news service reported that Goldman’s CEO, Lloyd Blankfein, told a public audience at a securities industry conference that Goldman was, and would continue to be, net short the subprime markets: “[Mr. Blankfein] said the firm is still betting that mortgage-backed assets and collateralized debt obligations will drop. ... ‘Given that point of view, we continue to be net short in these markets.’” 1979 In reaction to another November 2007 news report on how Goldman “dodged the mortgage mess,” 1980 Mr. Blankfein sent an email to his colleagues stating: “Of course we didn’t dodge the mortgage mess. We lost money, then made more than we lost because of shorts.” 1981 Goldman also prepared for public use a corporate statement entitled, “How Did GS Avoid the Mortgage Crisis? Our Response.” 1982 The statement was prepared for Mr. Viniar’s use in 1976 1977 11/7/2007 letter from Goldman Sachs to the SEC, GS MBS-E-015713460, Hearing Exhibit 4/27-50. 11/13/2007 Goldman email, GS MBS-E-010023525 (attachment, 11/14/2007 “Tri-Lateral Combined Comments, ” GS MBS-E-010135693-715 at 694). 1978 1979 Id. “Goldman Doesn ’t Plan Significant Mortgage W ritedown, ” Bloomberg (11/13/2007); see also 11/13/2007 email to Lloyd Blankfein, GS MBS-E-009601759 (forwarding Bloomberg article regarding Mr. Blankfein ’s remarks at conference sponsored by Merrill Lynch & Co. in New York City on Nov. 13, 2007). 1980 1981 “Goldman Sachs Rakes in Profit in Credit Crisis,” New York Times (11/19/2007). 11/18/2007 email from Lloyd Blankfein, “RE: NYT, ” GS MBS-E-009696333, Hearing Exhibit 4/27-52. Goldman ’s Co-President, Gary Cohn, replied to Mr. Blankfein ’s message, adding, “W e were just smaller in the toxic products ” Id. 1982 11/7/2007 Goldman document, “How Did GS Avoid the Mortgage Crisis?, ” GS M BS-E-009713204, Hearing Exhibit 4/27-51. responding to questions about the Mortgage Department’s performance in a fourth quarter conference call with analysts. Goldman’s public statement outlined the steps it took to reduce its subprime mortgage inventory and related subprime risks in late 2006 and early 2007, characterizing these “proactive” steps as part of its ordinary risk management efforts. Goldman went on to state: “[O]ne should not be led to believe that we went through this period unscathed and somehow significantly profited from a ‘bet’ on the downturn in mortgage markets.” 1983 After noting that significant writedowns in the value of its long mortgage inventory had resulted in a “weak” second quarter for mortgages, Goldman wrote: “[D]uring the third quarter we were able to make money on mortgages as a result of our net short position. As a consequence, we believe that we are well-positioned to opportunistically participate in the inevitable restructuring of the mortgage market.” 1984 CHRG-110hhrg46596--113 Mr. Neugebauer," Last question then, as a follow-up on that. Do you have evidence that this capital injection has, in fact, led to increased lending activity? Have you monitored that? " CHRG-110hhrg46593--144 Mr. Bernanke," If we invoked our ability to lend under unusual and exigent circumstances, and if we were fully collateralized, we would have that power. We have not made a decision to do that. " fcic_final_report_full--575 Transportation and Community Development, 110th Cong., 1st sess., June 26, 2007. 26. Email and data attachment from former Golden West employee to FCIC, subject: “re: Golden West Estimated Volume of Adjustable Rate Mortgage Originations,” December 6, 2010. 27. Herbert Sandler, interview by FCIC, September 22, 2010. 28. Washington Mutual, “Option ARM Focus Groups—Phase II,” September 17, 2003; Washington Mutual, “Option ARM Focus Groups—Phase I,” August 14, 2003, Exhibits 35 and 36 in Senate Perma- nent Subcommittee on Investigations, exhibits, Wall Street and the Financial Crisis: The Role of High Risk Home Loans , 111th Cong., 2nd sess., April 13, 2010 (hereafter cited as PSI Documents), PDF pp. 330–51, available at http://hsgac.senate.gov/public/_files/Financial_Crisis/041310Exhibits.pdf. 29. PSI Documents, Exhibits 35 and 36 pp. 330–51. 30. Ibid., pp. 330–51, 334. 31. Ibid., p. 345. 32. Ibid., p. 346. 33. Washington Mutual, “Option ARM Credit Risk,” August 2006, PSI Document Exhibit 37, p. 366. 34. PSI Documents Exhibit 37, p. 366, showing average FICO score of 698; p. 356; comparing con- forming and jumbo originations. 35. Ibid., p. 357. 36. Document listing Countrywide originations by quarter from 2003 to 2007, provided by Bank of America. 37. Countrywide October 2003 Loan Program Guide (depicting a maximum CLTV of 80 and mini- mum FICO of 680) and July 2004 Loan Program Guide (showing 90% 620 FICO). 38. Countrywide Loan Program Guide, dated March 7, 2005. 39. Federal Reserve, “Residential Mortgage Lenders Peer Group Survey: Analysis and Implications for First Lien Guidance,” November 30, 2005, pp. 6, 8. 40. Angelo Mozilo, email to Carlos Garcia (cc: Stan Kurland), Subject: “Bank Assets,” August 1, 2005. 41. Angelo Mozilo, email to Carlos Garcia (cc: Kurland), subject: “re: Fw: Bank Assets,” August 2, 2005. 42. Countrywide, 2005 Form 10-K, p. 57; 2007 Form 10-K, p. F-45. 43. See Washington Mutual, 2006 Form 10-K, p. 53. 44. John Stumpf, interview by FCIC, September 23, 2010. 45. Countrywide, 2007 Form 10-K, p. F-45; 2005 Form 10-K, p. 57 46. Washington Mutual, 2007 Form 10-K, p. 57; 2005 Form 10-K, p. 55 47. Kevin Stein, testimony before the FCIC, Sacramento Hearing on the Impact of the Financial Crisis–San Francisco, day 1, session 2: Mortgage Origination, Mortgage Fraud and Predatory Lending in the Sacramento Region, September 23, 2010, transcript, p. 72. 48. Mona Tawatao, in ibid., p. 228. 49. Real Estate Lending Standards, Federal Register 57 (December 31, 1992): 62890. 50. Ibid. 51. Office of the Comptroller of the Currency, Board of Governors of the Federal Deposit Insurance Corporation, Office of Thrift Supervision, “Real Estate Lending Standards: Final Rule,” SR 93–1, January 11, 1993. 52. Office of the Comptroller of the Currency, Board of Governors of the Federal Deposit Insurance Corporation, Office of Thrift Supervision, “Interagency Guidance on High LTV Residential Real Estate Lending,” October 8, 1999. 53. Final Report of Michael J. Missal, Bankruptcy Court Examiner, In RE: New Century TRS Hold- ings, Chapter 11, Case No. 07-10416 (KJC), (Bankr. D.Del.), February 29, 2008, pp. 128, 149, 128. 54. Yuliya Demyanyk and Otto Van Hemert, “Understanding the Subprime Mortgage Crisis,” Review of Financial Studies, May 2009. 55. Sandler, interview. 56. CoreLogic loan performance data for subprime and Alt-A loans, and CoreLogic total outstanding loans servicer data provided to the FCIC. 57. Christopher Mayer, Karen Pence, and Shane M. Sherlund, “The Rise in Mortgage Defaults,” Jour- nal of Economic Perspectives 23, no. 1 (Winter 2009): 32. 58. William Black, testimony for the FCIC, Miami Hearing on the Impact of the Financial Crisis, day 1, session 1: Overview of Mortgage Fraud, September 21, 2010, p. 27. 59. Richard Bowen, interview by FCIC, February 27, 2010. 60. Jamie Dimon, testimony before the FCIC, January 13, 2010, p. 60. 61. This particular deal would be described as an excess-spread over-collateralized-based credit en- hancement structure; see Gary Gorton, “The Panic of 2007,” paper presented at the Federal Reserve Bank of Kansas City’s Jackson Hole Conference, August 2008, p. 23. 62. FCIC staff estimates based on analysis of data from BlackBox, S&P, and Bloomberg. The prospec- tive loan pool for this deal originally contained 4,507 mortgages. Eight of these had been dropped from the pool by the time the bonds were issued. Therefore, these estimates may differ slightly from those re- ported in the deal prospectus because these estimates are based on a pool of 4,499 loans. 63. Ibid. 64. Federal Register 69 (January 7, 2004): 1904. The rules were issued in proposed form at Federal Reg- ister 68 (August 5, 2003): 46119. 65. See OTS Opinion re California Minimum Payment Statute, October 1, 2002, p. 6. 66. Comptroller of the Currency John Hawke, remarks before Women in Housing and Finance, CHRG-111shrg57322--294 Mr. Sparks," With respect to maybe appearance of a conflict of--yes, I think that there is that concern with respect to that particular point. Senator Ensign. I want to go to a deal that Goldman Sachs did, known as Hudson 1. It was a synthetic CDO that referenced $2 billion in subprime BBB-rated mortgage-backed securities. Goldman selected the referenced assets. The purpose of the transaction appears to have been to get those assets off Goldman's own books. Basically Goldman was the only buyer to sell this CDO and then make a bet against it. Is that an accurate description of what happened with Hudson 1? " CHRG-111shrg57321--244 Mr. McDaniel," I am surprised that there was a subprime RMBS security issued in the market. To the extent that we had updated our views and felt that those views would now be sufficient to provide protection for the ratings assigned, I can understand why the rating committee would do so. Senator Levin. Let me go back again to Exhibit 24b.\1\ There are a lot of interesting things there that your Chief Credit Officer, Mr. Kimball, wrote in October 2007 about issues and weaknesses that the organization needs to address after the subprime market had collapsed.--------------------------------------------------------------------------- \1\ See Exhibit No. 24b, which appears in the Appendix on page 319.--------------------------------------------------------------------------- One of the things he wrote, and this is under market share, he says in paragraph five, ``Ideally, competition would be primarily on the basis of ratings quality''--that is ideally--``with a second component of price and a third component of service. Unfortunately, of the three competitive factors, rating quality is proving the least powerful.'' Then two lines down, he says, ``The real problem is not that the market does underweights rating quality but rather that, in some sectors it actually penalizes quality by awarding rating mandates based on the lowest credit enhancement needed for the highest rating. Unchecked competition on this basis can place the entire financial system at risk. It turns out that ratings quality has surprisingly few friends; issuers want high ratings; investors don't want rating downgrades; short-sighted bankers labor short-sightedly to game the rating agencies for a few extra basis points on execution.'' Would you agree with that? " FinancialCrisisReport--511 Nevertheless, in May 2006, Goldman acted as co-lead underwriter with WaMu to securitize about $532 million in subprime second lien mortgages originated by Long Beach. Long Beach Mortgage Loan Trust 2006-A (LBMLT 2006-A) issued approximately $495 million in RMBS securities backed by those Long Beach mortgages. The top three tranches, representing about 66% of the principal loan balance, received AAA ratings from S&P, even though the pool contained subprime second lien mortgages – loans which could recover funds in the event of a default only after the primary loan was repaid — and even though the loans were issued by one of the nation’s worst performing mortgage lenders. Yet Goldman was able to use two-thirds of that extremely risky debt to issue AAA rated securities which Goldman then sold to its customers. In less than a year, the Long Beach loans began incurring delinquencies. In February 2007, a Goldman analyst reported internally that all of Goldman’s 2006 subprime second lien RMBS securities were deteriorating in performance, but “deals backed by Fremont and Long Beach collateral have generally underperformed the most.” 2193 The analyst predicted “lifetime losses in the teens, and over 20% in some deals.” By May 2007, the cumulative net loss on the LBMLT 2006-A mortgage pool had climbed to over 12%, eliminating most of the financial cushion protecting the investment grade securities from loss. That month, S&P downgraded six out of the seven credit ratings for the mezzanine tranches of the securitization. The Long Beach securities plummeted in value. Goldman held some of the unsold Long Beach mezzanine securities on its books, meaning LBMLT 2006-A securities that carried credit ratings of BBB or BBB-. Goldman had also purchased the short side of a CDS contract that would pay off if those same securities lost value. On May 17, 2007, Deeb Salem, a trader on the Mortgage Department’s ABS Desk, learned of additional losses in the Long Beach securitization and wrote to his supervisor Michael Swenson with the news: “[B]ad news … [The loss] wipes out the m6s [mezzanine tranches] and makes a wipeout of the m5 imminent. … [C]osts us about 2.5 [million dollars]. … [G]ood news ... [W]e own 10 [million dollars] protection at the m6 … [W]e make $5 [million].” 2194 In other words, Goldman lost $2.5 million from the unsold Long Beach securities still on its books, but gained $5 million from the CDS contract shorting those same securities. Overall, Goldman profited from the decline of the same type of securities it had earlier sold to its customers. 2192 2193 See, e.g., 4/14/2005 OTS email, “Fitch,” OTSW ME05-012 0000806, Hearing Exhibit 4/13-8a. 2/8/2007 email from Goldman analyst to Mr. Sparks, Mr. Gasvoda, and others, “2006 Subprime 2nds Deals Continue to Underperform **INTERNAL ONLY**,” GS MBS-E-003775340, Hearing Exhibit 4/27-167d. 2194 5/17/2007 email from Deeb Salem to Michael Swenson, “FW : LBML 06A,” GS M BS-E-012550973, Hearing Exhibit 4/27-65. CHRG-111hhrg56776--88 Mr. Volcker," I cannot deny that. There were gaps in regulations, gaps in authority. One was large gaps in the investment banking area, in my opinion, where a lot of the crisis arose. You had gaps in the subprime mortgage. You had some regulatory authority over some parts of it, but none over other parts of it. You had a big gap given what we know now, and I keep coming back to it because I think it is important, in the resolution authority. There was no resolution authority that gave the supervisors a reasonably effective and efficient way of closing down a non-bank institution with minimal damage. That is something you have to legislate. " FinancialCrisisReport--531 Anderson’s assets were purchased from 11 different broker-dealers from September 2006 to March 2007. Goldman was the source of 28 of the 61 CDS contracts in Anderson, and Goldman retained the short side. The next largest short party was Lehman Brothers which sold six CDS contracts to Anderson and retained the short side. Goldman also served as the sole credit protection buyer to the Anderson CDO, acting as the intermediary between the CDO and the various broker- dealers selling it assets. 2311 By February 2007, the Anderson warehouse account contained $305 million out of the intended $500 million worth of single name CDS, many of which referenced mortgage pools originated by New Century, Fremont, and Countrywide, subprime lenders known within the industry for issuing poor quality loans and RMBS securities. Approximately 45% of the referenced RMBS securities contained New Century mortgages. 2312 Falling Mortgage Market. During the same time period in which the Anderson single name CDS contracts were being accumulated, Goldman was becoming increasingly concerned about the subprime mortgage market, was reacting to bad news from the subprime lenders it did business with, 2313 and was building a large short position against the same types of BBB rated RMBS securities referenced in Anderson. 2314 By February 2007, the value of subprime RMBS securities was falling, and the Goldman CDO Origination Desk was forced to mark down the value of the long single name CDS contracts in its CDO warehouse accounts, including Anderson. Goldman was also aware that its longtime customer, New Century, was in financial distress. On February 7, 2007, New Century announced publicly it would be restating its 2006 earnings, causing a sharp drop in the company’s share price. On February 8, 2007, Goldman’s Chief Credit Officer Craig Broderick sent Mr. Sparks and others a press clipping about New Century and warned: “[T]his is a materially adverse development. The issues involve inadequate [early payment default] provisions and marks on residuals .... [I]n a confidence sensitive industry it will be 2310 2311 2312 Id. See Goldman response to Subcommittee QFR at PSI_QFR_GS0192. This number was compiled using a list of referenced securities supplied by Goldman at QFR_PSI_GS0192 and registration statements available at www.sec.gov . When looking at all mortgages underlying each reference security, New Century originated 48% by value of the underlying mortgages. However, each mortgage may have a different weight in the Anderson CDO based on the size of the reference security it is held in. Therefore, the economic effect of the New Century mortgages could be greater than or less than 48%. The next largest mortgage originator by value was Countrywide at 8%. 2313 See, e.g., 1/4/2007 Goldman presentation, “Sub-Prime Mortgage Lenders - Update,” GS MBS-E-009978840-59, Hearing Exhibit 4/27-169. 2314 See discussion of Goldman ’s net short position, Section C(4), above. ugly even if all problems have been identified. ... We have a call with the company in a few minutes (to be led by Dan Sparks).” 2315 CHRG-110shrg50409--89 Mr. Bernanke," Well, Senator, you point to a legitimate question, which is that there are still many people, disproportionately immigrants, who do not have a checking account, do not have a savings account, and these are the ``unbanked,'' as the term goes. In not all but in many cases, those people would be better off with a banking relationship. They might be able to avoid high fees for remittances, for example, or high fees for check cashing if they were associated with a bank. To some extent, it is a cultural element. We encourage banks to reach out to communities, to have people who speak the appropriate language. On the other side, as you know--and this is one of your important issues that you have been a leader on--is to promote financial literacy and to get folks to understand, how to manage their finances and how important having the right relationships with financial institutions can be. So I think it is really on both sides. We have to get the banks to reach out. We have to get the public to understand and reach out. Where necessary, as in the case of home mortgages, disclosures and regulation may be necessary to keep the contracts, clear enough that the public can make use of them. And in that respect, I hope that, for example, our actions on mortgage lending will restore some confidence where there are people who feel that they got burned taking out a subprime mortgage. Perhaps in the future, they will see more clearly what the contract entails, and they will be more confident in taking out a mortgage. So it is a very important issue, and we can address it, I think, from a number of different directions. Senator Akaka. Thank you. Working families, as you know, are having trouble paying for increases today in gasoline, groceries, and other daily living expenses while wages are not increasing fast enough and affordable credit is becoming harder to obtain. I am deeply concerned that too many working families are being exploited by the unscrupulous lenders who give payday loans, and this is where protection, I think, is needed. I have been impressed by the work of the National Credit Union Administration, NCUA, due to a NCUA grant on the windward side of the island of Oahu in Hawaii at the Community Federal Credit Union at Kailua, and it has developed an affordable alternative to payday loans to help U.S. Marines and other members they serve. We must further encourage the development of these alternatives so that working families have access to affordable small loans. My question to you is: What must be done to protect consumers from high-cost payday loans and encourage the development of affordable payday loan alternatives? " FinancialCrisisReport--236 In 2007, after the company announced its intent to restate its 2006 financial results, investors lost confidence in the company, its stock plummeted, and New Century collapsed. In April 2007, it filed for bankruptcy. 918 In February 2008, the bankruptcy examiner released a detailed report that found New Century was responsible for “significant improper and imprudent practices related to its loan originations, operations, accounting and financial reporting processes.” 919 Like WaMu, New Century had engaged in a number of harmful mortgage practices, including “increasing loan originations, without due regard to the risks associated with that business strategy”; risk layering in which it issued high risk loans to high risk borrowers, including originating in excess of 40% of its loans on a stated income basis; allowing multiple exceptions to underwriting standards; and utilizing poor risk management practices that relied on the company’s selling or securitizing its high risk mortgages rather than retaining them. After New Century’s bankruptcy, a 2007 class action complaint was filed by the New York State Teachers’ Retirement System and others alleging that New Century executives had violated federal securities laws and committed fraud. 920 Among other matters, the complaint alleged that the company sold poor quality loans that incurred early payment defaults, received numerous demands from third party buyers of the loans to repurchase them, and built up a huge backlog of hundreds of millions of dollars in repurchase requests that the company deliberately delayed paying to make its 2005 and 2006 financial results appear better than they actually were. 921 The complaint also alleged that New Century issued loans using lax underwriting standards to maximize loan production, 922 and “routinely and increasingly lent money to people who were unable to repay the debt shortly after the loans were closed.” 923 The suit took note of a news article stating: “Loans made by New Century, which filed for bankruptcy protection in March, have some of the highest default rates in the industry.” 924 In December 2009, the SEC filed a civil complaint charging three former New Century executives, the CEO, CFO, and controller, with fraudulent accounting that misled investors about the company’s finances. 925 The SEC alleged that, while the company’s financial disclosures painted a picture that the company’s performance exceeded that of its peers, its executives had failed to disclose material negative information, such as significant increases in its loans’ early 917 In re New Century TRS Holdings, Inc. , Case No. 07-10416 (KJC) (US Bankruptcy Court, Del.), 2/29/2008 Final Report of Michael J. Missal, Bankruptcy Court Examiner, at 2, http://graphics8.nytimes.com/packages/pdf/business/Final_Report_New_Century.pdf (hereinafter “New Century Bankruptcy Report”). See also New Century Class Action Complaint at ¶ 59-60. 918 In re New Century TRS Holdings, Inc. , Case No. 07-10416 (KJC) (US Bankruptcy Court, Del.). 919 New Century Bankruptcy Report. 920 New Century Class Action Complaint. 921 Id. at ¶¶ 75-79. 922 Id. at ¶ 112. See also ¶¶ 126-130. 923 Id. at ¶ 113. See also ¶¶ 114-116. 924 Id. at ¶ 123. 925 SEC Complaint against New Century Executives; See also 12/7/2009 SEC Press Release, “SEC Charges Former Offices of Subprime Lender New Century With Fraud.” payment defaults and a backlog of loan repurchases, which had the effect of materially overstating the company’s financial results. The SEC complaint also stated that, although New Century had represented itself as a prudent subprime lender, it “soon became evident that its lending practices, far from being ‘responsible,’ were the recipe for financial disaster.” 926 The complaint detailed a number of high risk lending practices, including the issuance of interest only loans; 80/20 loans with loan-to-value ratios of 100%; and stated income loans in which the borrower’s income and assets were unverified. 927 The complaint charged the New Century executives with downplaying the riskiness of the company’s loans and concealing their high delinquency rates. CHRG-111hhrg52400--140 Mr. Royce," Yes. Thank you, Mr. Chairman. I will pick up on Mr. Spence's point. Insurance operations were not regulated by the Fed. The New York Insurance Department reviewed and monitored AIG's securities lending program. AIG's securities lending program heavily invested in long-term mortgage-backed securities, as a matter of fact, took that money from the insurance subsidiaries. AIG Life insurers suffered $20 billion in losses related to their securities lending operations last year. And of course, the bottom line, the Federal Reserve has provided billions now to recapitalize AIG Life Insurance companies. So, you know, we have a patchwork quilt here of regulation. We had--as I said in my opening statement, we had problems with the Financial Products unit, we had problems with the Securities Lending unit and the Securities Lending program. So we have a difficulty here. Now, at this--as we have discussed at this subcommittee, there was an implicit belief in the market that, should Fannie Mae and Freddie Mac get into trouble, the Federal Government would step in to save them. In part, it was that perceived Federal lifeline that enabled these firms to borrow cheaply and take on so much risk. As we discuss reforming our regulatory structure to address firms that are too-big-to-fail, I am concerned that we run the risk of bifurcating our financial system between those that we designate as systemically significant and everybody else that is in competition. As our experience with the housing Government-Sponsored Enterprises demonstrates, this would be a big mistake. And it would provide competitive advantages to companies that have the implicit backing of the taxpayers, and they would be incentivized to engage in higher-risk behavior. That's what economists who look at this model tell us when they fret about what we're doing here. So, in the context of systemic risk regulation, do we run the risk of distorting the market by labeling those institutions that are too-big-to-fail as such? And would it be more effective for a systemic risk regulator to focus on potentially high-risk activities in the market, instead, rather than a set of large financial firms? Mr. Spence? " fcic_final_report_full--462 By 2008, the result of these government programs was an unprecedented number of subprime and other high risk mortgages in the U.S. financial system. Table 1 shows which agencies or firms were holding the credit risk of these mortgages- -or had distributed it to investors through mortgage-backed securities (MBS)-- immediately before the financial crisis began. As Table 1 makes clear, government agencies, or private institutions acting under government direction, either held or had guaranteed 19.2 million of the NTM loans that were outstanding at this point. By contrast, about 7.8 million NTMs had been distributed to investors through the issuance of private mortgage-backed securities, or PMBS, 16 primarily by private issuers such as Countrywide and other subprime lenders. The fact that the credit risk of two-thirds of all the NTMs in the financial system was held by the government or by entities acting under government control demonstrates the central role of the government’s policies in the development of the 1997-2007 housing bubble, the mortgage meltdown that occurred when the bubble deflated, and the financial crisis and recession that ensued. Similarly, the fact that only 7.8 million NTMs were held by investors and financial institutions in the form of PMBS shows that this group of NTMs were less important as a cause of the financial crisis than the government’s role. The Commission majority’s report focuses almost entirely on the 7.8 million PMBS, and is thus an example of its determination to ignore the government’s role in the financial crisis. Table 1. 17 Entity No. of Subprime Unpaid Principal Amount and Alt-A Loans Fannie Mae and Freddie Mac 12 million $1.8 trillion FHA and other Federal* 5 million $0.6 trillion CRA and HUD Programs 2.2 million $0.3 trillion Total Federal Government 19.2 million $2.7 trillion Other (including subprime and 7.8 million $1.9 trillion Alt-A PMBS issued by Countrywide, Wall Street and others) Total 27 million $4.6 trillion *Includes Veterans Administration, Federal Home Loan Banks and others. To be sure, the government’s efforts to increase home ownership through the AH goals succeeded. Home ownership rates in the U.S. increased from approximately 64 percent in 1994 (where it had been for 30 years) to over 69 percent in 2004. 18 Almost everyone in and out of government was pleased with this—a long term goal 16 In the process known as securitization, securities backed by a pool of mortgages (mortgage- backed securities, or MBS) and issued by private sector firms were known as private label securities (distinguishing them from securities issued by the GSEs or Ginnie Mae) or private MBS (PMBS). 17 See Edward Pinto’s analysis in Exhibit 2 to the Triggers Memo, April 21, 2010, p.4. http://www.aei.org/ docLib/Pinto-Sizing-Total-Federal-Contributions.pdf. 18 Census Bureau data. 457 of U.S. housing policy—until the true costs became clear with the collapse of the housing bubble in 2007. Then an elaborate process of shifting the blame began. 2. The Great Housing Bubble and Its Effects FinancialCrisisReport--124 In July 2007, Moody’s and S&P downgraded the credit ratings of hundreds of subprime RMBS and CDO securities, due to rising mortgage delinquencies and defaults. Included were approximately 40 Long Beach securities. 446 A July 12, 2007 presentation prepared by Moody’s to explain its ratings action shows that Long Beach was responsible for only 6% of all the subprime RMBS securities issued in 2006, but received 14% of the subprime RMBS ratings downgrades that day. 447 Only Fremont had a worse ratio. Over time, even AAA rated Long Beach securities performed terribly. Of the 75 Long Beach mortgage backed security tranches rated AAA by Standard and Poor’s in 2006, all 75 have been downgraded to junk status, defaulted, or been withdrawn. 448 In most of the 2006 Long Beach securitizations, the underlying loans have delinquency rates of 50% or more. 449 The problems were not confined to Long Beach loans. In early 2008, for example, an investment adviser posted information on his personal blog about a WaMu-sponsored RMBS securitization known as WMALT 2007-OC1. Formed in May 2007, this pool contained about 1,700 Alt A loans with a total outstanding balance of about $515 million. WaMu was the sole underwriter. The credit rating agencies gave AAA and other investment grade ratings to more than 92% of the securitization, but within eight months, 15% of the pool was in foreclosure. The posting suggested that the poor performance of WaMu securities was systemic. When informed by David Schneider of the complaint about the negative publicity surrounding the pool, David Beck responded: “Yes (ughh!) we are doing some peer group performance and looking at the servicing data … and putting together an analysis. … The collateral is full of limited doc layered risk alt a paper and at least half is TPO [third party originated]. The performance is not great but my opinion is not a WaMu specific issue.” 450 445 “WaMu subprime ABS delinquencies top ABX components,” Reuters (3/27/2007), Hearing Exhibit 4/13-52. 446 7/10/2007-7/12/2007 excerpts from Standard & Poor’s and Moody’s Downgrades, Hearing Exhibit 4/23-99. 447 7/12/2007 “Moody’s Structured Finance Teleconference and Web Cast: RMBS and CDO Rating Actions,” MOODYS-PSI2010-0046902, Hearing Exhibit 4/23-106. 448 See Standard and Poor’s data at www.globalcreditportal.com. 449 See, e.g., wamusecurities.com (subscription website maintained by JPMorgan Chase with data on Long Beach and WaMu mortgage backed securities showing, as of March 2011, delinquency rates for particular mortgage backed securities, including LBMLT 2006-1 – 58.44%; LBMLT 2006-6 – 60.06%; and LBMLT 2005-11 – 54.32%). 450 2/2/2008 email from David Beck to David Schneider and others, JPM_WM02445758, Hearing Exhibit 4/13-51. CHRG-110hhrg34673--59 Mr. Watt," Can I just interrupt you long enough to ask you to comment on whether you think we need a Federal predatory lending statute? " CHRG-111hhrg48674--187 Mr. Bernanke," Yes, sir. Every week in the H41 there is a breakdown of our lending programs and details on the maturities of the different loans, and we are looking to add more information. " CHRG-111hhrg48674--287 Mr. Bernanke," Sir, the expansion of the assets that we take, it would still work the same way, which is that investors would purchase these assets from the issuers of the ABS, and then we would lend to the--against that collateral we would lend to those investors in an amount between 85 and 95 percent of the principal value, depending on the risk that we saw in those assets. So the participants on the investors side may be very much the same, potentially the same group of people, just general investors. And on the issuers side, you have banks and other institutions which create ABS. The difference would be the types of assets which are being securitized, and that would affect different markets like the commercial mortgage market, for example. " CHRG-110shrg50417--113 Mr. Campbell," I would say that clearly the intent at Wells Fargo is to use that capital to continue to lend and lend more, as well as to help remedy the crisis that exists in the home mortgage business. And as a result of that, to put other provisions on us that would not allow us to pursue normal activities that we have pursued over the years, I think we would probably would not be in favor of that kind of prohibition, because just like others here, while we are currently not in a position because of decisions we made to pursue acquisitions, in 3 or 4 years we may very well be in a position where we would like to do that, and then having agreed to a provision that would not allow us to do it would certainly not be something we would like. Senator Brown. OK. Thank you. Thanks, Mr. Chairman. " CHRG-111hhrg51698--90 Mr. Gooch," Yes, I do. The CDS is a specific type of credit derivative that I am concerned about the elimination of the naked risk. If you went to that extent, then I guess you could disallow disinterested parties from buying and selling stock options or shorting stocks. And you could just do the same thing in the foreign exchange markets and the bond markets, and have the same thing in the agricultural markets and have no liquid markets. My concern with the elimination of the naked-risk trading, the elimination of it in the CDS market, is once you do that, you take the risk-taker and capital provider out of the equation, right now I take the contrary view to Mr. Greenberger that the credit derivatives are not the reason the banks aren't lending. The banks aren't lending because they are concerned about their capital requirements. You have mark-to-market, which I said in normal markets makes sense, and they are reluctant to put money out on the street because they can't get it back in a moment's notice; and they don't want to go to you guys for very expensive preferred equity, so they are sitting there not lending. Finally enough, the only lenders in the market are the providers of credit default swap protection that are still very willing to provide that protection, and that is making it possible for some of the most secure credits to be provided with capital. It is also allowing for these very banks to protect some of their risk they have with certain lending relationships they have now, which, otherwise, they might curtail to an even greater extent. So, as you know, I only have 18 percent of my business in credit derivatives. If it disappeared tomorrow, we would find something else to intermediate, probably carbon credits. So I am not speaking from my own personal best interest, I am actually talking about the U.S. economy and the global economy. My concern, as an independent, neutral marketplace for credit derivatives, is that if you take it away, you are going to really significantly damage the very fragile credit market we have now. " FOMC20081007confcall--30 28,MR. EVANS.," Thank you, Mr. Chairman. I was jotting down some of the figures on the lending facilities and the magnitudes just to see if I had the right ballpark. You know, from the TAF to the TSLF, the primary dealer credit facility, and on down to today's facility on commercial paper, and then if you throw in the Treasury program, which is not exactly ours, and the swaps as well, I get to something like over $3 trillion that is being put out against collateral and to be lent. Is that the right order of magnitude? I guess the question I have is whether we have any sense that this is likely to get to the point of unlocking the lending capacity that's so important to get the economy going? " CHRG-111hhrg53244--52 Mr. Bernanke," Certainly. Most central banks do have this authority, and they set a Fed funds equivalent rate in the open market, but they use the interest on reserves rate as sort of a floor or backstop. The Fed's authorities go back to the 1930's, and we are actually somewhat more limited on a number of these areas than other central banks. Other central banks have somewhat broader power to buy assets, to pay interest on reserves, and to lend to financial institutions. For example, we had to invoke the 13.3 authority to lend to the primary dealers and the investment banks. Whereas in Europe, for example, any financial institution can borrow from the central bank. " FOMC20070810confcall--30 28,CHAIRMAN BERNANKE.," President Fisher, our goal is to provide liquidity not to support asset prices per se in any way. My understanding of the market’s problem is that price discovery has been inhibited by the illiquidity of the subprime-related assets that are not trading, and nobody knows what they’re worth, and so there’s a general freeze-up. The market is not operating in a normal way. The idea of providing liquidity is essentially to give the market some ability to do the appropriate repricing it needs to do and to begin to operate more normally. So it’s a question of market functioning, not a question of bailing anybody out. That’s really where we are right now." FinancialCrisisInquiry--14 Even so, we remained relatively strong throughout the crisis so much so that we were called upon to take actions to help stabilize the system. Over the weekend of March 15, 2008, the federal government asked us to assist in preventing Bear Stearns from going bankrupt before the opening of the Asian markets on Monday morning. On September 25 th , we acquired the deposits, assets and certain liabilities of Washington Mutual from the FDIC. Later we learned that we were the only bank that was prepared to act immediately following the largest bank failure in U.S. history. In addition we continued to lend and support our clients’ financing and liquidity needs throughout the crisis. Over the course of the last year, we’ve provided more than $800 billion in direct lending and capital raising for investor and corporate clients. For example, we helped provide state and local government financing to cover cash flow shortfalls. We are the only institution that agreed to lend California $1.5 billion in its time of need. And even though small business loan demand has been down, we have maintained our lending levels to small business. In November of last year, we announced plans to increase lending to small businesses by $4 billion, to a total of $10 billion this year. For the millions of Americans feeling with the effects of this crisis, we are doing everything we can to help them meet their mortgage obligations. In 2009 we offered approximately 600,000 new trial loan modifications to struggling homeowners through our own program as well as through participation in government programs like the U.S. Making Home Affordable initiative. Our capabilities, size and diversity of business have been essential to our withstanding the crisis and emerging as a stronger firm. It is these trains that have put us in a position to acquire Bear Stearns and Washington Mutual. Some have suggested that size alone or the combination of investment banking and commercial banking caused the crisis. We disagree. If you consider the institutions that failed during the crisis, some of the largest and most consequential failures were stand-alone investment banks, mortgage companies, thrifts and insurance companies. CHRG-111hhrg50289--34 Mr. Graves," Ms. Blankenship. Ms. Blankenship. Yes. Actually our loans increased just over ten percent from 2007 to 2008 as well, but interestingly, our SBA loan percentages have been running about two to two and a half percent per year of our total portfolio. This year it is running 6.38. So we have really gotten behind a push to use the SBA program because what banks are facing right now is kind of a double-edged sworn. You hear Congress saying, ``Lend, lend, lend,'' but then the examiners are overreacting and they are coming in and we are getting stories of, you know, all commercial real estate being classified. So, you know, in my opinion, this is an opportune time to use the SBA program because you can mitigate some of that because you have that guaranty. Because the overwhelming majority of SBA loans will include typically, at least in our portfolio, some type of real estate as collateral. So we really need to mitigate the overreaction from the examining force. Again, I think it has been stated today there is an opportune time. The only other thing that I think would make the program more accessible in these times is perhaps raising the limits that we currently have on the size of 7(a) loans, and I think also on the 504s. So I think that would help a lot. " fcic_final_report_full--103 New Century and Ameriquest were especially aggressive. New Century’s “Focus ” plan concentrated on “originating loans with characteristics for which whole loan buyers will pay a high premium.”  Those “whole loan buyers” were the firms on Wall Street that purchased loans and, most often, bundled them into mortgage- backed securities. They were eager customers. In , New Century sold . bil- lion in whole loans, up from . billion three years before,  launching the firm from tenth to second place among subprime originators. Three-quarters went to two secu- ritizing firms—Morgan Stanley and Credit Suisse—but New Century reassured its investors that there were “many more prospective buyers.”  Ameriquest, in particular, pursued volume. According to the company’s public statements, it paid its account executives less per mortgage than the competition, but it encouraged them to make up the difference by underwriting more loans. “Our people make more volume per employee than the rest of the industry,” Aseem Mital, CEO of Ameriquest, said in . The company cut costs elsewhere in the origina- tion process, too. The back office for the firm’s retail division operated in assembly- line fashion, Mital told a reporter for American Banker; the work was divided into specialized tasks, including data entry, underwriting, customer service, account management, and funding. Ameriquest used its savings to undercut by as much as . what competing originators charged securitizing firms, according to an indus- try analyst’s estimate. Between  and , Ameriquest loan origination rose from an estimated  billion to  billion annually. That vaulted the firm from eleventh to first place among subprime originators. “They are clearly the aggressor,” Countrywide CEO Angelo Mozilo told his investors in .  By , Countrywide was third on the list. The subprime players followed diverse strategies. Lehman and Countrywide pur- sued a “vertically integrated” model, involving them in every link of the mortgage chain: originating and funding the loans, packaging them into securities, and finally selling the securities to investors. Others concentrated on niches: New Century, for example, mainly originated mortgages for immediate sale to other firms in the chain. When originators made loans to hold through maturity—an approach known as originate-to-hold —they had a clear incentive to underwrite carefully and consider the risks. However, when they originated mortgages to sell, for securitization or other- wise—known as originate-to-distribute —they no longer risked losses if the loan de- faulted. As long as they made accurate representations and warranties, the only risk was to their reputations if a lot of their loans went bad—but during the boom, loans were not going bad. In total, this originate-to-distribute pipeline carried more than half of all mortgages before the crisis, and a much larger piece of subprime mortgages. For decades, a version of the originate-to-distribute model produced safe mort- gages. Fannie and Freddie had been buying prime, conforming mortgages since the s, protected by strict underwriting standards. But some saw that the model now had problems. “If you look at how many people are playing, from the real estate agent all the way through to the guy who is issuing the security and the underwriter and the underwriting group and blah, blah, blah, then nobody in this entire chain is re- sponsible to anybody,” Lewis Ranieri, an early leader in securitization, told the FCIC, not the outcome he and other investment bankers had expected. “None of us wrote and said, ‘Oh, by the way, you have to be responsible for your actions,’” Ranieri said. “It was pretty self-evident.”  CHRG-111shrg56262--2 Chairman Reed," The Committee will come to order. I want to welcome everyone and particularly thank our witnesses for making themselves available today. This hearing will examine a key activity within our financial markets--the securitization of mortgages and other assets--and will build on previous hearings this Subcommittee has held to address various aspects of regulatory modernization, including hedge funds, derivatives, corporate governance, SEC enforcement, and risk management at large financial institutions. Securitization is the packaging of individual loans or other debt instruments into marketable securities to be purchased by investors. At its core this process helps free lenders to make more loans available for families to purchase items like homes and cars and for small businesses to thrive. But we have learned from the financial crisis that securitization or how it is conducted can also be extremely harmful to the financial markets and families without appropriate diligence and oversight. Arguably, many of the basic requirements needed for effective securitization were not met over the course of the last several years. Today's panel will discuss how in recent years the securitization process created incentives throughout the chain of participants to emphasize loan volume over loan quality, contributing to the buildup and collapse of the subprime mortgage market and the broader economy. Today we find ourselves in the opposite position from a few years back with hardly any issuances in key markets that could help return lending to responsible levels. So this afternoon's hearing is about how to strengthen the securitization markets and enact any needed changes to ensure that securitization can be used in ways that expand credit without harming consumers and the capital markets. I have asked today's witnesses to address a number of key issues, including the role securitization played in the financial crisis, the current conditions of these markets, and what changes may be needed for Federal oversight of the securitization process. Unfortunately, a number of the banks who issue these securities could not find anyone in their workforce who was willing to testify today, but we are lucky to have experts here, both academic and business experts. I welcome you all and look forward to your testimony. Let me now turn it over to Senator Bunning for his remarks. CHRG-111hhrg53241--28 Mr. Ireland," Good morning, Chairman Frank, Mr. Hensarling, and members of the committee. I am a partner in the financial services practice in the Washington, D.C., office of Morrison & Foerster. I previously spent 26 years with the Federal Reserve System, 15 years as an Associate General Counsel at the Board in Washington. I am pleased to be here today to address the Administration's financial regulatory reform proposals and, in particular, the consumer protection aspects of the proposals. The current recession was sparked by problems in subprime and Alt-A residential mortgages. As a result, investors lost confidence in subprime and Alt-A mortgage-backed securities. The loss in confidence spread to other mortgage-backed securities, disrupting the flow of funds for mortgage credit and leading to a downward spiral in housing prices and a panoply of new government programs and extraordinary actions by Federal regulators. Clearly, these events warrant a rethinking of what has worked, what has not worked, and why, in financial regulation. The Administration has proposed to create a new stand-alone Consumer Financial Protection Agency to protect consumers of financial products and services. Although I strongly support the goal of consumer protection, I believe that creating a separate stand-alone agency for this purpose ignores the increasingly vertically integrated nature of the market for consumer financial services. A primary reason for regulating consumer financial services is that we believe these services are beneficial for consumers. Leading up to the current crisis, excess demand for mortgage-backed securities encouraged mortgage origination practices that later triggered the panic in the secondary market. The relationship between these steps and the mortgage lending process was interactive, and neither is fully understood by looking at only one step in the process. In order to foster an efficient market for home mortgages, it is necessary to have an understanding of the entire market, from the consumer borrower to the ultimate investor, and the role of that market in the economy as a whole. The oversight and regulation of each component of the market needs to take into consideration its effect on the other components. Bifurcating regulation of the market, as is contemplated by creation of a dedicated consumer protection agency, is likely to create conflicts between the agency and prudential supervisors. The expertise of each regulator will be less available to the others than under the current regulatory structure, making each of their jobs more difficult rather than easier and leading to a less efficient, rather than a more efficient, market for home mortgages. These considerations weigh strongly against creation of a separate agency. The countervailing argument is, of course, that the current system did not work to prevent the mortgage crisis and that changes are needed. The mortgage crisis has been a product of multiple failures at all levels, both in the public and private sectors. The fact that regulators may have made errors suggests that steps should be taken to prevent similar errors in the future. However, my view, it does not mean the architecture of the regulatory system is the problem. There is a strong relationship between consumer issues, prudential supervision and, ultimately, monetary policy. In the end, these interests are not in conflict. Rather, they all seek the same goal, a healthy economy and a high standard of living for all Americans. The goal of regulatory policy should be to ensure that prudential and consumer interest are harmonized, rather than that they are in conflict. The creation of a separate agency is a recipe for conflict, rather than harmonization. Thank you for the opportunity to be here today to address this important issue, and I will be happy to answer questions. [The prepared statement of Mr. Ireland can be found on page 45 of the appendix.] " CHRG-110shrg46629--13 STATEMENT OF SENATOR CHARLES E. SCHUMER Senator Schumer. Thank you, Mr. Chairman. I want to thank you for holding this hearing and I want to thank Chairman Bernanke. As Chairman of the Joint Economic Committee, I am always interested in hearing your thoughts on the current state of economy and appreciate your availability on so many issues when we reach out to you. As I have said in the past, we live in interesting economic times. And you face a number of important challenges in setting a course for monetary policy that will achieve the multiple goals of high employment, balanced economic growth, and low inflation. Right now, there are certain reasons to be concerned about where we find ourselves. In the short-term, even with the likely improvements in the second quarter, overall economic growth in the first half of the year has been disappointing to say the least. Most forecasters have revised downward their expectations for economic growth through the rest of the year. The Administration continues to run high budget deficit that threaten our future stability to compete with the rest of the world. And our trade gap, particularly with China, remains immense and growing at a rapid rate. Energy prices are hovering at record highs, feeding our trade gap and fueling anxiety among middle-class families. The collapse of parts of the housing market which you call a correction has become a serious drag on our economic growth and a threat to economic security of too many American families. And while I welcome the Fed's new pilot program to monitor independent subprime brokers, I do not think consumers will truly be safe from irresponsible and deceptive lending practices until we enact tougher Federal laws to protect the subprime mess from happening again. As indication of the weakness in the housing market continue to mount, there is an urgent need for better protections for existing and aspiring homeowners, although I do want to thank--the Appropriations Committee did a $100 million in for the workouts. So nonprofits can do workouts that Senators Casey, Brown, and I had asked them to do. Most importantly, a view is recognized. We have an economy whose rewards seems to be more and more going to fewer and fewer privileged Americans. We are facing the greatest concentration of income since 1928 right before the crash and the beginning of the Depression when 24 percent of all income went to the richest 1 percent. It is now close to 22 percent and will pass the 24 percent, if present trends continue, all too soon. At a time when the wealthiest in this country have been doing extremely well, the American middle class, the engine of our economy, has not been as fortunate. Most Americans have not seen the benefits of working harder in their paychecks. Between 2000 and 2006 the typical worker's earnings grew less than 1 percent after accounting for inflation while productivity increased a whopping 18 percent. And now that economic growth seems to be slowing, its fair to ask whether most middle-class Americans will slip even further behind. The dramatic increase in productivity and its failure to raise wage rates is a great conundrum for our economy that needs all of our attention. I do not pretend that there are easy solutions to the troubling challenges facing our economy but we need to remember that our collective focus must be on achieving strong sustainable long-term economic growth that can be shared by all families in this country, not just those in the top 1 or 5 percent. Unless economic fortunes in this country grew together rather than apart, we cannot be confident about our children's economic futures. I look forward to your testimony, and thank you, Mr. Chairman, for the time. " CHRG-111shrg57319--114 Mr. Cathcart," Well, it is the old image of boiling a frog. It happened gradually. I think if we had all been paying attention, we all would have realized it began in Q3 of 2006, when HSBC had the big write-downs on subprime, which we at the time attributed to poor integration with Household Financial. As it turns out, that was the thin edge of the wedge. And I would say it is fair to say that I didn't realize that was the beginning of it. I would also say that there was an ingrained belief, and I certainly shared it, that the house prices in the country would not reduce simultaneously because they had not---- Senator Coburn. In other words, there would be a geographical difference? " CHRG-111shrg51303--178 PREPARED STATEMENT OF ERIC DINALLO Superintendent, New York State Insurance Department March 5, 2009 I would like to thank Chairman Christopher Dodd, Ranking Member Richard Shelby, and the Members of the Senate Committee on Banking, Housing, and Urban Affairs for inviting me to testify today at this hearing on ``American International Group: Examining What Went Wrong, Government Intervention, and Implications for Future Regulation.'' My name is Eric Dinallo and I am Insurance Superintendent for New York State. I very much appreciate the Committee holding this hearing so that we can discuss what has happened at AIG and how to improve financial services regulation in the future. I would like to start by taking this opportunity to clear up some confusion. I have read a number of times statements that the New York State Insurance Department is the primary regulator of AIG. The New York Insurance Department is not and never has been the primary regulator for AIG. AIG is a huge, global financial services holding company that does business in 130 countries. Besides its 71 U.S.-based insurance companies, AIG has 176 other financial services companies, including non-U.S. insurers. State insurance departments have the power and authority to act as the primary regulator for those insurance companies domiciled in their State. So the New York Department is primary regulator for only those AIG insurance companies domiciled in New York. Specifically, the New York Insurance Department is the primary regulator for 10 of AIG's 71 U.S. insurance companies: American Home Assurance Company, American International Insurance Company, AIU Insurance Company, AIG National Insurance Company, Commerce and Industry Insurance Company, Transatlantic Reinsurance Company, American International Life Assurance Company of New York, First SunAmerica Life Insurance Company, United States Life Insurance Company in the City of New York, and Putnam Reinsurance Company. AIG's New York life insurance companies are relatively small. The property insurance companies are much larger. Other States act as primary regulator for the other U.S. insurance companies. State insurance regulators are not perfect. But one thing we do very well is focus on solvency, on the financial strength of our insurance companies. We require them to hold conservative reserves to ensure that they can pay policyholders. That is why insurance companies have performed relatively well in this storm. One clear lesson of the current crisis is the importance of having plenty of capital and not having too much leverage. The crisis for AIG did not come from its State regulated insurance companies. The primary source of the problem was AIG Financial Products, which had written credit default swaps, derivatives and futures with a notional amount of about $2.7 trillion, including about $440 billion of credit default swaps. For context, that is equal to the gross national product of France. Losses on certain credit default swaps and collateral calls by global banks, broker dealers and hedge funds that are counterparties to these credit default swaps are the main source of AIG's problems. Faced with ratings downgrades, AIG Financial Products and AIG holding company faced tens of billions of dollars of demands for cash collateral on the credit default swaps written by Financial Products and guaranteed by the holding company. Federal Reserve Chairman Bernanke recently said, ``AIG had a financial products division which was very lightly regulated and was a source of a great deal of systemic trouble.'' This week, Chairman Bernanke accurately called the Financial Products unit ``a hedge fund basically that was attached to a large and stable insurance company, made huge numbers of irresponsible bets, took huge losses.'' The main reason why the Federal Government decided to rescue AIG was not because of its insurance companies. Rather, it was because of the systemic risk created by Financial Products. There was systemic risk because of Financial Products relationships and transactions with virtually every major commercial and investment bank, not only in the U.S., but around the world. I would like to note that insurance companies were not the purchasers of AIG's toxic credit default swaps. To quote Chairman Bernanke again, Financial Products ``took all these large bets where they were effectively, quote, `insuring' the credit positions of many, many banks and other financial institutions.'' By purchasing a savings and loan in 1999, AIG was able to select as its primary regulator the Federal Office of Thrift Supervision, the Federal agency that is charged with overseeing savings and loan banks and thrift associations. The Office of Thrift Supervision is AIG's consolidated supervisor for purposes of Gramm-Leach-Bliley. AIG Financial Products is not a licensed insurance company. It was not regulated by New York State or any other State. We all agree that AIG Financial Products should have been subject to more and better regulation. A major driver of its problems stemmed from its unregulated use of credit default swaps, which were exempted from regulation by Federal legislation in the late nineties. Some have tried to use AIG's problems as an argument for an optional Federal charter for insurance companies. I am open to a Federal role in regulating insurance and the non-insurance operations of large financial services groups such as AIG. I have said as much in prior testimony to other Congressional committees. But an optional Federal charter is the wrong lesson to learn from AIG for two very clear reasons. One, when you permit companies to pick their regulator, you create the opportunity for regulatory arbitrage. The whole purpose of financial services regulation is to appropriately control risk. But when you allow regulatory arbitrage, you increase risk. Because you create the opportunity for a financial institution to select its regulator based on who might be more lenient, who might have less strict rules, who might demand less capital. This is not a theoretical contention. I refer the Committee to a January 22, 2009, article in the Washington Post titled ``By Switching Their Charters, Banks Skirt Supervision.'' The article reports that since 2000 at least 30 banks switched from Federal to State supervision to escape regulatory action. The actual number is likely higher because the newspaper was only able to count public regulatory actions. They could not discover banks that acted to pre-empt action when they saw it coming. In total, 240 banks converted from Federal to State charters, while 90 converted from State to Federal charters. The newspaper was unable to discover if any of those formerly State banks were avoiding State action. Two, what happened at AIG demonstrates the strength and effectiveness of State insurance regulation, not the opposite. The only reason that the Federal rescue of AIG is possible is because there are strong operating insurance companies that provide the possibility that the Federal Government and taxpayers will be paid back. And the reason why those insurance companies are strong is because State regulation walled them off from non-related activities in the holding company and at Financial Products. In most industries, the parent company can reach down and use the assets of its subsidiaries. With insurance, that is greatly restricted. State regulation requires that insurance companies maintain healthy reserves backed by investments that cannot be used for any other purpose. I've said that the insurance companies are the bars of gold in the mess that AIG has become. There are activities that the States need to improve, such as licensing and bringing new products to market. But where we are strong has been in maintaining solvency. I would note that at a time when financial services firms are in trouble because they do not have adequate capital and are too highly leveraged, at a time when commercial banks and investment banks have very serious problems, insurance companies remain relatively strong. There is justified concern about AIG's securities lending program, which affects only AIG's life insurance operations. I would like to review for you some facts about that program and the actions the New York Department has taken in regards to that program. It is important to understand that securities lending did not cause the crisis at AIG. AIG Financial Products did. If there had been no Financial Products unit and only the securities lending program as it was, we would not be here today. There would have been no Federal rescue of AIG. Financial Products' trillions of dollars of transactions created systemic risk. Securities lending did not. If not for the crisis caused by Financial Products, AIG would be just like other insurance companies, dealing with the stresses caused by the current financial crisis, but because of its size and strength, most likely weathering them well. Securities lending is an activity that has been going on for decades without serious problems. Many, if not most, large financial institutions, including commercial banks, investment banks and pension funds, participate in securities lending. Securities lending involves financial institution A lending a stock or bond it owns to financial institution B. In return, B gives A cash worth generally about 102 percent of the value of the security it is borrowing. A then invests the cash. A still owns the security and will benefit from any growth in its value. And A invests the cash to gain a small additional amount. Problems can occur if B decides it wants to return the security it borrowed from A. A is then required to sell its investment to obtain the cash it owes B. Generally, in a big securities lending program, A will have some assets it can easily sell. But if there is a run, if many of the borrowers return the securities and demand cash, A may not be able to quickly sell enough assets to obtain the cash it needs or may have to sell assets at a loss before they mature. AIG securities lending was consolidated by the holding company at a special unit it set up and controlled. This special unit was not a licensed insurance company. As with some other holding company activities, it was pursued aggressively rather than prudently. AIG maintained two securities lending pools, one for U.S. companies and one for non-U.S. companies. At its height, the U.S. pool had about $76 billion. The U.S. security lending program consisted of 12 life insurers, three of which were from New York. Those three New York companies contributed about 8 percent of the total assets in the securities lending pool. The program was invested almost exclusively in the highest-rated securities. Even the few securities that were not top rated, not triple A, were either double A or single A. Today, with the perfect clarity of hindsight, we all know that those ratings were not aligned with the market value of many mortgage-backed securities, which made up 60 percent of the invested collateral pool. The New York Department was aware of the potential stresses at the AIG securities lending program and was actively monitoring it and working with the company to deal with those issues. Those efforts were working, but were thwarted by the Financial Products crisis in September 2008. As early as July 2006, we were engaged in discussions about the securities lending program with AIG. In 2007, we began working with the company to start winding down the program. Unfortunately, the securities lending program could not be ended quickly because beginning in 2007 some of the residential mortgage securities could not be sold for their full value. At that time there were still few if any defaults, the securities were still paying off. But selling them would have involved taking a loss. Still, we insisted that the program be wound down and that the holding company provide a guarantee to the life companies to make up for any losses that were incurred as that happened. In fact, the holding company provided a guarantee of first $500 million, then $1 billion and finally $5 billion. In 2008, New York and other States began quarterly meetings with AIG to review the securities lending program. Meanwhile, the program was being wound down in an orderly manner to reduce losses. From its peak of about $76 billion it had declined by $18 billion, or about 24 percent, to about $58 billion by September 12, 2008. At that point, the crisis caused by Financial Products caused the equivalent of a run on AIG securities lending. Borrowers that had reliably rolled over their positions from period to period for months began returning the borrowed securities and demanding their cash collateral. From September 12 to September 30, borrowers demanded the return of about $24 billion in cash. The holding company unit that managed the program had invested the borrowers' cash collateral in mortgage-backed securities that had become hard to sell. To avoid massive losses from sudden forced sales, the Federal Government, as part of its rescue, provided liquidity the securities lending program. In the early weeks of the rescue, holding company rescue funds were used to meet the collateral needs of the program. Eventually the Federal Reserve Bank of New York created Maiden Lane II, a fund that purchased the life insurance companies' collateral at market value for cash. There are two essential points about this. First, without the crisis caused by Financial Products, there is no reason to believe there would have been a run on the securities lending program. We would have continued to work with AIG to unwind its program and any losses would have been manageable. In fact, the New York Department has worked and continues to work with other insurance companies to unwind their securities lending programs with no serious problems. Second, even if there had been a run on the securities lending program with no Federal rescue, our detailed analysis indicates that the AIG life insurance companies would not have been insolvent. Certainly, there would have been losses, with some companies hurt more than others. But we believe that there would have been sufficient assets in the companies and in the parent to maintain the solvency of all the companies. Indeed, before September 12, 2008, the parent company contributed slightly more than $5 billion to the reduction of the securities lending program. But that is an academic analysis. Whatever the problems at securities lending, they would not have caused the crisis that brought down AIG. And without Financial Products and the systemic risk its transactions created, there would have been no reason for the Federal Government to get involved. State regulators would have worked with the company to deal with the problem and protect policyholders. I would like to also review briefly what the New York Department has done generally about securities lending in the insurance industry. Based on what we were seeing at AIG, but before the Financial Products crisis in September, we warned all licensed New York companies that we expect them to prudently manage the risks in securities lending programs. On July 21, 2008, New York issued Circular Letter 16 to all companies doing business in New York which indicates Department concerns about security lending programs. We cautioned them about the risks, reminded them of the requirements for additional disclosure and told them we would be carefully examining their programs. On September 22, 2008, the Department sent what is known as a Section 308 letter to all life insurance companies licensed in New York requiring them to submit information relating to security lending programs, financing arrangements, security impairment issues and other liquidity issues. My staff then conducted a thorough investigation of the securities' lending programs at New York life insurance companies. The results were reassuring. Almost all of the companies had modest sized programs with highly conservative investments, even by today's standards. Companies with larger programs had ample liquidity to meet redemptions under stress. What became clear was that AIG, because of the Financial Products problems, was in a uniquely troubling situation. In the succeeding months we have continued to analyze the securities lending programs at New York companies. We are currently drafting regulatory guidelines that will govern the size and scope of securities lending programs and will include best practices. We will also continue to enforce our legal authority to shut-down any programs that we believe endanger policyholders. Also, as chair of the National Association of Insurance Commissioners Statutory Accounting Practices Working Group, we have successfully worked to have the NAIC adopt increased disclosure rules for securities lending programs. Our primary principle throughout the effort to assist AIG has been to continue to protect insurance company policyholders and stabilize the insurance marketplace. And it is appropriate to recognize that all our partners in this effort, including officials from the Federal Reserve Bank of New York, the Federal Reserve Board, the U.S. Treasury, AIG executives and their financial advisors, investment and commercial bankers, private equity investors, other State regulators at all times understand and agree that nothing should or would be done to compromise the protection of insurance company policyholders. The dependable moat of State regulation that protects policyholders remains solid. We will continue to evaluate any transactions involving AIG insurance companies on that basis. Thank you and I would be happy to answer your questions. RESPONSE TO WRITTEN QUESTIONS OF THE SENATE BANKING COMMITTEE FROM ERIC DINALLOQ.1.a. State Rescue Plan: Superintendent Dinallo, it has been reported that last year you and the Pennsylvania Insurance Commissioner sought to save AIG by allowing AIG's property and casualty insurers to transfer $20 billion in liquid government securities to AIG's holding company in exchange for stock in AIG's domestic life insurers. On September 15, 2008, New York Governor David Paterson issued a press release stating that he had instructed you to permit AIG's parent company to access the $20 billion from its subsidiary property-casualty insurance companies. Please provide the Committee with a complete description of this plan, including the documents you presented to Governor Paterson to obtain his approval for the plan.A.1.a. The basic terms of the initial proposed plan provided for three distinct elements: (1) the parent company American International Group, Inc. (AIG) raising equity capital from commercial sources, (2) AIG quickly selling a significant business unit or units, and (3) AIG property casualty companies exchanging liquid assets for equally valuable, but less liquid, assets owned by the parent and the parent in turn converting those liquid assets to cash. The plan was discussed at length over the weekend of September 12-14, 2008, and into Monday, September 15, 2008, as described below, but was supplanted by other actions and not implemented. This was not a formally developed ``Plan'' with lengthy development or long written analyses. The plan was a constantly evolving, working response developed during a rapidly changing crisis. We were aware of and engaged in discussions concerning all three parts of this plan. It was always our expectation and understanding that all three elements were required and that we would not implement the third element unless there was a comprehensive solution for the crisis. In addition, the third element was itself never finalized. One of the conditions for our final approval was the company providing assets that would be, in our estimation, of sufficient value to protect the property casualty companies and their policyholders. Governor Paterson's direction was to ensure that policyholders inside and outside New York were protected. The Governor's press release on Monday, September 15, reflected an agreement in principle. It was clearly not a final approval. As the weekend of September 12 to 14 progressed, AIG's projected cash needs grew substantially. By early Tuesday, it was clear that, even if possible to complete, this plan would not suffice and all parties focused on other actions. For the first element of the plan, AIG discussed raising equity capital from a variety of commercial sources. If a capital raise resulted in another entity acquiring control, as defined in Article 15 of the New York Insurance Law (the ``Insurance Law''), of New York licensed insurance companies, New York State Insurance Department (the ``Department'') approval would have been required. While we were not negotiating the terms of any prospective capital raises, we were periodically updated on the progress of those discussions. For the second element of the plan, AIG was discussing possible imminent business unit sales. As noted above, another entity acquiring control, as defined in Article 15 of the Insurance Law, of New York licensed insurance companies would have required Department approval. As with AIG's capital raising efforts, while we were not negotiating the terms of any prospective sales, we were periodically updated on the progress of these discussions. For the third element of the plan, AIG sought to have certain of its property casualty companies exchange municipal bonds they owned for stock in AIG Life Holdings (U.S.), Inc. and AIG Retirement Services, Inc. (the ``Life Company Stock''), intermediate holding company subsidiaries of AIG which own substantial operating insurance companies, and for other assets including certain real estate interests and other investments. AIG would then seek to post these municipal bonds with the Federal Reserve Bank of New York in exchange for cash. That would allow AIG to use the cash to post cash collateral for its AIG Financial Products collateral calls. Among the property casualty companies considered for this exchange (as providers of municipal bonds and receivers of life insurance company stock) were American Home Assurance Company (AHAC) and Commerce and Industry Insurance Company (C&I), each a New York domiciled property casualty company. Additionally, three Pennsylvania domiciled property casualty companies were also considered, National Union Fire Insurance Company of Pittsburgh, Pa., New Hampshire Insurance Company, and The Insurance Company of the State of Pennsylvania. The stated goal of AIG for the proposed transactions in this third element of the plan was to provide $20 billion of liquidity to AIG. An aggregate purchase price for the Life Company Stock of approximately $15 billion dollars was proposed by AIG. The additional asset sales sought by AIG had a proposed aggregate purchase price of approximately $5 billion dollars. By Monday, September 15, as the plan evolved, the Department was considering only that the New York domiciled property casualty companies might purchase a portion of the Life Company Stock, and not any other assets. The plan contemplated that if the exchange were completed, the Life Company Stock would then be sold to third party purchasers over a longer sale period, with the sale proceeds retained by the property casualty companies. The discussions contemplated that the groups of New York and of Pennsylvania property casualty companies would each purchase approximately 50 percent of the Life Company Stock. Throughout Saturday and Sunday, September 13 and 14, my staff and I had many discussions with AIG and its advisors. We reviewed and discussed their various proposals and ideas for implementing the exchange. We did not at any time give final approval for the proposed exchange. Indeed, we were at all times clear that the proposal had to be part of a holistic solution and had to over-protect policyholders, or it would not be approved. As my statement in Governor Paterson's press release, issued on the morning of September 15, noted, as of Monday morning we continued ``working closely with AIG'' on its proposal. As the Governor stated in that release on the morning of September 15, I was, at the Governor's direction, working with the Federal Reserve Bank of New York (FRBNY) in response to the rapidly changing crisis. As my discussions with the FRBNY, the U.S. Treasury Department and numerous other parties continued through Monday afternoon and well into Monday night, other plans developed. The primary alternative considered was a commercial line of credit provided by commercial lenders. Through roughly midnight Monday or 1 a.m. on Tuesday, when I left AIG's offices, that appeared to be the most likely option. By the time of a meeting commencing at 7:30 a.m. Tuesday morning, that alternative appeared to have failed. Discussion then turned to possible Federal Reserve and Federal Government actions and consideration of the credit facility announced that night. The three part plan that is the subject of your question was not further pursued.Q.1.b. Which other State and Federal regulatory agencies, private sector firms and banks were involved in preparing this plan?A.1.b. Concerning our own advisors, in addition to Department resources, we retained the law firm of Fried, Frank, Harris, Shriver, and Jacobson as outside counsel. We later retained Centerview Partners as outside financial advisors, although such retention was not in effect during the period that your question covers. We dealt with many parties between September 12 and September 16. To say that they were each ``involved in preparing this plan'' is an overstatement and a more formal characterization than would be accurate. Each of them, however, played a role in those 5 days and our own response and actions incorporated, at least indirectly, our dealings with a broad range of other firms and agencies. Concerning commercial parties, these included AIG, JPMorgan Chase and Blackstone as advisors to AIG, Sullivan & Cromwell as counsel to AIG, Simpson Thacher & Bartlett as counsel to the AIG board of directors, J.C. Flowers & Co., Texas Pacific Group, Kohlberg Kravis & Roberts, and Berkshire Hathaway as prospective investors and/or purchasers. On September 15 and 16, these also included Goldman Sachs. I do not recall any other firms or banks as being involved, but only AIG and the other parties can say definitively whether they retained or engaged any other firms or banks. Concerning other government agencies, we dealt with the Federal Reserve Bank of New York, the FRBNY's financial advisors Morgan Stanley, the FRBNY's legal counsel Davis Polk & Wardwell, the United States Treasury Department, the Pennsylvania Department of Insurance, the National Association of Insurance Commissioners (including the then-NAIC president Sandy Praeger, who is the Kansas Insurance Commissioner and the NAIC president-elect, and now president, Roger Sevigny, who is the New Hampshire Insurance Commissioner), and a number of other State insurance departments. I have subsequently learned that a staff member of the United States Office of Thrift Supervision contacted one of my staff late on Sunday, September 14. I was unaware of that contact at the time and I had no contact with the Office of Thrift Supervision during the period covered by your question.Q.1.c. Did any State insurance regulators object to or express any concerns about this plan?A.1.c. Accurately answering your question requires separating it into two parts, the first being whether any insurance regulators ``object[ed] to'' such plan and the second being whether any insurance regulators ``express[ed] any concerns.'' On the first part, I do not recall any State insurance regulator saying that they objected to the plan. On the second part, all State insurance regulators I spoke with expressed concerns. Indeed, I had great concerns and worked virtually around the clock beginning Friday evening in response to those concerns. Our shared concerns were policyholder protection and the solvency of the licensed insurance companies. As Governor Paterson stated in his press release on the morning of September 15, protection of policyholders was a pre-condition for any approval and we focused intently on such protection. We worked to evaluate the possible asset exchange in detail, including whether the assets to be received by the property and casualty companies were of sufficient value, and continued doing so through late Monday, September 15.Q.2.a. Securities Lending: Superintendent Dinallo, according to AIG corporate records, AIG's securities lending program invested more than 60 percent of its collateral in long-term mortgage-backed securities. More than 50 percent of its mortgage-backed securities were comprised of subprime and alt-a mortgages. Since AIG loaned out securities for typically less than 180 days, there was a significant asset-liability mis-match in AIG's securities lending program. Why was AIG allowed to invest such a large percent of the collateral from its securities lending program in long-term assets? When did you first become aware that AIG had invested such a high percentage of the collateral from its securities lending program in mortgage-backed securities? Did it raise any concerns at the time? If so, what specific steps did your Department take to address those concerns?A.2.a. Based on what we were seeing at AIG, but before AIG Financial Products caused a crisis in September 2008, we warned all licensed New York companies that we expect them to prudently manage the risks in securities lending programs. On July 21, 2008, the New York Department issued Circular Letter 16 to all insurance companies doing business in New York, indicating Department concerns about securities lending programs. We cautioned them about the risks, reminded them of the requirements for additional disclosure and told them we would be carefully examining their programs. The Department does not issue many circular letters and they are understood by the industry to be important communications. Immediately after the AIG crisis began, on September 22, 2008, the Department sent what is known as a Section 308 letter to all life insurance companies licensed in New York, requiring them to submit information relating to securities lending programs, financing arrangements, security impairment issues and other liquidity issues. My staff then conducted a thorough investigation of the securities lending programs at New York life insurance companies. Besides gathering information from all companies, the Department met with 25 New York life insurance companies which have a securities lending program. The results were reassuring. Almost all of the companies had modest sized programs with highly conservative investments, even by today's standards. Companies with larger programs had ample liquidity to meet redemptions under stress. None of them had the same issues as the AIG program. In the succeeding months we have continued to analyze the securities lending programs at New York companies. We are currently drafting regulatory guidelines that will govern the size and scope of securities lending programs and will include updated best practices. We will use our legal authority to shut down any programs that we believe endanger policyholders. AIG's securities lending program was operated by a special unit created by the holding company, rather than by each individual AIG life insurance company. No other New York insurance company operates its securities lending at the holding company. The New York Insurance Department began discussing securities lending with AIG in 2006 in the context of applying risk-based capital. Risk-based capital looks at the risk of a particular investment and requires the company to hold capital against that investment based on an analysis of the risk. For securities lending, the Department took the position that insurers with securities lending programs had counterparty risk and should take a risk-based capital charge on that basis. AIG in particular, and the industry in general, disagreed with our position. Taking a charge would have protected the company and its policyholders, but would also have reduced the amount earned from securities lending. In early 2007, AIG gave the Department a presentation about its securities lending program. The intent of the presentation was to explain why there should be no risk-based capital charge. The company explained that they had reinvested the cash collateral largely in asset-backed and mortgage-backed securities. They explained to us that they maintained sufficient liquidity to meet ``normal'' collateral calls and that the reinvested assets were in AAA-rated, highly-liquid assets. At the time of the presentation, these assertions seemed valid and in fact the market value of the securities was sufficient to cover the liability, that is, the return of the cash collateral. The issue of a risk-based capital charge for securities lending was settled to our satisfaction in 2007. The Department, as chair of the NAIC Capital Adequacy Task Force, spearheaded a subgroup to review the risk-based capital formula to ensure that the appropriate charge was taken by all companies for their securities lending programs. The subgroup completed its work in 2007, and recommended changes that were adopted and effective for the 12/31/08 annual statement filing. The bad news about the residential mortgage-backed securities market began to become serious in the summer of 2007. Because of that, we conducted further discussions with AIG in September 2007. In those discussions, we focused on the percentage of the investments in mortgage-backed securities and their terms and maturity. At that time, the AIG U.S. securities lending program reached its peak of $76 billion. AIG stated that the program was structured to ensure that sufficient liquidity was maintained to meet the cash calls of the program under ``normal circumstances.'' At that time, AIG's securities lending program held 16 percent cash and cash equivalents, 33 percent securities with 2 years or less maturity, 34 percent securities with 3 to 5 years maturity, 15 percent securities with 5 to 10 years to maturity and only 2 percent securities with more than 10 years maturity. It was then clear that the program should be reduced. The holding company promised at that time to pay the securities lending program for any losses on sales of securities up to $1 billion, which later was increased to $5 billion, to protect the life insurance companies. We began to work with the company on reducing the size of the program. \1\--------------------------------------------------------------------------- \1\ According to an unofficial transcript, in my oral statement to the Committee on March 5, which I did not read, but presented from brief notes, I stated that we began working with the company to reduce the securities lending program ``starting in the beginning of 2007.'' Later in my testimony, I stated more precisely that ``starting in 2007, we did begin to wind down'' the program. While we were working with AIG on issues related to the securities lending program in early 2007, in fact, as noted, we began working with the company specifically on reducing the size of the program towards the end of 2007.--------------------------------------------------------------------------- In March 2008, New York and other States began quarterly meetings with AIG to review the securities lending program. Meanwhile, the program was being wound down in an orderly manner to reduce losses. Because of the size of the program and the bad market conditions, the company had to proceed slowly with sales of assets in order to reduce losses on those sales. Despite those problems, the company was able to make substantial progress. From its peak of about $76 billion in September 2007, the securities lending program had declined by $18 billion, or about 24 percent, to about $58 billion by September 12, 2008. At that point, the crisis caused by Financial Products caused the equivalent of a run on the AIG securities lending program. Securities borrowers that had reliably rolled over their positions from period to period for months began returning the borrowed securities and demanding their cash collateral. From September 15 to September 30, borrowers demanded the return of about $24 billion in cash. The holding company unit managing the program had invested the securities borrowers' cash collateral in mortgage-backed securities that had become hard to sell. To avoid massive losses from sudden forced sales, the Federal Government, as part of its rescue, provided liquidity to the securities lending program. In the early weeks of the rescue, holding company rescue funds were used to meet the collateral needs of the program. Eventually the FRBNY created Maiden Lane II, a special purpose vehicle which, according to AIG, purchased the life insurance companies' securities lending collateral at an average price of about 50 percent of par. If not for the Financial Products crisis, we believe that AIG could have continued to manage the reduction of its securities lending program. It would have incurred some losses, but they would have been manageable. There is no doubt in my mind that the Federal Government would not have stepped in to rescue AIG if the company only had its securities lending problems. It is also important to note that despite the fact that New York life insurance companies are relatively small and made up only 8 percent of the AIG securities lending program, the New York Insurance Department was active from the start in dealing with the issues related to the program.Q.2.b. How does the reinvestment strategy of AIG's securities lending program compare with those of other insurance companies? Are you aware of any other companies having a similarly risky reinvestment strategy?A.2.b. In September and October 2008, the Department met with 25 New York life insurance companies which have a securities lending program. In addition, the Department sent out 134 letters (Section 308 requests) to New York insurance companies to obtain information on securities lending programs, as well as other liquidity issues. The review indicated that none of the New York companies had a similar reinvestment strategy.Q.3. Holding Company Supervision: Superintendent Dinallo, what authority does New York insurance law give your office to examine the activities of insurance holding companies and their affiliates? Did your office ever exercise this authority with respect to AIG?A.3. Beginning nearly two generations ago, most if not all States in the Nation, New York included, enacted a ``holding company act'' to ensure that any authorized (i.e., licensed) insurance company that is part of a holding company system is subject to scrutiny by insurance regulators. The purpose of these holding company acts is to ensure, first and foremost, that insurance companies can meet their obligations to policyholders, and are not exploited in ways that inure to policyholder detriment. Thus, under holding company acts, insurance regulators must review, among other things, the financial condition and trustworthiness of any person or entity that seeks to acquire control of an authorized insurer, as well as significant transactions within a holding company system. New York's holding company act is codified at Article 15 of the New York Insurance Law. Section 1504(b) sets forth the Insurance Superintendent's authority to examine holding companies themselves: ``Every holding company and every controlled person within a holding company system shall be subject to examination by order of the superintendent if he has cause to believe that the operations of such persons may materially affect the operations, management or financial condition of any controlled insurer within the system and that he is unable to obtain relevant information from such controlled insurer'' (emphasis added). This power does not provide that such non-licensed holding companies or other affiliates are regulated by the Department. It is a far more narrow authority providing for an ability to examine such entities under the specified conditions. In the case of AIG, the New York Insurance Department did not exercise its authority under section 1504(b) to examine the holding company. First, the AIG holding company and its Financial Products unit were regulated by the Federal Office of Thrift Supervision. AIG chose OTS as its primary regulator in 1999 based on the fact that the company owned a tiny savings and loan. It is worth noting that the courts have stopped other State agencies that tried to take action against federally regulated companies. Second, at no time did the Department request ``relevant information'' from an insurer in the AIG holding company system that we were ``unable'' to obtain from that insurer. To the contrary, the AIG insurance entities domesticated in New York have been responsive to requests for information from the New York Insurance Department. Further, insurers like American Home Assurance in AIG's commercial insurance group have had such strong financial positions--with billions of dollars of policyholder surplus, and, until September 2008, top credit ratings from rating agencies--that the Superintendent had no ``cause to believe that the operations'' of AIG's holding company might ``materially affect the operations, management or financial condition of any controlled insurer within the system.''Q.4. AIG Securities Lending Operations: Based on data provided by the company, it appears that several insurers suffered losses on their securities lending during 2008 that exceeded the amount of their total adjusted capital at the start of 2008. Due to the Fed's loan, these companies have been recapitalized. If the Fed had not intervened, however, it appears several companies, including New York insurers, could have been close to insolvency. Had the Fed not intervened to rescue AIG, was the New York State Guaranty Fund prepared to handle the insolvency of one or more AIG companies? Please provide data to support your answer.A.4. The data provided below do not support the view that AIG's life insurance companies would have been insolvent both before and after the Financial Products crisis without the intervention of the FRBNY. As of the end of 2007, the companies had adjusted capital and surplus (inclusive of asset valuation reserves) of $27 billion. Their aggregate securities lending losses in 2008 totaled $21 billion, leaving them with remaining adjusted capital and surplus as a group of about $5.8 billion. The AIG parent company contributed $5.3 billion apart from any action by the FRBNY. So without accounting for any action by the Federal Reserve, and without accounting for any ordinary course earnings during 2008, the life insurance companies had total adjusted capital and surplus of $11 billion. As a result of the Federal Reserve action, that total increased to $19 billion. Adjusted Capital & Surplus for AIG Life Insurance Companies Participating in Securities Lending ($ in billions)---------------------------------------------------------------------------------------------------------------- Total Adj. Capital 12- 31-07 Securities Parent Net Surplus 12-31-08 State % of Pool (includes Lending Gross Cap Capital (Gap) After FRBNY asset Losses 2008 (C&S-losses) Infusions Before FRBNY Capital valuation pre-FRBNY Infusions reserve)---------------------------------------------------------------------------------------------------------------- 3 NY Co's 8.4% $1.682 ($1.82) ($.138) $.722 $.584 $1.901 All AIG 100% $27.078 ($21.305) $5.773 $5.387 $11.16 $19.069---------------------------------------------------------------------------------------------------------------- As noted, the New York domestic companies would not have been insolvent without Federal Reserve intervention. As to the New York State Life Insurance Guaranty Fund, under the Life Insurance Company Guaranty Corporation of New York, the basic answer is that the New York Department was and is prepared to deal with the potential insolvency of a life insurer. Generally, the first effort is to determine if the parent company has the ability to cure the insolvency. If that is not possible, the second step is usually to seek a buyer. This is often possible. The final step is to take a company into rehabilitation or liquidation. Since life insurance obligations extend over a long period, there is generally some time to determine the extent to which a company's assets are insufficient to meet its liabilities. Had it been necessary to take the three AIG New York life insurance companies into rehabilitation and/or liquidation, the Department would have been ready for such action. It is important to note that two of the three New York domestic companies are licensed in all 50 States and would be subject to the guaranty funds of the 50 States, not just the New York Guaranty Fund. The third company is licensed in three States, so the guaranty funds of the three States would be involved. In New York, as well as the other 49 States, the guaranty funds are funded by assessments from its licensed companies. Even if a company is deemed insolvent, assessments may not be required immediately. Generally, assessments are only imposed as they are actually needed. The Department believes that the guaranty funds would have been ready to handle the insolvency of one or more AIG companies." CHRG-111hhrg55811--329 Mr. Johnson," I believe that the subprime market was the catalyst, the trigger in this episode and the opacity that was associated with the collateralized debt obligations. The funny ratings from the rating agencies played a very large role. But I do not think that is the exclusive source of opacity in this very large scale derivatives markets. Nor, by the way, do I think that derivatives are--I think they play a meaningful role, but they have to be structured so that as the gentleman speaking before me said, counterparties can assess each other and not become afraid and not withdraw credit in times of crisis or shock that emanates from any source, domestic or foreign. " CHRG-111shrg62643--152 Mr. Bernanke," If you don't control the deficits over time, eventually, the markets won't lend to you at reasonable interest rates. Senator Menendez. Now, speaking about lending at reasonable interest rates, if we continue--you know, my colleagues from Montana and Colorado, I could echo in New Jersey the reality of what banks tell us, particularly community banks and others. So it gets to be a little wide swath of the same set of statements that are being made, which always make me think a little bit about the truthfulness in terms of there seems to be more voracity when I continuously get from a wide range of entities the same answer. But if you can borrow from the Federal Reserve at, what is it, one point? " FinancialCrisisReport--327 The ABX Index allowed investors to place unlimited bets on the performance of one or more of the subprime RMBS baskets. It also made it easier and cheaper for investors, including some investment banks, to short the subprime mortgage market in bulk. 1254 Investment banks not only helped establish the ABX Index, they encouraged their clients to enter into CDS contracts based upon the ABX Index, and used it themselves to bet on the mortgage market as a whole. The ABX Index expanded the risks inherent in the subprime mortgage market by providing investors with a way to make unlimited investments in RMBS securities. Synthetic CDOs. By mid-2006, there was a large demand for RMBS and CDO securities as well as a growing demand for CDS contracts to short the mortgage market. To meet this demand, investment banks and others began to make greater use of synthetic CDOs, which could be assembled more quickly, since they did not require the CDO arranger to find and purchase actual RMBS securities or other assets. The increasing use of synthetic CDOs injected even greater risk into the mortgage market by enabling investors to make unlimited wagers on various groups of mortgage related assets and, if those assets performed poorly, expanding the number of investors who would realize losses. Synthetic CDOs did not depend upon actual RMBS securities or other assets to bring in cash to pay investors. Instead, the CDO simply developed a list of existing RMBS or CDO securities or other assets that would be used as its “reference obligations.” The parties to the CDO were not required to possess an ownership interest in any of those reference obligations; the CDO simply tracked their performance over time. The performance of the underlying reference obligations, in the aggregate, determined the performance of the synthetic CDO. The synthetic CDO made or lost money for its investors by establishing a contractual agreement that they would make payments to each other, based upon the aggregate performance of the underlying referenced assets, using CDS contracts. The “short” party essentially agreed to make periodic payments, similar to insurance premiums, to the other party in exchange for an agreement that the “long” party would pay the full face value of the synthetic CDO if the underlying assets lost value or experienced a defined credit event such as a ratings downgrade. In essence, then, the synthetic CDO set up a wager in which the short party bet that its underlying assets would perform poorly, while the long party bet that they would perform well. 1254 Subcommittee Interview of Joshua Birnbaum (4/22/2010); Subcommittee Interview of Rajiv Kamilla (10/12/2010). CHRG-110hhrg34673--227 Mr. Bernanke," It is a bit early to tell. We saw a big spike in bankruptcy filings in advance of the law because people, if they were thinking of going bankrupt, they wanted to get that done before the law change. Since then we have seen a moderate rate of bankruptcy, I think somewhat lower than in the past, but whether that is due to the change in the law or just to generally good financial conditions in the last few years is hard to say. Again, we have seen, for example, very few delinquencies in consumer credit or in mortgages outside the subprime market, so there has been a generally good credit situation in the last couple of years, and that seems to be reflected in a relatively low rate of bankruptcies. " CHRG-111hhrg55809--248 Mr. Manzullo," Correct. How do you balance, if that is the work that the oversight council would do, with a new consumer financial protection agency, especially if it comes to a dispute over instruments, products? You may think that a particular product may pose a systemic risk, such as the whole rotten subprime market, when people were allowed to get 3/27 and 2/28 mortgages and teaser rates and things like that and were allowed to get loans without written proof of their income. What happens if you have a conflict with the oversight council and a new consumer financial protection agency? " FinancialCrisisReport--326 The short party, or CDS buyer, typically pays periodic premiums, similar to insurance premiums, to the long party or CDS seller, who has guaranteed the referenced assets against a loss in value or a negative credit event such as a credit rating downgrade, default, or bankruptcy. If the loss or negative credit event occurs, the CDS seller is required to pay an agreed upon amount to the CDS buyer. Many CDS contracts also tracked the changing value of the referenced assets over time, and required the long and short parties to post cash collateral with each other to secure payment of their respective contractual obligations. CDS contracts that reference a single, specific security or bond for protection against a loss in value or negative credit event have become known as “single name” CDS contracts. Other CDS contracts have been designed to protect a broader basket of securities, bonds, or other assets. By 2005, investment banks had standardized CDS contracts that referred to a “single name” RMBS or CDO security. Some investment banks and investors, which held large inventories of RMBS and CDO securities, purchased those single name CDS contracts as a hedge against possible losses in the value of their holdings. Other investors, including investment banks, began to purchase single name CDS contracts, not as a hedge to offset losses from the RMBS or CDO securities they owned, but as a way to profit from particular RMBS or CDO securities they predicted would lose value or fail. CDS contracts that paid off on securities that were not owned by the CDS buyer became known as “naked credit default swaps.” Naked CDS contracts enabled investors to bet against mortgage related assets, using the minimal capital needed to make the periodic premium payments and collateral calls required by a CDS contract. The key significance of the CDS product for the mortgage market was that it offered an alternative to investing in RMBS and CDO securities that would perform well. Single name CDS contracts instead enabled investors to place their dollars in financial instruments that would pay off if specific RMBS or CDO securities lost value or failed. ABX Index. In January 2006, a consortium of investment banks, led by Goldman Sachs and Deutsche Bank, launched still another type of structured finance product, linked to a newly created “ABX Index,” to enable investors to bet on multiple subprime RMBS securities at once. The ABX Index was administered by a private company called the Markit Group and consisted of five separate indices, each of which tracked the performance of a different basket of 20 designated subprime RMBS securities. 1253 The values of the securities in each basket were aggregated into a single composite value that rose and fell over time. Investors could then arrange, through a broker-dealer, to enter into a CDS contract with another party using the ABX basket of subprime RMBS securities as the “reference obligation” and the relevant ABX Index value as the agreed 1253 Each of the five indices tracked a different basket of subprime RM BS securities. One index tracked a basket of 20 AAA rated RMBS securities; the second a basket of AA rated RMBS securities; and the remaining indices tracked baskets of A, BBB, and BBB- rated RMBS securities. Every six months, a new set of RM BS securities was selected for each index. See 3/2008 Federal Reserve Bank of New York Staff Report No. 318, “Understanding the Securitization of Subprime Mortgage Credit, ” 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. upon value of that basket. For a fee, investors could take either the “long” position, betting on the rise of the index, or the “short” position, betting on the fall of the index, without having to physically purchase or hold any of the referenced securities or raise the capital needed to pay for the full face value of those referenced securities. The index also used standardized CDS contracts that remained in effect for a standard period of time, making it easier for investors to participate in the market, and buy and sell ABX-linked CDS contracts. CHRG-111hhrg49968--62 Mr. Scott," Some banks have also complained that the additional FDIC fees will reduce their lending capacity and, therefore, have an adverse effect on the economy. Do you have a comment on that? " CHRG-111shrg51290--34 Chairman Dodd," Thank you, Senator, very much. Let me say, if I can, and some of these questions have been asked, that we have talked a lot about the brokers and the lack of regulation at that level of the chain. In fact, I remember at a hearing we had here, I think Senator Shelby and Senator Schumer will remember, we had displayed the Web site of the brokers at the time--this was back about 2 years ago--and on the Web site, the first rule was, convince the borrower you are their financial advisor. That was the first rule. And, of course, that was fairly easy to do in Committee ways. You are talking about people who are relatively unaccustomed to all of this. I was with a group of bankers not long ago and I asked them a question I suppose all of us ask ourselves any time we have been to a closing. How many times do we find ourselves with the lawyers there with the tabs and sign the tabs and we don't find ourselves reading everything. We assume that these things are pretty boilerplate, standardized stuff and accept it for what it is. And so the idea that there is this level playing field between the borrower and the lender, any more than there is between the patient and a physician in cases of medical malpractice, is questionable. Obviously, the borrower and the patient have responsibilities. That is not to suggest they don't have any, but the suggestion somehow that they are both equal in terms of that moment of bargaining is, I think, something that most of us--all of us--would recognize as being unrealistic. I am interested in, and this is a point that Professor McCoy made, why we have focused largely on the problem at origination. Professor McCoy, you lay out in your testimony the role played by Wall Street. Essentially, you argue that it was the demand for product to securitize that drove the lending standards down, not the other way around. And I wonder whether or not you, Ms. Seidman, would agree with that and how you feel about that, Steve. Ms. Seidman. I think both work. The collapse of the subprime market was the trigger here, but the fact that there was a gigantic bubble to break happened because of the investment side demand. Who knows what other products would have been created to fill that demand if the mortgage products hadn't. The mortgage products had a big advantage. They were regarded as extremely safe and producing rates of return that were significantly higher than Treasuries. And, of course, back in the 1990s, mortgage products were extremely safe and produced higher returns than Treasuries. So I think both were definitely part of the problem and that if we had just had lax consumer protection without the investment side, we would have had a problem for a lot of consumers, but we probably wouldn't have had a global international crisis. " CHRG-110hhrg46593--113 Secretary Paulson," Well, okay, to answer that question, there are no banks, when the system is under pressure, unless they are ready to fail, that are going to raise their hand and say, please, I need capital; give me some capital. What happens when an economy turns down and when there is a crisis, they pull in their horns. They say, I don't need help. They don't deal with other banks. They don't lend, and the system gets ready to collapse. So the step that we took was very, very critical, and to be able to go out and go out to the healthy banks and go out before they became unhealthy and to increase confidence in the banks and of the banks so that they lend and that they do business with each other, that was absolutely what we were about. And when we came here to-- " FOMC20081029meeting--92 90,MR. SHEETS.," Just to put some numbers on IMF lending capacity--total IMF lending capacity is about $250 billion. To get even that high they have to call in some special arrangements that they have with a variety of countries. The maximum capacity is $250 billion. So the $120 billion that we're proposing today would be essentially half of what the IMF could do. In that sense I really see what we're proposing as our taking off the IMF's hands some of the largest potential liquidity needs, which then allows them to focus on a whole range of additional countries. A related point is that I understand that, in an IMF executive board meeting today, the managing director indicated that they are getting a fair amount of interest in this new facility. It really is a different kind of facility, and frankly, even a week ago if you told me that the IMF was going to be able to put this facility together in this quick a time, I would have said, ""No way. There's no way that the IMF can move this quickly."" So it is about as good as we could expect and maybe even better than what we could have expected from the Fund. I think that they are doing what they can to minimize stigma. On the other hand, they don't have enough lending capacity to really handle these folks that we're talking about today. " fcic_final_report_full--196 Mudd responded, “My experience is that email is not a very good venue for con- versation, venting or negotiating.” If Dallavecchia felt that he had been dealt with in bad faith, he should “address it man to man,” unless he wanted Mudd “to be the one to carry messages for you to your peers.” Mudd concluded, “Please come and see me today face to face.”  Dallavecchia told the FCIC that when he wrote this email he was tired and upset, and that the view it expressed was more extreme than what he thought at the time.  Fannie, after continuing to purchase and guarantee higher-risk mortgages in , would report a . billion net loss for the year, caused by credit losses. In , Mudd’s compensation totaled . million and Levin’s totaled  million. In , Freddie Mac also persisted in increasing purchases of riskier loans. A strategic plan from March highlighted “pressure on the franchise” and the “risk of falling below our return aspirations.”  The company would try to improve earnings by entering adjacent markets: “Freddie Mac has competitive advantages over non- GSE participants in nonprime,” the strategy document explained. “We have an op- portunity to expand into markets we have missed—Subprime and Alt-A.”  It took that opportunity. As OFHEO would note in its  examination report, Freddie purchased and guaranteed loans originated in  and  with higher-risk char- acteristics, including interest-only loans, loans with FICO scores less than , loans with higher loan-to-value ratios, loans with high debt-to-income ratios, and loans without full documentation. Financial results in  were poor: a . billion net loss driven by credit losses. The value of the  billion subprime and Alt-A private- label securities book suffered a  billion decline in market value.  In , Syron’s compensation totaled . million and McQuade’s totaled . million. Affordable housing goals: “GSEs cried bloody murder forever” As discussed earlier, beginning in , the Department of Housing and Urban Devel- opment (HUD) periodically set goals for the GSEs related to increasing homeowner- ship among low- and moderate-income borrowers and borrowers in underserved areas. Until , these goals were based on the fraction of the total mortgage market made up of low- and moderate-income families. The goals were intended to be only a modest reach beyond the mortgages that the GSEs would normally purchase.  From  to ,  of GSE purchases were required to meet goals for low- and moderate-income borrowers. In , the goal was raised to .  Mudd said that as long as the goals remained below half of the GSEs’ lending, loans made in the normal course of business would satisfy the goals: “What comes in the door through the natural course of business will tend to match the market, and therefore will tend to meet the goals.”  Levin told the FCIC that “there was a great deal of business that came through normal channels that met goals” and that most of the loans that satis- fied the goals “would have been made anyway.”  In  HUD announced that starting in ,  of the GSEs’ purchases would need to satisfy the low- and moderate-income goals. The targets would reach  in  and  in .  Given the dramatic growth in the number of riskier loans originated in the market, the new goals were closer to where the market really was. But, as Mudd noted, “When  became [] ultimately, then you have to work harder, pay more attention, and create a preference for those loans.”  Targeted goals loans (loans made specifically to meet the targets), while always a small share of the GSEs’ purchases, rose in importance. FinancialCrisisReport--533 As CDO execution has become more uncertain we have moved a couple warehouses closer to their MTM which has significantly increased our losses. Also, our MTModel results have shown losses as expected liability spreads have widened significantly and the overall strength of the CDO market has waned due to fundamental credit decline in 06/07 in RMBS subprime (90+% of assets) and increased co[r]relation between ABX/TABX levels and mezz debt levels in CDOs. We expect this co[r]relation to increase volatility in our warehouse marks for the [sic] a while (this series of events have happened quickly within the last month and the co[r]relation is getting closer to 1 as global markets get more familiar with fundamentals in subprime and trading levels in ABX/TABX). Additional losses have also resulted from the liquidation of 3 warehouses. In each case, the realized loss from the sale of assets has been higher than our MTM or MTModel. This is attributable to both volatility in subprime markets and that our competitors are closing their CDO warehouse accounts from buying our subprime or CDO positions. The buyer base has suddenly shrunk significantly. As this continues, we expect this lack of liquidity to further weaken our MTMs and feed into our losses in our remaining warehouse marks.” 2321 At about 11 p.m. that Saturday night, February 24, 2007, Mr. Sparks seemed to reach a decision to liquidate Anderson. He sent an email to Mr. Ostrem, Mr. Bieber, and several others stating: “I want to liquidate Anderson Monday – we should begin the discussion with gsc asap.” 2322 After Mr. Sparks relayed this decision, Messrs. Ostrem and Bieber began to strategize ways to convince Mr. Sparks to reverse his decision. 2323 Messrs. Ostrem and Bieber assembled a list of likely buyers of the Anderson securities to present to Mr. Sparks, and brainstormed about other CDOs that could potentially buy Anderson securities for their asset pools. 2324 Mr. Ostrem also proposed allowing a hedge fund to short assets into the deal as an incentive to buy the Anderson securities, but Mr. Bieber thought Mr. Sparks would want to “preserve that ability for Goldman.” 2325 At some point, Mr. Sparks changed his mind and decided to go forward with underwriting the Anderson CDO. None of the Goldman personnel interviewed by the Subcommittee could recall why the final decision was made to go forward with Anderson. In one email on March 2, 2007, Jonathan Egol, head of the Goldman Correlation Trading Desk, suggested adding $195 million more in assets to Anderson, with Goldman selecting the assets internally and shorting them. 2326 Mr. 2321 2322 2323 2324 2325 2326 2/24/2007 email from Peter Ostrem to colleagues, GS MBS-E-010383828-29. 2/24/2007 email from Daniel Sparks to Peter Ostrem, others, GS MBS-E-001996601, Hearing Exhibit 4/27-95. 2/25/2007 Goldman internal email chain, GS MBS-E-001996601, Hearing Exhibit 4/27-97. Id. Id. 3/2/2007 email from Jon Egol to Daniel Sparks and others, GS MBS-E-010637566, Hearing Exhibit 4/27-97. fcic_final_report_full--576 Washington, D.C., February 12, 2002, attached to OCC News Release 2002-10, p. 2. 67. John Hawke, quoted in Jess Bravin and Paul Beckett, “Friendly Watchdog: Federal Regulator Of- ten Helps Banks Fighting Consumers,” Wall Street Journal, January 28, 2002. 68. Oren Bar-Gill and Elizabeth Warren, “Making Credit Safer,” University of Pennsylvania Law Re- view 157 (2008): 182-83, 192-94. 69. See Watters v. Wachovia Bank NA, 550 U.S. 1 (2007). 70. John Dugan, testimony before the FCIC, Public Hearing on Subprime Lending and Securitization and Government-Sponsored Enterprises (GSEs), day 2, session 2: Office of the Comptroller of the Cur- rency, April 8, 2010, transcript, p. 150. 71. Lisa Madigan, testimony before the FCIC, First Public Hearing of the FCIC, day 2, panel 2: Inves- tigations into the Financial Crisis—State and Local Officials, January 14, 2010, transcript, p. 104. 573 72. John D. Hawke Jr., written testimony for the FCIC, Public Hearing on Subprime Lending and Se- curitization and Government-Sponsored Enterprises (GSEs), day 2, session 2: Office of the Comptroller of the Currency, April 8, 2010, p. 6. 73. Citigroup Warehouse Lines of Credit with Mortgage Originators, in Global Securitized Markets, 2000–2010 (revised), produced by Citigroup; staff calculations. 74. Charles O. Prince, interview by FCIC, March 17, 2010. 75. Moody’s Special Report, “The ABCP Market in the Third Quarter of 1998,” February 2, 1999. 76. Moody’s 2007 Review and 2008 Outlook: US Asset-backed Commercial Paper, February 27, 2008. 77. Moody’s ABCP Reviews of Park Granada and Park Sienna. 78. Moody’s ABCP Program Review: Park Granada, July 16, 2007. 79. Letters from the American Securitization Forum (November 17, 2003) and State St. Bank (November 14, 2003) to the Office of Thrift Supervision. 80. Darryll Hendricks, interview by FCIC, August 6, 2010. 81. Citi August 29, 2006, Loan Sale. 82. Correspondence between Citi and New Century provided to FCIC. FCIC staff estimates from prospectus and Citigroup production dated November 4, 2010. Citi August 29, 2006, Loan Sale. 83. Fannie Mae Term Sheet. 84. For the more than 20 institutional investors around the world, see Citigroup letter to the FCIC re Senior Investors, October 14, 2010. The $582 million figure is based on FCIC staff estimates that, in turn, were based on analysis of Moody’s PDS database. 85. See Brad S. Karp, counsel for Citigroup, letter to FCIC, about senior investors, October 14, 2010, p. 2. See also Eric S. Goldstein, counsel for JPMorgan Chase & Co., letter to FCIC, November 16, 2010. 86. Citigroup letter to the FCIC, November 4, 2010. 87. See, e.g., Simon Kennedy, “BNP Suspends Funds Amid Credit-Market Turmoil,” August 9, 2007. (www.marketwatch.com/story/bnp-suspends-fund-valuations-amid-credit-market-turmoil). 88. See Brad S. Karp, letter to FCIC, about mezzanine investors, November 4, 2010, p. 1. The equity tranches were not offered for public sale but were retained by Citigroup. 89. FCIC staff estimates from prospectus and Citigroup production dated November 4, 2010. 90. Patricia Lindsay, interview by FCIC, March 24, 2010. 91. PSI Documents, Exhibit 59a: “Long Beach Mortgage Production, Incentive Plan 2004,” and Ex- hibit 60a (quoting page 2 of WaMu Home Loans Product Strategy PowerPoint presentation). 92. John M. Quigley, “Compensation and Incentives in the Mortgage Business,” Economists’ Voices (The Berkeley Electronic Press, October 2008), p. 2. 93. Barclays Capital, Bear Stearns, BNP Paribas, Citigroup, Deutsche Bank, Goldman Sachs, HSBC, FOMC20080130meeting--74 72,MS. LIANG.," As discussed earlier, Treasury yields and stock prices are down sharply since the December FOMC meeting on news that indicated greater odds of a recession and large writedowns at financial institutions. As shown by the blue line in the top left panel of exhibit 6, the fall in stock prices pushed up the ratio of trend forward earnings to price. The difference between this ratio and the real Treasury perpetuity yield, shown by the shaded area and plotted to the right, is a rough measure of the equity premium. As you can see, this measure jumped in the past few months and is now at the high end of its range of the past twenty years. In the corporate bond market, the spread on high-yield corporates, the black line in the middle panel, widened sharply, and investment-grade spreads, the red and blue lines, also rose. Forward spreads (not shown) rose especially in the near-term, suggesting particular concern about credit risk in the next few years. In the forecast, we assume that the equity premium and bond spreads will recede some from their recent peaks as the risk of recession recedes and activity picks up, but they will remain on the wide side of their historical averages. As shown in the bottom left panel, our most recent indicators suggest that the OFHEO national purchase-only house-price index, the black line, fell 2� percent in the fourth quarter; we project further declines of about 3� percent in both 2008 and 2009. In some states with many subprime mortgages-- such as California, Arizona, Nevada, and Florida--house prices, the red line, began to fall earlier and have declined by more. Reports of spectacular writedowns from some financial firms may also have caused investors to assign greater odds of tighter financial conditions. As noted in the bottom right panel, financial firms took writedowns and loan-loss provisions of more than $80 billion in the fourth quarter. Most of the reported losses were from subprime mortgages and related CDO exposures, but many banks also increased loss provisions for other types of loans. In response, financial firms raised substantial outside capital and cut dividends and share repurchases. Still, the risk remains that writedowns and provisioning will grow larger if house prices or economic activity will slow more than currently anticipated or if financial guarantors are downgraded further. Moreover, many of the largest firms are still at risk of further unplanned asset expansion from previous commitments for leveraged loans and their continued inability to securitize non-agency mortgages. Consequently, these firms are likely to be cautious in managing asset growth. Your next exhibit focuses on business financial conditions. As shown by the black line in the top left panel, top-line operating earnings per share for S&P 500 firms for the fourth quarter are now estimated to be about 23 percent below their year-ago level, dragged down by losses at financial firms. For nonfinancial firms, the green line, earnings per share are estimated to be up 10 percent from a year ago. Analysts' estimates of Q1 earnings for nonfinancial firms were trimmed a bit last week but suggest continued growth. Robust profits since 2002 have put most businesses in strong financial shape. As shown in the right panel, loss rates on highyield corporate bonds, the black line, have been near zero for more than a year as very few bonds defaulted and recovery rates were high. However, we project that bond losses will rise gradually in the next two years as the nonfinancial profit share slips from its currently high level. In commercial real estate, the middle left panel, the net charge-off rate at banks, the black line, was low in the third quarter of last year despite a slight tilt up mostly from troubled loans related to residential land acquisition and construction. We project that this rate will rise fairly steeply, reflecting weakness in housing and expected softening in rents for commercial properties. A similar outlook may lie behind the tighter standards for business loans reported in the January Senior Loan Officer Opinion Survey. As shown by the orange line in the middle right panel, the net percentage of domestic banks reporting having tightened standards on commercial real estate loans in the past three months reached 80 percent, a notable increase from the October survey. In addition, one-third of domestic banks tightened lending standards on C&I loans in the past three months. Large majorities of the respondents that tightened standards pointed to a less favorable or more uncertain outlook or a reduced tolerance for risk. Despite wider spreads, borrowing rates for investment-grade firms are lower than before the December FOMC meeting. As shown by the red line in the lower left panel, yields on ten-year BBB-rated bonds, the red line, fell about 25 basis points, and rates on thirty-day A2/P2 nonfinancial commercial paper, the blue line, have plummeted about 200 basis points since just before year-end. In contrast, yields on ten-year high-yield bonds, the black line, are up and now are close to 10 percent. Net borrowing by nonfinancial businesses, shown in the right panel, is on track in January to stay near the pace of recent months. Net bond issuance, the green bars, has been sizable in recent weeks with most of that issuance by investment-grade firms. Unsecured commercial paper, the yellow bars, rebounded after substantial paydowns ahead of year-end. Your next exhibit focuses on the household sector. As shown in the top left panel, delinquency rates at commercial banks for credit cards, the blue line, and nonrevolving consumer loans, the black line, edged up in the third quarter, as did rates for auto loans at finance companies through November. Some of the recent rise in delinquency rates for credit cards is in states with the largest house-price declines, and could represent spillovers from weak housing markets. As shown to the right, delinquency rates on subprime adjustable-rate mortgages, the solid red line, continued to climb and topped 20 percent in November, and delinquency rates on fixed-rate subprime and on prime and near-prime mortgages also rose. Looking ahead, we expect delinquency rates on consumer loans to rise a bit from below-average levels as household resources are strained by higher unemployment and lower house prices. These developments have spurred lenders to tighten standards on consumer loans. As noted in the middle left panel, responses to the January Senior Loan Officer Opinion Survey indicate a further increase in the net percentage of banks tightening standards on credit cards and other consumer loans in the past three months. Banks also reported substantial net tightening of standards for subprime and prime mortgages, with the latter up considerably from the October survey. In addition, spreads on lower-rated tranches of consumer auto and credit card ABS jumped in January amid news that lenders were increasing loan-loss provisions. That said, interest rates on auto loans and credit cards, not shown, are not up, and most households still appear to have access to these forms of credit. As shown to the right, issuance of securities backed by these loans was robust through January. Securitization of nonconforming mortgages, the grey bars in the lower left panel, was weak in the fourth quarter of last year, and there has been little, if any, this month. But agency-backed securitization, the red bars, was quite strong in the fourth quarter and appears to be again in January. Moreover, as shown to the right, interest rates have fallen appreciably. Rates on conforming thirty-year fixed-rate mortgages, the blue line, and one-year ARMs, the red line, fell, and offer rates on prime fixed-rate jumbo mortgages, the black line, are also down. The six-month LIBOR, the rate to which most subprime ARMs reset, plunged in January, although, even at this level, the first payment reset will still be substantial for many households. The next exhibit presents our outlook for mortgage defaults. The top left panel shows cumulative default rates for subprime 2/28 ARMs by year of origination. A default here is defined as a loan termination that is not from a refinancing or sale. The default rates for mortgages originated in 2006 and 2007, the red and orange lines, respectively, have shot up, and for mortgages originated in 2006, about 18 percent will have defaulted by the loan age of eighteen months. This rate is higher at every comparable age than for mortgages made in 2005, the blue line, and the average rate for loans made in 2001 to 2004, shown by the black line, with the shaded area denoting the range across years. Softer house prices likely played an important role in defaults on 2006 and 2007 loans because borrowers had little home equity to tap when they lost their jobs or became ill, or they walked away when their mortgages turned upside-down. These mortgages have not yet faced their first interest rate reset. As shown to the right, we expect a sizable number of borrowers to reset to higher payments, about 375,000 each quarter this year, if these mortgages are not prepaid or rates are not reduced. While many borrowers still have time to refinance or sell before the first rate reset, lower house prices and tighter credit conditions are likely to damp this activity. As noted in the middle left panel, to project defaults on subprime ARMs, we use a loan-level model that jointly estimates prepayments and defaults. The model considers loan and borrower characteristics at origination, subsequent MSA- or state-level house prices and employment fluctuations, interest rates, and ""vintage"" effects. As shown to the right, with data for the first three quarters in hand, we estimate that defaults in 2007 about doubled from 2006 and predict that they will climb further in 2008 and stay elevated in 2009. These estimates imply that 40 percent of the current stock of subprime ARMs will default over the next two years. An important source of uncertainty around our projections is how borrowers will behave if falling house prices push their loan-to-value ratios above 100 percent. As shown in the first line of the bottom left panel, we estimate that 20 percent of subprime borrowers had a combined loan-to-value ratio of more than 100 percent in the third quarter of last year. If we assume that national house prices fall about 7 percent over the forecast period, as in the Greenbook, an estimated 44 percent of subprime mortgages would have combined LTVs above 100 percent. A similar calculation for prime and near-prime mortgages, shown in the second line, indicates that a not-inconsequential share, 15 percent, of these would also be upside-down by the end of 2009. While prime borrowers likely have other financial assets upon which to draw in the case of job loss or sickness, such high LTVs pose an upside risk to our baseline projection of defaults. Another source of uncertainty--this one on the positive side of the ledger--is how loan modifications can reduce defaults or loss of a home. We have limited information, but recent surveys indicate that loan workouts and modifications were modest through the third quarter of last year but likely accelerated in the fourth quarter. Servicers are strained working on the large number of loans that are delinquent before the first reset. One survey indicated that servicers assisted about 150,000 subprime borrowers in the third quarter, which would represent about 15 percent of those with past-due accounts, but were not addressing current accounts with an imminent reset. As highlighted in the top panel of your next exhibit, we summarize our projections for credit losses in the next two years for major categories of business and household debt. These projections rely on the paths for house prices, unemployment, interest rates, and other factors from the Greenbook baseline. We also present projections based on the Greenbook recession alternative with the additional assumption that national house prices fall 20 percent. In this alternative scenario, real GDP growth turns negative in 2008, and the unemployment rate rises above 6 percent in 2009. As shown in the first column of the bottom panel, if we use the loss rates over the past decade or two as a guide to approximate losses under average economic conditions, total losses, line 6, would be projected to be $440 billion over the next two years. Such losses could be considered what might be expected by lenders of risky debt in the normal conduct of business. But conditions over the next two years are not expected to be normal, even under the baseline scenario. As shown in the second column, losses under the Greenbook baseline are expected to be considerably higher than average and total $727 billion, given our outlook for only modest growth. These losses might not greatly exceed the amounts that investors already have come to expect given signs of slowing activity. The above-average losses are especially large for residential mortgages, line 1, including those for nonprime mortgages, line 2. In contrast, losses for consumer credit, line 3, and business debt, line 4, are only a touch higher than normal. In the alternative scenario, in which business and household conditions worsen further, losses are projected to rise even more, not only for mortgages but also for other debt. Losses of this dimension would place considerable strains on both households and financial institutions, creating the potential for more-serious negative feedback on aggregate demand and activity than is captured by our standard macroeconomic models. Nathan will continue our presentation. " CHRG-111hhrg52261--61 Mr. Anderson," I don't know if that is going to create a bottleneck. I am not sure. We feel that we need to slow down, maybe look at this further. We are all for--the National Association of Mortgage Brokers is all for simpler, easier disclosures. I think if we look at what happened in the past with the subprime and all of those other loans, I think we--I relate it to the pharmaceutical industry. If you take Vioxx, what happened to Vioxx? It was banned. We didn't go after the pharmacists or the drugstores on the corner. We went after the manufacturer. And I think if we control the manufacturer, that is, the product--if the product caused the foreclosure crisis, we need to eliminate that product. " CHRG-111shrg54789--144 Mr. Plunkett," But that occurs all the time in the securities world. Suitability is embedded in the new legislation that the House has passed on mortgage lending. It is absolutely possible to make those determinations and it is done in law. " FOMC20080130meeting--113 111,VICE CHAIRMAN GEITHNER.," Thank you, Mr. Chairman. Nellie, I have two questions for you. One is on exhibit 9, where you forecast in the middle right panel the rate of increase in defaults on subprime ARMs. If you compare that with your reset rate estimate and your house-price assumption or the house-price assumption in the market, I wonder whether that looks a little optimistic. Can you just say a little more about why, under the baseline scenario, given what has happened to house prices already and what is ahead, you wouldn't think that would be substantially greater? " CHRG-111hhrg56766--333 Mr. Minnick," If the Chairman has just a few more moments, I would like to ask a couple of questions. During the Reagan Administration and dealing with the problem of commercial bank lending, which we are going to have a hearing on as the chairman said on Friday, in dealing with a similar situation, the Reagan Administration adopted a policy they called ``forbearance,'' which was a temporary reduction in the capital requirements at the discretion of regulators in order to permit banks that were scraping against the very minimum capital levels in the appropriate circumstance to continue to lend. Do you have an opinion as to the efficacy and appropriateness of that kind of a policy, and if you think it has merit, is it something we should consider in the present circumstance? " FinancialCrisisReport--234 In July 2007, after the credit rating agencies downgraded the ratings on most subprime mortgage backed securities and the subprime secondary market collapsed, IndyMac – like WaMu – was left holding a large inventory of poor quality mortgage loans it could not sell. As delinquencies increased and the value of the mortgages fell, IndyMac incurred substantial losses, and its depositors began withdrawing funds. The withdrawals continued throughout 2007 and into 2008, eventually reaching $1.55 billion and triggering a liquidity crisis at the bank. 900 In July 2008, IndyMac collapsed and was seized by the FDIC, which had to pay more than $10 billion from the Deposit Insurance Fund to protect insured deposits and pay related expenses. 901 As it did with WaMu, OTS gave IndyMac high CAMELS ratings until shortly before the thrift’s failure, despite the fact that OTS had identified numerous problems with IndyMac’s subprime mortgage business practices. 902 Those problems included adopting an overly narrow definition of “subprime,” so that IndyMac could maintain a lower level of capital reserves; 903 poor underwriting and sloppy property appraisal practices; 904 and improper risk mitigation. 905 Neither OTS nor the FDIC ever took a public enforcement action against the bank. After IndyMac’s failure, the Treasury Inspector General conducted a review and issued a report evaluating OTS’ oversight efforts. 906 The report attributed IndyMac’s collapse to its strategy of rapid growth; originating and securitizing nontraditional, high risk loans; lack of verification of borrowers’ income or assets; lax underwriting; and reliance on high interest loans for its own operations. 907 The Treasury IG found that OTS was aware of IndyMac’s problems, but did not take sufficient enforcement action to correct them. 908 According to the Inspector 899 Id. at 7. 900 Id. at 3. 901 Id. at 1. 902 Id. at 8. 903 Id. at 18. 904 Id. at 21-31. 905 Id. 906 Id. In addition to the Material Loss Review, the Treasury Inspector General investigated OTS’ conduct in permitting thrifts, including IndyMac to backdate certain capital infusions. See 12/22/2008 Office of the Inspector General, Dept. of the Treasury, Letter to Ranking Member Charles Grassley, Senate Committee on Finance, http://media.washingtonpost.com/wp- srv/business/documents/Indymac_Thorson_122308pdf.pdf?sid=ST2008122202386. Darrel Dochow was removed from his position as Director of the OTS West Division for having allowed IndyMac to backdate a capital contribution of $18 million, which made it appear stronger than it really was in the relevant financial statement. Then Acting OTS Director Scott Polakoff was also placed on leave during the backdating investigation, but he disputed that he directed anyone to allow backdated capital injections and asserted that the real impetus for his being placed on leave was his Congressional testimony critical of the agency’s conduct related to AIG. Subcommittee interview of Scott Polakoff (3/16/10). 907 3/31/2009 Office of the Inspector General, Dept. of the Treasury, “Semiannual Report to Congress,” at 15, http://www.treasury.gov/about/organizational-structure/ig/Documents/sar042009.pdf. 908 Id. at 31. CHRG-109hhrg31539--245 Mr. Bernanke," I can answer the first three at least. The Federal Reserve has recently expanded the data collection under HMDA, the Home Mortgage Disclosure Act, which collects data on every single home mortgage loan essentially made in the country including pricing, including denial rates, and including ethnicity. So we have a great deal of data on that issue, and we are using it as an initial screen to check for fair lending violations. With respect to CRA, it is absolutely correct that if the purpose of CRA is to get banks and other institutions to reach out to underserved communities, and they get credit for doing that when they do, and if they violate the fair lending laws, that's a debit in their CRA rating. Ms. Lee. But that is not so at this point. " FOMC20080929confcall--16 14,CHAIRMAN BERNANKE., The issue of unusual and exigent is not coming up here because we're not dealing with any section 13(3) lending today. President Evans. fcic_final_report_full--272 CITIGROUP: “THAT WOULD NOT IN ANY WAY HAVE EXCITED MY ATTENTION ” Five days after O’Neal’s October  departure from Merrill Lynch, Citigroup an- nounced that its total subprime exposure was  billion, which was  billion more than it had told investors just three weeks earlier. Citigroup also announced it would be taking an  to  billion loss on its subprime mortgage–related holdings and that Chuck Prince was resigning as its CEO. Like O’Neal, Prince had learned late of his company’s subprime-related CDO exposures. Prince and Robert Rubin, chairman of the Executive Committee of the board, told the FCIC that before September , they had not known that Citigroup’s investment banking division had sold some CDOs with liquidity puts and retained the super-senior tranches of others.  Prince told the FCIC that even in hindsight it was difficult for him to criticize any of his team’s decisions. “If someone had elevated to my level that we were putting on a  trillion balance sheet,  billion of triple-A-rated, zero-risk paper, that would not in any way have excited my attention,” Prince said. “It wouldn’t have been useful for someone to come to me and say, ‘Now, we have got  trillion on the balance sheet of assets. I want to point out to you there is a one in a billion chance that this  billion could go south.’ That would not have been useful information. There is nothing I can do with that, because there is that level of chance on everything.”  In fact, the odds were much higher than that. Even before the mass downgrades of CDOs in late , a triple-A tranche of a CDO had a  in  chance of being downgraded within  years of its original rating.  Certainly, Citigroup was a large and complex organization. That  trillion bal- ance sheet—and . trillion off-balance sheet—was spread among more than , operating subsidiaries in . Prince insisted that Citigroup was not “too big to manage.”  But it was an organization in which one unit would decide to reduce mortgage risk while another unit increased it. And it was an organization in which senior management would not be notified of  billion in concentrated exposure—  of the company’s balance sheet and more than a third of its capital—because it was perceived to be “zero-risk paper.”  Significantly, Citigroup’s Financial Control Group had argued in  that the liq- uidity puts that Citigroup had written on its CDOs had been priced for investors too cheaply in light of the risks.  Also, in early , Susan Mills, a managing director in the securitization unit—which bought mortgages from other companies and bun- dled them for sale to investors—took note of rising delinquencies in the subprime market and created a surveillance group to track loans that her unit purchased.  By mid-, her group saw a deterioration in loan quality and an increase in early pay- ment defaults—that is, more borrowers were defaulting within a few months of get- ting a loan. From  to , Mills recalled before the FCIC, the early payment default rates nearly tripled from  to  or .  In response, the securitization unit slowed down its purchase of loans, demanded higher-quality mortgages, and con- ducted more extensive due diligence on what it bought. However, neither Mills nor other members of the unit shared any of this information with other divisions in Citi- group, including the CDO desk.  Around March or April , in contrast with the securitization desk, Citigroup’s CDO desk increased its purchases of mortgage- backed securities because it saw the distressed market as a buying opportunity.  “Effective communication across businesses was lacking,” the company’s regula- tors later observed. “Management acknowledged that, in looking back, it should have made the mortgage deterioration known earlier throughout the firm. The Global Consumer Group saw signs of sub-prime issues and avoided losses, as did mortgage backed securities traders, but CDO structures business did so belatedly—[there was] no dialogue across businesses.”  CHRG-111shrg53085--151 Mr. Patterson," Those institutions obviously in the present environment are capital constrained by the assets that are on their books, the difficult things that they are having to deal with---- Senator Schumer. Yes, I know that. " Mr. Patterson," ----as a result of all this. So they clearly are capital constrained. The vast majority of commercial banks are looking for loans, have the equity to support continuing to expand loans. And I think if you would survey throughout the membership of the ABA, the availability of credit is not an issue, except possibly in metropolitan areas such as where the money center banks had their---- Senator Schumer. Well, let me tell you, I have found in New York, and I compared this to my colleagues--my time is up--that that is not the case, that we not only have a failure for people to get new lending, but you have lines of credit being pulled regularly from institutions that are still profitable, and it is because of what you said. They have an asset on their books that is valued at 80. It was once 100. It is at 80, but they are worried it might go to 50. They are not making a new loan. They are holding their capital in case it falls to 50. I am not right now criticizing the bank that does that. They are looking for their own survival. I am just saying we have to find new ways of lending. One quick last question just to Mr. Patterson. Do you think the TALF will expand more lending, particularly to small business. " CHRG-110hhrg46593--395 Mr. Cleaver," This is for both of you. We have to go. I wanted to talk about situational conservatism, but we don't have time, Dr. Feldstein. I mean, it is always amusing that people are opposed to government involvement until they want government involvement, but that is just not what I am going to talk about now, because I don't have time. But the question I want to ask is, do either of you find that there is something wrong with the fact that the banks are able to borrow cheap money from the government? The loan rate, the lending rate between banks is still unstable; and, at the same time, the consumers' borrowing costs seem to be rising. I mean, is there something--does that bother you, trouble you at all, particularly when you consider the fact that we are putting money into these lending institutions? " CHRG-111shrg57319--526 Mr. Killinger," Yes, our originations declined and our market share of subprime originations declined from--first of all, we were only 6 percent, and we cut it to about 3 percent, and that market share was about half of what we had in the overall market. But in terms of what we held in portfolio, the portfolio shrank, and we had plans to grow it. Senator Coburn. Between 2004 and 2005, at the time you shifted towards this high-risk strategy, at the same time you switched from doing business with Fannie Mae to doing more business with Freddie Mac. Is that simply a coincidence? Or was there a business advantage to moving to Freddie Mac from Fannie Mae? " CHRG-111hhrg48874--206 Mr. Menzies," Thank you, Mr. Chairman. Thank you, Ranking Member Bachus. It is certainly my honor to be here. As you said, I am president of Easton Bank and Trust from the beautiful Eastern Shore of Maryland. I am especially proud to be the new chairman of the Independent Community Bankers of America. We are a $170 million bank on the Eastern shore, a community bank, a Subchapter S bank. I am thrilled to represent some 8,000 banks from around this Nation and our 5,000 members in the ICBA to talk about exploring the balance between increased credit availability and prudent lending standards. Notwithstanding Mr. Long's concern that community banks are overextended, and community banks need to be prepared for a worse environment, the vast majority of community banks are well capitalized, well managed institutions, actively participating in the economic recovery by lending to small and medium-sized businesses and consumers in their communities. Community banks represent thousands of communities throughout the Nation and they make relationship-based decisions. We do not make decisions based solely on scoring models or rating agencies, algorithms or computer simulations. However, the community bank regulatory climate is causing many community banks to unnecessarily restrict lending activities. For one, there appears to be a disconnect between the banking regulators in Washington who are promoting lending, and we are hearing this, and the field examination staff who require overly aggressive write-down's and reclassifications of viable commercial real estate loans and other assets. Yes, Mr. Bachus, what they are saying at the top is not reaching the bottom. Community bankers report that examiners require write-down's or classifications of performing loans due to the value of collateral irrespective of the income or the cash flow or the liquidity of the borrower. By placing loans on non-accrual, even though the borrower is current on payments, discounting entirely the value of guarantors, substituting the examiner judgment for that of the appraiser, and de-valuing loans merely because it is lying in or close to an area of high foreclosure levels, this all reduces credit available to communities. What we expect is examiners to be more thorough and careful with their examinations during an economic downturn. Based on what we have heard from our members, we believe that in many cases, examiners have gone too far. Excessively through exams that result in potentially unnecessary losses of earnings and capital can have an adverse impact on the ability of community banks to lend, since community banks are the prime engine behind small business lending, any contraction of lending further exacerbates the current economic downturn and impedes the flow of loans to creditworthy borrowers. Community banks are not de-leveraging. We are leveraging up and we need to continue to leverage up. ICBA does appreciate the recent overtures from banking regulators to improve the examination environment for better communications between banks and regulators, and the education of agency field staffs on the consequences of overly restrictive examination practices on credit availability. We have several recommendations in our written testimony that would create a regulatory environment that promotes community bank lending. I would like to highlight a few. Number one, examiners must take a long-term view toward real estate held by banks as collateral on loans and not demand aggressive write-down's and reclassifications of loans because illiquid or dysfunctional markets have forced sales. Real estate assets are long-term assets, and should not be based upon the short-term business cycle valuations that we are facing today. Number two, unlike some large money center in regional banks, the hallmark of community bank loan underwriting is a personal relationship with the borrowers we lend to, and character does in fact count in community bank lending. During this economic crisis, regulators should allow a bank to hold a small basket of character loans from borrowers who have a strong record of meeting contractual obligations and where there are other indicators that support the repayment of that loan. Loans in the basket would be exempt from strict underwriting standards and could not be criticized by examiners as long as they are performing. The amount of loans that could be held in such a basket might be a percentage of capital. Three, the examination in the field process should be strengthened to make it easier for bankers to appeal without fear of examination retaliation. Agency ombudsman determinations should be strengthened and the ombudsman made more independent. Four, the FDIC should find an alternative, and we are pleased they are seeking an alternative, to the 20 basis points special assessment which would consume much of bank earnings in 2009 and further constrain lending. The special assessment should include a systematic risk premium and be based on assets. I have never lost based on deposits and liabilities. Five, OTTI accounting rules are distorting the true value of financial firms and needlessly exacerbating the credit crisis. This does not serve the best interest of investors or the economy. We appreciate the committee's efforts to resolve this accounting issue. We believe FASB's recent proposal could be a positive step in resolving mark-to-market problems. We will be providing further suggestions and clarifications to the FASB. If there is time later, I would be happy to comment about this subject to performing loans, I have strong opinions about the meaning of a ``performing loan'' in today's regulatory world. Thank you so much for this opportunity. [The prepared statement of Mr. Menzies can be found on page 151 of the appendix.] " CHRG-111hhrg52400--180 Mr. McRaith," Right. Thank you for that question, because securities lending has come up in other comments, as well. It is important to understand that the problem--first of all, that the New York Department of Insurance was working to reduce the level of securities lending in the AIG subsidiaries before the crisis. The crisis, remember, was a result of the--essentially, a collateral call on the AIG holding company, resulting from the credit default swaps. This would not have been a problem, but for the CDS failure. And it is also important to remember that the securities which were involved were AAA-rated securities at the time. So it points to the need for better regulation of the credit default swap market. The-- Ms. Bean. So where would the $44 billion have come from? " FinancialCrisisInquiry--196 CHAIRMAN ANGELIDES : You refer to “animal spirits,” in the context of your remarks today. To what extent do the animal spirits extend beyond the housing market? In other words, as we look at causes, perhaps—I don’t want to characterize it—it was certainly a large fire burning, but what were the other fires burning—what were the other areas of excess within the economy in the last few years, in your judgment? If any? ZANDI: I think the... CHAIRMAN ANGELIDES: And by proportion? (LAUGHTER) ZANDI: I think the hubris in the financial system was widespread. I think it was clearest and most evident in the residential mortgage market, thus the focus on that. But I think it extends well beyond that, and, as we can see to this day, into commercial real estate lending, which many small banks are now struggling with, to corporate lending, all various kinds of—of corporate lending. It was evident more broadly in financial markets, in the derivatives market, stock prices, obviously in commodity markets at certain points in time. So I think the hubris among investors, global investors, was extraordinarily widespread and cut across lots of different markets, a whole range of markets. In fact, it would be more difficult to identify the markets that weren’t affected at the height of this by that hubris. CHAIRMAN ANGELIDES: Is there any way of measuring proportionality? CHRG-110hhrg46591--7 Mr. Ackerman," A major contributing factor to the economic crisis facing the country is that our financial regulatory system is broken and needs to be fixed. Without question, at least part of the blame for the seizure of our credit markets rests with the credit rating agencies. The credit ratings that were assigned to many mortgage-backed securities over the past 3 years were not based on sound historical data and for good reason. There was none. The types of securities that were bought and sold in the secondary market contain new subprime mortgage products that had no historical data on which to base any rating. Accordingly, the AAA ratings assigned to securities that contained subprime loans had absolutely no statistical basis whatsoever, but the pension fund managers and investors who placed their trust in the ratings took the credit rating agencies at their word and purchased these exotic products. That the credit rating agencies would rate these securities without any statistical data is bad enough, but continuing to do so is absolutely bewildering. Mr. Chairman, if we are to fix the cause of this crisis, that area surely needs to be addressed. Mr. Castle and I have introduced legislation that would require nationally rated statistical rating organizations, those who are registered with the SEC, to assign two classes of ratings. One class, SRO ratings, would be reserved solely for homogenous securities whose ratings are based on historical statistical data and whose ratings pension fund managers and risk adverse investors could rely on. The other class of ratings would permit the rating agencies to continue to rate heterogeneous riskier products that may not have data. " CHRG-111shrg61513--99 Mr. Bernanke," It boils down--well, I do not think--I think Treasury was right not to terminate it unconditionally at this point because there is still some risk out there that we may have further financial problems. I think it is small. But to have some flexibility in case some new crisis were to arise, I think at least for a short period, is not unreasonable. I am afraid I am going to have to defer to Congress on whether or not you think the other programs that are being proposed, like support for small business lending and those things, are within the spirit of the TARP or good programs in themselves. I do not know how to help you on that one. Senator Bennett. All right. Well, this Member of Congress thinks they are not. Thank you, Mr. Chairman. Senator Johnson. Senator Merkley. Senator Merkley. Thank you very much, Mr. Chair. And thank you, Chair Bernanke, for your testimony. I first wanted to note that when Senator Vitter asked the question on whether there is a need to limit the Fed's ability to use Section 13(3) Federal Reserve Act emergency lending power funds to support individual firms, I just wanted to note that in Chair Dodd's draft that action--that is, emergency lending to individual firms--is prohibited. And so a point I was asked to put forward and clarify. I wanted to turn to the issue of recapitalizing our community banks. This is something I hear about back home all the time, the challenge of these banks to be able to put out new loans given their leverage limitations and their capital challenges. And I had supported an effort to recapitalize community banks, and the Administration has now put forward a very similar plan. I was just wondering if you could give us any insights on your perceptions on how the role of community banks in supporting lending to small business might be a factor in the recovery of our economy. " CHRG-110shrg50409--23 Chairman Dodd," Thank you. Senator Menendez. Senator Menendez. Thank you, Mr. Chairman. Thank you, Chairman Bernanke, for your testimony and your successful. I want to visit with you on the housing issue. In March of 2007, you said that, ``The impact on the broader economy and financial markets of the subprime market seems likely to be contained.'' And I assume you would want to change that statement today somewhat, amend it, with the ability of 20/20 hindsight. What do you think in the housing crisis, do you see it hitting rock bottom this year? A year from now? Because this is one of the significant challenges within the economy. What do you see on the horizon? " CHRG-111shrg57322--1178 Mr. Blankfein," Yes, I did. Senator Levin. And what they said is that investors must believe that their investment banker would not offer them bonds unless the banker believed them to be safe, and ended up saying, but while the banker may make mistakes, he must never make the mistake of offering investments to his clients which he does not believe in. Now, you turned that idea, which is a pretty fundamental idea, offering to clients investments that the banker does not believe in, you said you shouldn't have to be sure that an investment is good for a client. I agree with that. But that is not the issue. You can't guarantee an investment is going to be good for a client. The question is if you believe that it is a bad investment for that client because you are going short against that at the same time you are selling it, that is what these Senators back in the 1930s were saying was one of the causes of the Great Depression, that bankers were selling things, making money for themselves, by selling things that they didn't believe in. And that is what happened here. You were selling things that you didn't believe in. What was the sure test of that is that you were betting against them at the same time you were selling them. You were taking and intending to keep a short position, and that is a very different thing from what you said about 20 minutes ago, that is you should not have to make sure that an investment is good for the client. No one is saying that. Of course, you can't make sure. But you can make sure that someone you sell an investment to knows that you believe it is a bad investment and that you, at the same time, are betting against that same investment. Now, I am going to leave it at that. You obviously don't see that. It troubles me that you don't see that. It troubles me that you don't see that your client is yourself, that is what this has turned into too often, is that Goldman Sachs has turned itself into its own client and has taken advantage of a relationship by doing what you did in so many of these cases. And another thing you did, you took stuff from your own inventory in massive amounts which you didn't believe in and sold it. That is OK, but you did more than that. You then bet against your own sale. That happened in at least two of these cases. That is what is so troubling to me. Now, there is another problem here which is the bigger issue, a broader issue, that you made a major decision to bet against the housing market. We can spend a lot more time on that if you want to. Let us put up a couple of charts here to just show you very quickly what I mean by that. Put up the chart about their long sales. Exhibit 163.\1\--------------------------------------------------------------------------- \1\ See Exhibit No. 163, which appears in the Appendix on page 1009.--------------------------------------------------------------------------- Now, if you take a look at Exhibit 50 \2\--I will get to Exhibit 163 in a minute. This is what you sent to the Securities and Exchange Commission on November 7, 2007. If you look at page 5, you will see here that you said your long cash subprime mortgage exposure consists of mortgage loans and mortgage-backed securities. And then you said, ``As of August 31, 2007 and November 24, 2006 our investments in subprime mortgages totaled $462 million and $7.8 billion, respectively, and our investments in subprime mortgage-backed.''--------------------------------------------------------------------------- \2\ See Exhibit No. 50, which appears in the Appendix on page 390.--------------------------------------------------------------------------- " CHRG-110hhrg34673--212 Mr. Bernanke," Yes. That is part of the Truth in Lending Act. By nature of the act, it is focused on disclosures, and it will be focused on short-term credit like credit cards. " fcic_final_report_full--38 The balance was tipping. According to Siddique, before Greenspan left his post as Fed chairman in January , he had indicated his willingness to accept the guid- ance. Ferguson worked with the Fed board and the regional Fed presidents to get it done. Bies supported it, and Bernanke did as well.  More than a year after the OCC had began discussing the guidance, and after the housing market had peaked, it was issued in September  as an interagency warn- ing that affected banks, thrifts, and credit unions nationwide. Dozens of states fol- lowed, directing their versions of the guidance to tens of thousands of state-chartered lenders and mortgage brokers. Then, in July , long after the risky, nontraditional mortgage market had dis- appeared and the Wall Street mortgage securitization machine had ground to a halt, the Federal Reserve finally adopted new rules under HOEPA to curb the abuses about which consumer groups had raised red flags for years—including a require- ment that borrowers have the ability to repay loans made to them. By that time, however, the damage had been done. The total value of mortgage- backed securities issued between  and  reached . trillion.  There was a mountain of problematic securities, debt, and derivatives resting on real estate assets that were far less secure than they were thought to have been. Just as Bernanke thought the spillovers from a housing market crash would be contained, so too policymakers, regulators, and financial executives did not under- stand how dangerously exposed major firms and markets had become to the poten- tial contagion from these risky financial instruments. As the housing market began to turn, they scrambled to understand the rapid deterioration in the financial system and respond as losses in one part of that system would ricochet to others. By the end of , most of the subprime lenders had failed or been acquired, in- cluding New Century Financial, Ameriquest, and American Home Mortgage. In Jan- uary , Bank of America announced it would acquire the ailing lender Countrywide. It soon became clear that risk—rather than being diversified across the financial system, as had been thought—was concentrated at the largest financial firms. Bear Stearns, laden with risky mortgage assets and dependent on fickle short- term lending, was bought by JP Morgan with government assistance in the spring. fcic_final_report_full--252 When JP Morgan contacted Bear’s co-president Alan Schwartz in April about its up- coming margin call, Schwartz convened an executive committee meeting to discuss how repo lenders were marking down positions and making margin calls on the basis of those new marks.  In early June, Bear met with BSAM’s repo lenders to explain that BSAM lacked cash to meet margin calls and to negotiate a -day reprieve. Some of these very same firms had sold Enhanced and High-Grade some of the same CDOs and other securities that were turning out to be such bad assets.  Now all  refused Schwartz’s appeal; instead, they made margin calls.  As a direct result, the two funds had to sell collateral at distressed prices to raise cash.  Selling the bonds led to a complete loss of confidence by the investors, whose requests for redemptions accelerated. Shortly after BSAM froze redemptions, Merrill Lynch seized more than  mil- lion of its collateral posted by Bear for its outstanding repo loans. Merrill was able to sell just  million of the seized collateral at auction by July —and at discounts to its face value.  Other repo lenders were increasing their collateral requirements or refusing to roll over their loans.  This run on both hedge funds left both BSAM and Bear Stearns with limited options. Although it owned the asset management busi- ness, Bear’s equity positions in the two BSAM hedge funds were relatively small. On April , Bear’s co-president Warren Spector approved a  million investment into the Enhanced Leverage Fund.  Bear Stearns had no legal obligation to rescue either the funds or their repo lenders. However, those lenders were the same large invest- ment banks that Bear Stearns dealt with every day.  Moreover, any failure of entities related to Bear Stearns could raise investors’ concerns about the firm itself. Thomas Marano, the head of the mortgage trading desk, told FCIC staff that the constant barrage of margin calls had created chaos at Bear. In late June, Bear Stearns dispatched him to engineer a solution with Richard Marin, BSAM’s CEO. Marano now worked to understand the portfolio, including what it might be worth in a worst- case scenario in which significant amounts of assets had to be sold.  Bear Stearns’s conclusion: High-Grade still had positive value, but Enhanced Leverage did not. On the basis of that analysis, Bear Stearns committed up to . billion—and ulti- mately loaned . billion—to take out the High-Grade Fund repo lenders and be- come the sole repo lender to the fund; Enhanced Leverage was on its own. During a June Federal Open Market Committee (FOMC) meeting, members were informed about the subprime market and the BSAM hedge funds. The staff reported that the subprime market was “very unsettled and reflected deteriorating fundamen- tals in the housing market.” The liquidation of subprime securities at the two BSAM hedge funds was compared to the troubles faced by Long-Term Capital Management in . Chairman Bernanke noted that the problems the hedge funds experienced were a good example of how leverage can increase liquidity risk, especially in situa- tions in which counterparties were not willing to give them time to liquidate and possibly realize whatever value might be in the positions. But it was also noted that the BSAM hedge funds appeared to be “relatively unique” among sponsored funds in their concentration in subprime mortgages.  CHRG-110hhrg46596--359 Mr. Feeney," A finance background. The severity of the credit crisis today is reminiscent, certainly not as severe, as what happened after the October 29th stock market crash in America. At the time, it was a contraction in the monetary supply by some 33 percent over 4 years. Today, the Fed is easing significantly. Interest rates are next to zero, we have TARP trying to pour money into financial institutions, and yet there is more than anecdotal evidence that there is a credit seizure. Even banks often refusing to lend to banks, let alone small business borrowers, etc. If you are not an economist by background, you are familiar with the term ``paradox of thrift.'' If each of us or any particular institution saves, that is probably a good thing at a micro level; but if everybody decides to save and not lend. Yet, that is exactly what is happening as banks and financial institutions put this money in their balance sheets to firm up their own creditworthiness. But they are, for a variety of reasons, not lending to others, including a crackdown by Federal Reserve regulations on existing loans to businesses and others. There is a severe credit contraction that continues today regardless of what you are trying to do with interest rates or with TARP. Are you familiar with what Mr. Isaac at the FDIC did during the 1980's savings and loan crisis to save the credit crunch in the United States? " FinancialCrisisReport--430 Mr. Swenson raising questions about values assigned to certain CDS contracts: “These levels look quite wide. Do you have any specific market color that points this direction?” 1765 The May 2007 attempted short squeeze described in Mr. Salem’s performance self- evaluation did not succeed in compelling existing CDS holders to sell their short positions. In Subcommittee interviews, Mr. Salem and Mr. Swenson denied that an attempted short squeeze even took place. Any attempt that did take place was apparently abandoned in June 2007, when Goldman stopped offering to sell CDS short positions. Trading with the intent to manipulate market prices, even if unsuccessful, is a violation of the federal securities laws. 1766 Given the novelty of credit default swaps and their use in the mortgage field, however, the Subcommittee is unaware of any enforcement action or case applying an anti-manipulate prohibition to the CDS market. Because Goldman is a registered broker-dealer subject to the supervision of the Financial Industry Regulatory Authority (FINRA), the conduct of its ABS traders raises questions about their compliance with FINRA’s Rule 2010, which provides: “A member, in the conduct of his or her business, must observe high standards of commercial honor and just and equitable principles of trade.” (d) Building the Big Short In the months of June and July 2007, Goldman’s Mortgage Department went short again. This time, it built an even larger net short position than earlier in the year, reaching a peak of $13.9 billion in late June, 1767 which Mr. Viniar later referred to as “the big short.” 1768 This net short 1763 1764 1765 6/11/2007 Goldman email chain, “Please advise – Client challenging marks,” GS MBS-E-018947548. 6/12/2007 email from controllers, “CDS,” GS MBS-E-012445404. 6/19/2007 email from controllers, “A3 subprime bonds in transition account,” GS M BS-E-012458169. Mr. Swenson replied: “Tier 4 bonds talk to Deeb [Salem].” 1766 See Markowski v. SEC , 274 F.3d 525, 527-28 (D.C. Cir. 2001) (Congress determined that “ ‘manipulation ’ may be illegal solely because of the actor ’s purpose ”); In re IPO Litigation , 241 F. Supp. 2d 281, 391 (S.D.N.Y. 2003) (no additional requirements aside from manipulative intent); H.R. Rep. No. 1383, 73rd Cong., 2d Sess. 20 (1934) (under Securities Exchange Act, “if a person is merely trying to acquire a large block of stock for investment, or desires to dispose of his holdings, his knowledge that in doing so he will affect the market price does not make his actions unlawful. His transactions become unlawful only when they are made for the purpose of raising or depressing the market price. ”); but see GLF Advantage Fund, Ltd. v. Colkitt , 272 F.3d 189, 205 (3d Cir. 2001) (requiring, in addition to manipulative intent, “that the alleged manipulator injected inaccurate information into the market or created a false impression of market activity ”). Single name CDS contracts referencing RMBS and CDO securities appear to qualify as “security-based swap agreements ” subject to anti-manipulation and anti-fraud prohibitions under the federal securities laws. 1767 PSI Net Short Position Chart; 8/17/2007 Goldman chart, “RMBS Subprime Notional History (Mtg Dept.),” GS MBS-E-012928391, Hearing Exhibit 4/27-56a. 1768 7/25/2007 email from Mr. Viniar to Mr. Cohn, “Private & Confidential: FICC Financial Package 07/25/07,” GS MBS-E-009861799, Hearing Exhibit 4/27-26. position included the $9 billion AAA ABX short which had suddenly begun gaining value as the subprime market worsened. In June, two Bear Stearns hedge funds specializing in subprime mortgage assets collapsed. In July 2007, the credit rating agencies began downgrading ratings for hundreds and then thousands of RMBS and CDO securities. Soon after, the subprime mortgage backed securities market froze and then collapsed. Each of these events increased the value of Goldman’s net short position. CHRG-110hhrg44900--39 Secretary Paulson," Well, let me mention the student loans, because here is a case where I think you have seen our department work creatively with the Department of Education to deal with a problem that's here and now, and so we have a program in place which I think is going to be acceptable to most fellow lenders. I think it's going to work. To the extent that we need something else, the Department of Education is ready with their direct lending, their lending of last resort. Meanwhile, we are working creatively at Treasury to come up with other market-based solutions to help this market. So we are working through this. We have a program that's going to get us through this period, and we are working to do things to help that securitization market become more vital. " fcic_final_report_full--479 The best summary of how the deflation of the housing bubble led to the financial crisis was contained in the prepared testimony that FDIC chair Sheila Bair delivered to the FCIC in a September 2 hearing: Starting in mid 2007, global financial markets began to experience serious liquidity challenges related mainly to rising concerns about U.S. mortgage credit quality. As home prices fell , recently originated subprime and non-traditional mortgage loans began to default at record rates . These developments led to growing concerns about the value of financial positions in mortgage-backed securities and related derivative instruments held by major financial institutions in the U.S. and around the world. The diffi culty in determining the value of mortgage-related assets and, therefore, the balance-sheet strength of large banks and non-bank financial institutions ultimately led these institutions to become wary of lending to one another, even on a short-term basis. 47 [emphasis supplied] All the important elements of what happened are in Chairman Bair’s succinct statement: (i) in mid 2007, the markets began to experience liquidity challenges because of concerns about the credit quality of NTMs; (ii) housing prices fell; NTMs began to default at record rates; (iii) it was diffi cult to determine the value of MBS, and thus the financial condition of the institutions that held them; and, (iv) finally, as a consequence of this uncertainty—especially after the failure of Lehman—financial institutions would not lend to one another. That phenomenon was the financial crisis. The following discussion will show how each of these steps operated to bring down the financial system. Markets Began to Experience Liquidity Challenges To understand the transmission mechanism, it is necessary to distinguish between PMBS, on the one hand, and the MBS that were distributed by government agencies such as FHA/Ginnie Mae and the GSEs (referred to jointly as “Agencies” in this section). As shown in Table 1, by 2008, the 27 million NTMs in the U.S. financial system were held as (i) whole mortgages, (ii) MBS guaranteed by the GSEs, or insured or held by a government agency or a bank under the CRA, or (iii) as PMBS securitized by private firms such as Countrywide. The 27 million NTMs had an aggregate unpaid principal balance of more than $4.5 trillion, and the portion represented by PMBS consisted of 7.8 million mortgages with an aggregate unpaid principal balance of approximately $1.9 trillion. As mortgage delinquencies and defaults multiplied in the U.S. financial system, the losses were transmitted to financial institutions through their holdings of PMBS. How did this happen, and what role was played by government housing policy? Both Agency MBS and PMBS pass through to investors the principal and interest received on the mortgages in a pool that backs an issue of securities; the difference between them is the way they protect investors against credit risk—i.e., the possibility of losses in the event that the mortgages in the pool begin to default. The Agencies insure or place a guarantee on all the securities issued by a pool they or some other entity creates. Because of the Agencies’ real or perceived government 47 Sheila C. Bair, “Systemically Important Institutions and the Issue of ‘Too-Big-to-Fail,’” Testimony to the FCIC, September 2, 2010, p.3. backing, all these securities are rated or considered to be AAA. CHRG-110shrg50416--67 Mr. Kashkari," It worries us, too. We want these institutions to lend, absolutely, but also recognize the situation we are all in right now is the situation of unprecedented lack of confidence in the system. Senator Schumer. Understood " CHRG-111hhrg48867--49 The Chairman," So is that an option of--the Federal charter would be the Federal insurance regulator, but it would go up. Let me ask one other issue, and Mr. Silvers made an important point about the compensation. And I have one other question that I hear everybody talking about, and that is, it is my impression that part of the problem--Mr. Yingling mentioned the subprime loans--if enough bad decisions are made at the outset, it seems to me it is very hard to recover from that. The ability to securitize 100 percent of the loans appears to me to be part of the problem. Should we explore some limitation on the ability to securitize? Should there be some risk-retention requirement in that area? Mr. Bartlett, let's begin with you. " CHRG-111shrg57320--14 Mr. Rymer," I think what you have here is a combination of not only very aggressive loan products, the Option ARMs, the purchase of subprime loans that they did, the home equity line of credit (HELOC) loans that they did, coupled with lax underwriting standards, and then over that very lax enterprise risk management processes. So I think the products themselves were risky. The administration of those products, the underwriting of those products were risky. And then the management and control after those loans were originated was really inadequate. Senator Levin. I think regulators banned negatively amortizing credit card loans about 5 years ago. Should we do the same thing relative to home loans? " FinancialCrisisInquiry--223 ROSEN: Yes, I would. I think that’s—the data seems to show that. THOMPSON: Yes, OK. Ms. Gordon, you talked about predatory practices, and you specifically said it seemed as though some of that might have been targeted at minorities, African- Americans and Hispanics. Do you have evidence to support that statement? And are there lawsuits or activities underway that would suggest that this is not just predatory, but perhaps illegal? GORDON: Well it’s well documented that African American and Latino families disproportionately received the expensive and dangerous subprime loans that we’ve been talking about. You—you know, there—there are Federal Reserve papers on this. The HUMDA data will show that to you, because it collects the demographic data that you need to get this. I think—in one—one data point I have in my testimony is that in 2006 among consumers who received conventional mortgages for single family homes, about half of African Americans and Hispanic borrowers received a higher rate mortgage compared to about one fifth of White borrowers. You know, our—our research has shown that African Americans and Latinos were much more likely to receive higher rate subprime loans. Another study has shown that minority communities were more likely to get loans with prepayment penalties even after controlling for other factors. You know, and like I said while it’s hard right now to get really good demographic data on foreclosures, you know, given that we know which loans have the highest rates of default, it’s not that hard to connect the dots. THOMPSON: Dr. Rosen, in your written testimony you gave a number of very thoughtful things that people should do as they thought about originating mortgages. And these seem to be quite simple. Better underwriting standards, better mechanisms that discourage speculation, so on and so forth. And since these seem so simple yet so necessary, in your opinion, why weren’t they done? CHRG-111shrg57319--549 Mr. Killinger," If I could, again--because I am setting the--with the board setting the strategy for the overall company, it really needs to be in the context, when we talked about diversifying the company, that included having a strategy for entering the credit card business, and we subsequently did the Providian acquisition, which was a significant part. It also had a material reduction in interest rate risk. That is why we sold so many mortgage servicing rights. And we also had, even in the Home Loans area, that this would be a lesser part of our overall business, and that the primary growth of the business would be in our retail banking stores, and that is where we are going to open up significant numbers of retail banking stores. So the overall context of the company is still a shrinkage of the home lending business, but within the home lending business that we would have more of a focus on some of these other products. Senator Levin. Some of the other products being high-risk products. " CHRG-111shrg57321--28 Mr. Kolchinsky," I think so. As Mr. Michalek said, I am not competent on what occurred in the RMBS group, but had this information come on the CDO side, we certainly would have looked into it, or should have looked into it. I would also say I was not involved in 2007, as this information went through with the folks who rated subprime directly. But there was almost a feeling when dealing with them that there was a ``see no evil, hear no evil'' sort of attitude, and partly I think it is because people who had done these deals, rated these deals, did not want to believe what was going on, partly profit motivated, partly because they were part of this market, and it just should not be happening. Senator Levin. Part of that culture. " FOMC20070810confcall--16 14,MR. MISHKIN.," So is it spending directly? Are the banks buying commercial paper, or are they lending directly to the people who can’t roll over their commercial paper?" CHRG-111hhrg48674--348 Mr. Bernanke," We need to get through that crisis, but I very much agree with Mr. Lacker that we need to clarify regulatory responsibilities, and that lending and other such interventions ought to be aligned with those authorities and with congressional intent. " CHRG-111hhrg54872--29 The Chairman," Next, Michael Calhoun, president and chief operating officer of the Center for Responsible Lending. STATEMENT OF MICHAEL CALHOUN, PRESIDENT AND CHIEF OPERATING CHRG-111hhrg50289--81 Mr. Cohen," My track record in business and my healthy balance sheet were not enough anymore. So I actually chose to forego the additional borrowing and finance the two new stores or the last two stores using cash generated from operations. The eight stores that I eventually opened required a capital investment of $1.8 million and created 74 new direct jobs, but I will likely delay opening additional stores until the restrictions on credit are eased. Lack of credit is keeping entrepreneurs on the sidelines and delaying our recovery, and the problem is even looking worse for those looking to get into business for the first time. The findings of a recently released study, The Small Business Lending Matrix and analysis prepared for the IFA Educational Foundation, support the notion that an economic recovery and job creation will start with small business lending. In fact, the study determined that for every million dollars in new small business lending, the franchise business sector would create 34.1 jobs and generate $3.6 million in economic output. Now, I would like to ask that this entire report be included with my statement if the Committee would approve that.[Study submitted by Mr. Cohen is included in the appendix.] " CHRG-110hhrg46591--375 Mr. Yingling," I agree with that answer completely. I think one of the problems with this idea of putting capital into community banks is a perception problem. And that is--and you see it on TV, you see it in the media--are we bailing out these banks? We don't need to bail out these banks. These banks are solid banks, willing to lend, and they don't have to take this capital. But the capital markets are pretty well closed to them right now. So if you want them to have more lending, you have to say, we want you to do this. And in a way, you are a hero to do it. It is not a natural thing for community banks to say, I want a government investment. That is against their philosophy. But they need to know they are not going to have a scarlet ``A'' around their necks if they do this kind of thing. " fcic_final_report_full--471 Even today, there are few references in the media to the number of NTMs that had accumulated in the U.S. financial system before the meltdown began. Yet this is by far the most important fact about the financial crisis. None of the other factors offered by the Commission majority to explain the crisis—lack of regulation, poor regulatory and risk management foresight, Wall Street greed and compensation policies, systemic risk caused by credit default swaps, excessive liquidity and easy credit—do so as plausibly as the failure of a large percentage of the 27 million NTMs that existed in the financial system in 2007. It appears that market participants were unprepared for the destructiveness of this bubble’s collapse because of a chronic lack of information about the composition of the mortgage market. In September 2007, for example, after the deflation of the bubble had begun, and various financial firms were beginning to encounter capital and liquidity diffi culties, two Lehman Brothers analysts issued a highly detailed report entitled “Who Owns Residential Credit Risk?” 34 In the tables associated with the report, they estimated the total unpaid principal balance of subprime and Alt-A mortgages outstanding at $2.4 trillion, about half the actual number at the time. Based on this assessment, when they applied a stress scenario in which housing prices declined about 30 percent, they still found that “[t]he aggregate losses in the residential mortgage market under the ‘stressed’ housing conditions could be about $240 billion, which is manageable, assuming it materializes over a five-to six-year horizon.” In the end, of course, the losses were much larger, and were recognized under mark-to-market accounting almost immediately, rather than over a five to six year period. But the failure of these two analysts to recognize the sheer size of the subprime and Alt-A market, even as late as 2007, is the important point. Along with most other observers, the Lehman analysts were not aware of the true composition of the mortgage market in 2007. Under the “stressed” housing conditions they applied, they projected that the GSEs would suffer aggregate losses of $9.5 billion (net of mortgage insurance coverage) and that their guarantee fee income would be more than suffi cient to cover these losses. Based on known losses and projections recently made by the Federal Housing Finance Agency (FHFA), the GSEs’ credit losses alone could total $350 billion—more than 35 times the Lehman analysts’ September 2007 estimate. The analysts could only make such a colossal error if they did not realize that 37 percent—or $1.65 trillion—of the GSEs’ credit risk portfolio consisted of subprime and Alt-A loans (see Table 1, supra ) or that these weak loans would account for about 75% of the GSEs’ default losses over 2007- 34 Vikas Shilpiekandula and Olga Gorodetski, “Who Owns Resident i al Credit Risk?” Lehman Brothers Fixed Income U.S. Securitized Products Research , September 7, 2007. 2010. 35 It is also instructive to compare the Lehman analysts’ estimate that the 2006 vintage of subprime loans would suffer lifetime losses of 19 percent under “stressed” conditions to other, later, more informed estimates. In early 2010, for example, Moody’s made a similar estimate for the 2006 vintage and projected a 38 percent loss rate after the 30 percent decline in housing prices had actually occurred. 36 The Lehman loss rate projection suggests that the analysts did not have an accurate estimate of the number of NTMs actually outstanding in 2006. Indeed, I have not found any studies in the period before the financial crisis in which anyone— scholar or financial analyst—actually seemed to understand how many NTMs were in the financial system at the time. It was only after the financial crisis, when my AEI colleague, Edward Pinto, began gathering this information from various unrelated and disparate sources that the total number of NTMs in the financial markets became clear. As a result, all loss projections before Pinto’s work were bound to be faulty. CHRG-109hhrg28024--144 Mr. Bernanke," The minimum wage affects a very small number of workers actually. I don't think it would affect a great majority of people that you are concerned about. Be that as it may, I just want to say that I do support very strongly fair lending. I will be actively involved in making sure that our fair lending policies are actively prosecuted. I would also agree with you on the inappropriateness in some circumstances of using FICO scores for evaluating creditworthiness. I know some banks are experimenting with non-standard approaches that take into account people's relatively short credit histories, for example, or alternative backgrounds. I think that is good banking. I think it is good for the society and the Federal Reserve will work with banks to look at those kinds of alternative approaches. " CHRG-111shrg52619--175 PREPARED STATEMENT OF JOSEPH A. SMITH, JR. North Carolina Commissioner of Banks, and Chair-Elect of the Conference of State Bank Supervisors March 19, 2009Introduction Good morning Chairman Dodd, Ranking Member Shelby, and Members of the Committee. My name is Joe Smith, and I am the North Carolina Commissioner of Banks. I also serve as incoming Chairman of the Conference of State Bank Supervisors (CSBS) and a member of the CSBS Task Force on Regulatory Restructuring. I am pleased to be here today to offer a state perspective on our nation's financial regulatory structure--its strengths and its deficiencies, and suggestions for reform. As we work through a federal response to this financial crisis, we need to carry forward a renewed understanding that the concentration of financial power and a lack of transparency are not in the long-term interests of our financial system, our economic system or our democracy. This lesson is one our country has had to learn in almost every generation, and I hope that the current lesson will benefit future generations. While our largest and most complex institutions are no doubt central to a resolution of the current crisis, my colleagues and I urge you to remember that the health and effectiveness of our nation's financial system also depends on a diverse and competitive marketplace that includes community and regional institutions. While changing our regulatory system will be far from simple, some fairly simple concepts should guide these reforms. In evaluating any governmental reform, we must ask if our financial regulatory system: Ushers in a new era of cooperative federalism, recognizing the rights of states to protect consumers and reaffirming the state role in chartering and supervising financial institutions; Fosters supervision tailored to the size, scope and complexity of an institution and the risk it poses to the financial system; Assures the promulgation and enforcement of consumer protection standards that are applicable to both state and federally chartered institutions and are enforceable by state officials; Encourages a diverse universe of financial institutions as a method of reducing risk to the system, encouraging competition, furthering innovation, insuring access to financial markets, and promoting efficient allocation of credit; Supports community and regional banks, which provide relationship lending and fuel local economic development; and Requires financial institutions that are recipients of governmental assistance or pose systemic risk to be subject to safety and soundness and consumer protection oversight. We have often heard the consolidation of financial regulation at the federal level is the ``modern'' answer to the challenges our financial system. We need to challenge this assumption. For reasons more fully discussed below, my colleagues and I would suggest to you that an appropriately coordinated system of state and federal supervision and regulation will promote a more effective system of financial regulation and a more diverse, stable and responsive financial system.The Role of the States in Financial Services Supervision and Regulation The states charter and supervise more than 70 percent of all U.S. banks (Exhibit A), in coordination with the FDIC and Federal Reserve. The rapid consolidation of the industry over the past decade, however, has created a system in which a handful of large national banks control the vast majority of assets in the system. The more than 6,000 banks supervised and regulated by the states now represent less than 30 percent of the assets of the banking system (Exhibit B). While these banks are smaller than the global institutions now making headlines, they are important to all of the markets they serve and are critical in the nonmetropolitan markets where they are often the major sources of credit for local households, small businesses and farms. Since the enactment of nationwide banking in 1994, the states, working through CSBS, have developed a highly coordinated system of state-to-state and state-to-federal bank supervision. This is a model that has served this nation well, embodying our uniquely American dynamic of checks and balances--a dynamic that has been missing from certain areas of federal financial regulation, with devastating consequences. The dynamic of state and federal coordinated supervision for state-chartered banks allows for new businesses to enter the market and grow to meet the needs of the markets they serve, while maintaining consistent nationwide standards. Community and regional banks are a vital part of America's economic fabric because of the state system. As we continue to work through the current crisis, we need to do more to support community and regional banks. The severe economic recession and market distortions caused by bailing out the largest institutions have caused significant stress on these institutions. While some community and regional banks have had access to the TARP's capital purchase program, the processing and funding has grown cumbersome and slow. We need a more nimble and effective program for these institutions. This program must be administered by an entity with an understanding of community and regional banking. This capital will enhance stability and provide support for consumer and small business lending. In addition to supervising banks, I and many of my colleagues regulate the residential mortgage industry. All 50 states and the District of Columbia now provide some regulatory oversight of the residential mortgage industry. The states currently manage over 88,000 mortgage company licenses, over 68,000 branch licenses, and approximately 357,000 loan officer licenses. In 2003, the states, acting through the CSBS and the American Association of Residential Mortgage Regulators, first proposed a nationwide mortgage licensing system and database to coordinate our efforts in regulating the residential mortgage market. The system launched on January 2, 2008, on time and on budget. The Nationwide Mortgage Licensing System (NMLS) was incorporated in the federal S.A.F.E. Act and, as a result, has established a new and important partnership with the United States Department of Housing and Urban Development, the federal banking agencies and the Farm Credit Administration. We are confident that this partnership will result in an efficient and effective combination of state and federal resources and a nimble, responsive and comprehensive system of regulation. This is an example of what we mean by ``a new era of cooperative federalism.''Where Federalism Has Fallen Short For the past decade it has been clear to the states that our system of mortgage finance and mortgage regulation was flawed and that a destructive and widening chasm had formed between the interests of borrowers and of lenders. Over that decade, through participation in GAO reports and through congressional testimony, one can observe an ever-increasing level of state concern over this growing chasm and its reflection in the state and federal regulatory relationship. Currently, 35 states plus the District of Columbia have enacted predatory lending laws. \1\ First adopted by North Carolina in 1999, these state laws supplement the federal protections of the Home Ownership and Equity Protection Act of 1994 (HOEPA). The innovative actions taken by state legislatures have prompted significant changes in industry practices, as the largest multi-state lenders have adjusted their practices to comply with the strongest state laws. All too often, however, we are frustrated in our efforts to protect consumers by the preemption of state consumer protection laws by federal regulations. Preemption must be narrowly targeted and balance the interest of commerce and consumers.--------------------------------------------------------------------------- \1\ Source: National Conference of State Legislatures.--------------------------------------------------------------------------- In addition to the extensive regulatory and legislative efforts, state attorneys general and state regulators have cooperatively pursued unfair and deceptive practices in the mortgage market. Through several settlements, state regulators have returned nearly one billion dollars to consumers. A settlement with Household resulted in $484 million paid in restitution, a settlement with Ameriquest resulted in $295 million paid in restitution, and a settlement with First Alliance Mortgage resulted in $60 million paid in restitution. These landmark settlements further contributed to changes in industry lending practices. But successes are sometimes better measured by actions that never receive media attention. States regularly exercise their authority to investigate or examine mortgage companies for compliance not only with state law, but with federal law as well. These examinations are an integral part of a balanced regulatory system. Unheralded in their everyday routine, enforcement efforts and examinations identify weaknesses that, if undetected, might be devastating to the company and its customers. State examinations act as a check on financial problems, evasion of consumer protections and sales practices gone astray. Examinations can also serve as an early warning system of a financial institution conducting misleading, predatory or fraudulent practices. Attached as Exhibit C is a chart of enforcement actions taken by state regulatory agencies against mortgage providers. In 2007, states took nearly 6,000 enforcement actions against mortgage lenders and brokers. These actions could have resulted in a dialog between state and federal authorities about the extent of the problems in the mortgage market and the best way to address the problem. That did not happen. The committee should consider how the world would look today if the ratings agencies and the OCC had not intervened and the assignee liability and predatory lending provisions of the Georgia Fair Lending Act had been applicable to all financial institutions. I would suggest we would have far fewer foreclosures and may have avoided the need to bailout our largest financial institutions. It is worth noting that the institutions whose names were attached to the OCC's mortgage preemption initiative--National City, First Franklin, and Wachovia--were all brought down by the mortgage crisis. That fact alone should indicate how out of balance the system has become. From the state perspective, it has not been clear for many years exactly who was setting the risk boundaries for the market. What is clear is that the nation's largest and most influential financial institutions have been major contributing factors in our regulatory system's failure to respond to this crisis. At the state level, we sometimes perceived an environment at the federal level that is skewed toward facilitating the business models and viability of our largest financial institutions rather than promoting the strength of the consumer or our diverse economy. It was the states that attempted to check the unhealthy evolution of the mortgage market and apply needed consumer protections to subprime lending. Regulatory reform must foster a system that incorporates the early warning signs that state laws and regulations provide, rather than thwarting or banning them. Certainly, significant weaknesses exist in our current regulatory structure. As GAO has noted, incentives need to be better aligned to promote accountability, a fair and competitive market, and consumer protection.Needed Regulatory Reforms: Mortgage Origination I would like to thank this committee for including the Secure and Fair Enforcement for Mortgage Licensing Act (S.A.F.E.) in the Housing and Economic Recovery Act of 2008 (HERA). It has given us important tools that continue our efforts to reform mortgage regulation. CSBS and the states are working to enhance the regulatory regime for the residential mortgage industry to ensure legitimate lending practices, provide adequate consumer protection, and to once again instill both consumer and investor confidence in the housing market and the economy as a whole. The various state initiatives are detailed in Exhibit D.Needed Regulatory Reforms: Financial Services Industry Many of the problems we are experiencing are both the result of ``bad actors'' and bad assumptions by the architects of our modern mortgage finance system. Enhanced supervision and improved industry practices can successfully weed out the bad actors and address the bad assumptions. If regulators and the industry do not address both causes of our current crisis, we will have only the veneer of reform and will eventually repeat our mistakes. Some lessons learned from this crisis must be to prevent the following: the over-leveraging that was allowed to occur in the nation's largest institutions; outsourcing of loan origination with no controls in place; and industry consolidation to allow institutions to become so large and complex that they become systemically vital and too big to effectively supervise or fail. While much is being done to enhance supervision of the mortgage market, more progress must be made towards the development of a coordinated and cooperative system of state-federal supervision.Preserve and Enhance Checks and Balances/Forge a New Era of Federalism The state system of chartering and regulating has always been a key check on the concentration of financial power, as well as a mechanism to ensure that our banking system remains responsive to local economies' needs and accountable to the public. The state system has fostered a diversity of institutions that has been a source of stability and strength for our country, particularly locally owned and controlled community banks. To promote a strong and diverse system of banking-one that can survive the inevitable economic cycles and absorb failures-preservation of state-chartered banking should be a high priority for Congress. The United States boasts one of the most powerful and dynamic economies in the world because of those checks and balances, not despite them. Consolidation of the industry and supervision and preemption of applicable state law does not address the cause of this crisis, and has in fact exacerbated the problem. The flurry of state predatory lending laws and new state regulatory structures for lenders and mortgage brokers were indicators that conditions and practices were deteriorating in our mortgage lending industry. It would be incongruous to eliminate the early warning signs that the states provide. Just as checks and balances are a vital part of our democratic government, they serve an equally important role in our financial regulatory structure. Put simply, states have a lower threshold for crisis and will most likely act sooner. This is an essential systemic protection. Most importantly, it serves the consumer interest that the states continue to have a role in financial regulation. While CSBS recognizes the financial services market is a nationwide industry that has international implications, local economies and individual consumers are most drastically affected by mortgage market fluctuations. State regulators must remain active participants in mortgage supervision because of our knowledge of local economies and our ability to react quickly and decisively to protect consumers. Therefore, CSBS urges Congress to implement a recommendation made by the Congressional Oversight Panel in their ``Special Report on Regulatory Reform'' to eliminate federal preemption of the application of state consumer protection laws to national banks. In its report, the Panel recommends Congress ``amend the National Banking Act to provide clearly that state consumer protection laws can apply to national banks and to reverse the holding that the usury laws of a national bank's state of incorporation govern that bank's operation through the nation.'' \2\ We believe the same policy should apply to the Office of Thrift Supervision. To preserve a responsive system, states must be able to continue to produce innovative solutions and regulations to provide consumer protection.--------------------------------------------------------------------------- \2\ The Congressional Oversight Panel's ``Special Report on Regulatory Reform'' can be viewed at http://cop.senate.gov/documents/cop-012909-report-regulatoryreform.pdf--------------------------------------------------------------------------- The federal government would better serve our economy and our consumers by advancing a new era of cooperative federalism. The S.A.F.E. Act enacted by Congress requiring licensure and registration of mortgage loan originators through the Nationwide Mortgage Licensing System provides a model for achieving systemic goals of high regulatory standards and a nationwide regulatory roadmap and network, while preserving state authority for innovation and enforcement. The Act sets expectations for greater state-to-state and state-to-federal regulatory coordination. Congress should complete this process by enacting a federal predatory lending standard. A federal standard should allow for further state refinements in lending standards and be enforceable by state and federal regulators. Additionally, a federal lending standard should clarify expectations of the obligations of securitizers.Consumer Protection/Enforcement Consolidated regulation minimizes resources dedicated to supervision and enforcement. As FDIC Chairman Sheila Bair recently told the states' Attorneys General, ``if ever there were a time for the states and the feds to work together, that time is right here, right now. The last thing we need is to preempt each other.'' Congress should establish a mechanism among the financial regulators for identifying and responding to emerging consumer issues. This mechanism, perhaps through the Federal Financial Institutions Examination Council (FFIEC), should include active state regulator and law enforcement participation and develop coordinated responses. The coordinating federal entity should report to Congress regularly. The states must retain the right to pursue independent enforcement actions against all financial institutions as an appropriate check on the system.Systemic Supervision/Capital Requirements As Congress evaluates our regulatory structure, I urge you to examine the linkages between the capital markets, the traditional banking sector, and other financial services providers. Our top priority for reform must be a better understanding of systemic risks. The federal government must facilitate the transparency of financial markets to create a financial system in which stakeholders can understand and manage their risks. Congress should establish clear expectations about which regulatory authority or authorities are responsible for assessing risk. The regulator must have the necessary tools to identify and mitigate risk, and resolve failures. Congress, the administration, and federal regulators must also consider how the federal government itself may inadvertently contribute to systemic risk--either by promoting greater industry consolidation or through policies that increase risk to the system. Perhaps we should contemplate that there are some institutions whose size and complexity make their risks too large to effectively manage or regulate. Congress should aggressively address the sources of systemic risk to our financial system. While this crisis has demanded a dramatic response from the federal government, the short-term result of many of these programs, including the Troubled Asset Relief Program (TARP), has been to create even larger and more complex institutions and greater systemic risk. These responses have created extreme disparity in the treatment of financial institutions, with the government protecting those deemed to be too big or too complex to fail, perhaps at the expense of smaller institutions and the diversity of our financial system. At the federal level, our state-chartered banks may be too-small-to-care but in our cities and communities, they are too important to ignore. It is exactly the same dynamic that told us that the plight of the individual homeowner trapped in a predatory loan was less important than the needs of an equity market hungry for new mortgage-backed securities. There is an unchallenged assumption that federal regulatory reforms can address the systemic risk posed by our largest and most complex institutions. If these institutions are too large or complex to fail, the government must give preferential treatment to prevent these failures, and that preferential treatment distorts and harms the marketplace, with potentially disastrous consequences. Our experience with Fannie Mae and Freddie Mac exemplifies this problem. Large systemic institutions such as Fannie and Freddie inevitably garner advantages and political favor, and the lines between government and industry blur in ways that do not reflect American values of fair competition and merit-based success. My fellow state supervisors and I have long believed capital and leverage ratios are essential tools for managing risk. For example, during the debate surrounding the advanced approach under Basel II, CSBS supported FDIC Chairman Sheila Bair in her call to institute a leverage ratio for participating institutions. Federal regulation needs to prevent capital arbitrage among institutions that pose systemic risks, and should require systemic risk institutions to hold more capital to offset the grave risks their collapse would pose to our financial system. Perhaps most importantly, Congress must strive to prevent unintended consequences from doing irreparable harm to the community and regional banking system in the United States. Federal policy to prevent the collapse of those institutions considered too big to fail should ultimately strengthen our system, not exacerbate the weaknesses of the system. Throughout the current recession, community and regional banks have largely remained healthy and continued to provide much needed credit in the communities where they operate. The largest banks have received amazing sums of capital to remain solvent, while the community and regional banks have continued to lend in this difficult environment with the added challenge of having to compete with federally subsidized entities. Congress should consider creating a bifurcated system of supervision that is tailored to the size, scope, and complexity of financial institutions. The largest, most systemically significant institutions should be subject to much more stringent oversight that is comprehensive enough to account for the complexity of the institution. Community and regional banks should be subject to regulations that are tailored to the size and sophistication of the institutions. In financial supervision, one size should no longer fit all.Roadmap for Unwinding Federal Liquidity Assistance and Systemic Responses The Treasury Department and the Federal Reserve should be required to provide a plan for how to unwind the various programs established to provide liquidity and prevent systemic failure. Unfortunately, the attempts to avert crisis through liquidity programs have focused predominantly upon the needs of the nation's largest institutions, without consideration for the unintended consequences for our diverse financial industry as a whole, particularly community and regional banks. Put simply, the government is now in the business of picking winners and losers. In the extreme, these decisions determine survival, but they also affect the overall competitive landscape and relative health and profitability of institutions. The federal government should develop a plan that promotes fair and equal competition, rather than sacrificing the diversity of our financial industry to save those deemed too big to fail.Conclusion Chairman Dodd, Ranking Member Shelby, and Members of the Committee, the task before us is a daunting one. The current crisis is the result of well over a decade's worth of policies that promoted consolidation, uniformity, preemption and the needs of the global marketplace over those of the individual consumer. If we have learned nothing else from this experience, we have learned that big organizations have big problems. As you consider your responses to this crisis, I ask that you consider reforms that promote diversity and create new incentives for the smaller, less troubled elements of our financial system, rather than rewarding the largest and most reckless. At the state level, we are constantly pursuing methods of supervision and regulation that promote safety and soundness while making the broadest possible range of financial services available to all members of our communities. We appreciate your work toward this common goal, and thank you for inviting us to share our views today. APPENDIX ITEMSExhibit D: State Initiatives To Enhance Supervision of the Mortgage IndustryCSBS-AARMR Nationwide Mortgage Licensing System The states first recognized the need for a tool to license mortgage originators several years ago. Since then, states have dedicated tremendous monetary and staff resources to develop and enact the Nationwide Mortgage Licensing System (NMLS). First proposed among state regulators in late 2003, NMLS launched on time and on budget on January 2, 2008. The Nationwide Mortgage Licensing System is more than a database. It serves as the foundation of modern mortgage supervision by providing dramatically improved transparency for regulators, the industry, investors, and consumers. Seven inaugural participating states began using the system on January 2, 2008. Only 15 months later, 23 states are using NMLS and by January 2010--just 2 years after its launch--CSBS expects 40 states to be using NMLS. NMLS currently maintains a single record for every state-licensed mortgage company, branch, and individual that is shared by all participating states. This single record allows companies and individuals to be definitively tracked across state lines and over time as entities migrate among companies, industries, and federal and state jurisdictions. Additionally, this year consumers and industry will be able to check on the license status and history of the companies and individuals with which they wish to do business. NMLS provides profound benefits to consumers, state supervisory agencies, and the mortgage industry. Each state regulatory agency retains its authority to license and supervise, but NMLS shares information across state lines in real-time, eliminates any duplication and inconsistencies, and provides more robust information to state regulatory agencies. Consumers will have access to a central repository of licensing and publicly adjudicated enforcement actions. Honest mortgage lenders and brokers will benefit from the removal of fraudulent and incompetent operators, and from having one central point of contact for submitting and updating license applications. The hard work and dedication of the states was ultimately recognized by Congress as they enacted the Housing and Economic Recovery Act of 2008 (HERA). The bill acknowledged and built upon the work that had been done in the states to protect consumers and restore the public trust in our mortgage finance and lending industries. Title V of HERA, titled the Secure and Fair Enforcement for Mortgage Licensing Act of 2008 (S.A.F.E. Act), is designed to increase uniformity, reduce regulatory burden, enhance consumer protection, and reduce fraud by requiring all mortgage loan originators to be licensed or registered through NMLS. In addition to loan originator licensing and mandatory use of NMLS, the S.A.F.E. Act requires the states to do the following: 1. Eliminate exemptions from mortgage loan originator licensing that currently exist in state law; 2. Screen and deny mortgage loan originator licenses for felonies of any kind within 7 years and certain financially related felonies permanently; 3. Screen and deny licenses to individuals who have ever had a loan originator license revoked; 4. Require loan originators to submit personal history information and authorize background checks to determine the applicant's financial responsibility, character, and general fitness; 5. Require mortgage loan originators to take 20 hours of pre- licensure education in order to enter the state system of licensure; 6. Require mortgage loan originators to pass a national mortgage loan originator test developed by NMLS; 7. Establish either a bonding or net worth requirement for companies employing mortgage loan originators or a recovery fund paid into by mortgage loan originators or their employing company in order to protect consumers; 8. Require companies licensed or registered through NMLS to submit a Mortgage Call Report on at least an annual basis; 9. Adopt specific confidentiality and information sharing provisions; and 10. Establish effective authority to investigate, examine, and conduct enforcement of licensees. Taken together, these background checks, testing, and education requirements will promote a higher level of professionalism and encourage best practices and responsible behavior among all mortgage loan originators. Under the legislative guidance provided by Congress, the states drafted the Model State Law for uniform implementation of the S.A.F.E. Act. The Model State Law not only achieves the minimum licensing requirements under the federal law, but also accomplishes Congress' ten objectives addressing uniformity and consumer protection. The Model State Law, as implementing legislation at the state level, assures Congress that a framework of localized regulatory controls are in place at least as stringent as those pre-dating the S.A.F.E. Act, while setting new uniform standards aimed at responsible behavior, compliance verification and protecting consumers. The Model State Law enhances the S.A.F.E. Act by providing significant examination and enforcement authorities and establishing prohibitions on specific types of harmful behavior and practices. The Model State Law has been formally approved by the Secretary of the U.S. Department of Housing and Urban Development and endorsed by the National Conference of State Legislatures and the National Conference of Insurance Legislators. The Model State Law is well on its way to approval in almost all state legislatures, despite some unfortunate efforts by industry associations to frustrate, weaken or delay the passage of this important Congressional mandate.Nationwide Cooperative Protocol and Agreement for Mortgage Supervision In December 2007, CSBS and AARMR launched the Nationwide Cooperative Protocol and Agreement for Mortgage Supervision to assist state mortgage regulators by outlining a basic framework for the coordination and supervision of Multi-State Mortgage Entities (those institutions conducing business in two or more states). The goals of this initiative are to protect consumers; ensure the safety and soundness of institutions; identify and prevent mortgage fraud; supervise in a seamless, flexible, and risk-focused manner; minimize regulatory burden and expense; and foster consistency, coordination, and communication among state regulators. Currently, 48 states plus the District of Columbia and Puerto Rico have signed the Protocol and Agreement. The states have established risk profiling procedures to determine which institutions are in the greatest need of a multi-state presence and we are scheduled to begin the first multi-state examinations next month. Perhaps the most exciting feature of this initiative is the planned use of robust software programs to screen the institutions portfolios for risk, compliance, and consumer protection issues. With this software, the examination team will be able to review 100 percent of the institution's loan portfolio, thereby replacing the ``random sample'' approach that left questions about just what may have been missed during traditional examinations.CSBS-AARMR Reverse Mortgage Initiatives In early 2007, the states identified reverse mortgage lending as one of the emerging threats facing consumers, financial institutions, and supervisory oversight. In response, the states, through CSBS and AARMR, formed the Reverse Mortgage Regulatory Council and began work on several initiatives: Reverse Mortgage Examination Guidelines (RMEGs). In December 2008, CSBS and AARMR released the RMEGs to establish uniform standards for regulators in the examination of institutions originating and funding reverse mortgage loans. The states also encourage industry participants to adopt these standards as part of an institution's ongoing internal review process. Education materials. The Reverse Mortgage Regulatory Council is also developing outreach and education materials to assist consumers in understanding these complex products before the loan is made.CSBS-AARMR Guidance on Nontraditional Mortgage Product Risks In October 2006, the federal financial agencies issued the Interagency Guidance on Nontraditional Mortgage Product Risks which applies to insured depository institutions. Recognizing that the interagency guidance does not apply to those mortgage providers not affiliated with a bank holding company or an insured financial institution, CSBS and AARMR developed parallel guidance in November 2006 to apply to state-supervised residential mortgage brokers and lenders, thereby ensuring all residential mortgage originators were subject to the guidance.CSBS-AARMR-NACCA Statement on Subprime Mortgage Lending The federal financial agencies also issued the Interagency Statement on Subprime Mortgage Lending. Like the Interagency Guidance on Nontraditional Mortgage Product Risks, the Subprime Statement applies only to mortgage providers associated with an insured depository institution. Therefore, CSBS, AARMR, and the National Association of Consumer Credit Administrators (NACCA) again developed a parallel statement that is applicable to all mortgage providers. The Nontraditional Mortgage Guidance and the Subprime Statement strike a fair balance between encouraging growth and free market innovation and draconian restrictions that will protect consumers and foster fair transactions.AARMR-CSBS Model Examination Guidelines Further, to promote consistency, CSBS and AARMR developed state Model Examination Guidelines (MEGs) for field implementation of the Guidance on Nontraditional Mortgage Product Risks and the Statement on Subprime Mortgage Lending. Released on July 31, 2007, the MEGs enhance consumer protection by providing state regulators with a uniform set of examination tools for conducting examinations of subprime lenders and mortgage brokers. Also, the MEGs were designed to provide consistent and uniform guidelines for use by lender and broker compliance and audit departments to enable market participants to conduct their own review of their subprime lending practices. These enhanced regulatory guidelines represent a new and evolving approach to mortgage supervision.Mortgage Examinations With Federal Regulatory Agencies Late in 2007, CSBS, the Federal Reserve System (Fed), the Federal Trade Commission (FTC), and the Office of Thrift Supervision (OTS) engaged in a pilot program to examine the mortgage industry. Under this program, state examiners worked with examiners from the Fed and OTS to examine mortgage businesses over which both state and federal agencies had regulatory jurisdiction. The FTC also participated in its capacity as a law enforcement agency. In addition, the states separately examined a mortgage business over which only the states had jurisdiction. This pilot is truly the model for coordinated state-federal supervision. ______ FOMC20081216meeting--439 437,MR. DUDLEY.," The purpose of this facility is not to give investors profits. The purpose of this facility is to address the fact that lending spreads on AAA-rated securities are extremely wide right now and the securitization market is closed. The idea is that, if you offer moreattractive terms than those available in the market, the demand for these securities will increase, issuers will be able to sell these securities at better prices and lower spreads, and the consequences of that will be lower lending rates and improved credit availability to households. The goal at the end of the day is not to do anything for investors. The goal is to harness investors' profit motivation to drive down spreads in the AAA market. " FinancialCrisisReport--402 Goldman executives expressed the view that the subprime mortgage related market was likely to get much worse, and the firm should prepare for it. 1625 In December 2006, Goldman used the Hudson CDO to transfer the risk associated with $1.2 billion of its ABX long holdings to Hudson investors. But even after this transfer, Goldman still had billions of dollars in long ABX holdings on its books. Goldman’s Long Mortgage Holdings. In addition to its long ABX holdings, the Mortgage Department’s $6 billion net long position in December 2006 was due to a large inventory of RMBS, CDO, and other mortgage related assets in Goldman’s investment and sale inventories and in its CDO warehouses. In 2006, the Mortgage Department conducted numerous RMBS and CDO securitizations that required it to acquire and repackage whole loans, RMBS and CDO securities, and other mortgage related assets. When assembling CDOs, Goldman often worked with third party partners. These strategic partners bought a portion of the equity and bore some of the risk of loss in the CDO. The partners were generally smaller financial firms, such as hedge funds or asset managers with expertise in CDOs or a particular asset class. For a fee, the partners also sometimes served as a CDO’s collateral manager, helping to select the assets. 1626 Peter Ostrem, who was head of the CDO Origination Desk from 2006 until May 2007, was aware of substantial problems in the subprime mortgage market, but believed that the market distress was temporary and the market would stabilize. 1627 Mr. Ostrem wanted to continue to increase the CDO Desk’s business by producing as many marketable CDOs as possible. 1628 Darryl Herrick, who worked for Mr. Ostrem on the CDO Origination Desk expressed the view that hedge funds were shorting only the worst CDOs: “[CDO] shelves people are shorting are enhanced garbage.” 1629 The CDO Origination Desk was a primary contributor to the Mortgage Department’s net long position, as Goldman often had to hold or “warehouse” subprime assets until they were 1625 See, e.g., 12/15/2006 email from David Viniar to Tom Montag, “Subprime Risk Meeting with Viniar/McMahon Summary, ” GS MBS-E-009726498, Hearing Exhibit 4/27-3 ( “there will be very good opportunities as the markets goes into what is likely to be even greater distress ”); 2/8/2007 email from Daniel Sparks, “Post,” GS MBS-E- 002201668, Hearing Exhibit 4/27-7 ( “Subprime environment going from bad to worse (think whack a mole).”); 1/9/2007 Goldman Presentation, “Mortgage Department Update, ” GS M BS-E-002320968 ( “Risks, Challenges and Structural Issues: –Very tough going in Resi Credit world – p&l [profit and loss] will be challenging; –Housing price and loan volume declines; –Investing in business in very difficult environment”); cf. 11/1/2006 Goldman Structured Products Strategist memorandum, “Q3 Mortgage Investor Survey, ” GS MBS-E-006576068-76 ( “Clients expect a downturn in housing in 2007, investors worried about high LTV [loan-to-value], low/no doc loans, pay option ARMs, origination volumes to be down 10% in 2007 ”). 1626 1627 Subcommittee interview of Peter Ostrem (10/5/2010); Subcommittee interview of Darryl Herrick (10/13/2010) . Subcommittee interview of Peter Ostrem (10/5/2010). See also, e.g., 8/10/2006 email from Peter Ostrem to Daniel Sparks, “Leh CDO Fund, ” GS MBS-E-010898470 (urging Goldman to “do our own fund. SP CDO desk. Big time. ”). 1628 1629 Subcommittee interview of Peter Ostrem (10/5/2010). 6/8/2006 email from Darryl Herrick to Peter Ostrem, “**GS ABS** RMBS CDS Lineup,” GS MBS-E- 016445770. packaged into a CDO. 1630 Each CDO was designed to include or reference hundreds of millions or billions of dollars in assets, which the CDO Origination Desk and its partners had to locate and acquire, a process called “ramping” that averaged six to nine months per CDO. 1631 Goldman and its partners acquired these assets from other large Wall Street broker-dealers, often called “the Street,” or took them from their own inventory of assets. CHRG-110shrg50414--52 Mr. Cox," Thank you, Chairman Dodd, Ranking Member Shelby, and Members of the Committee, for inviting me here to today to discuss the current turmoil in our markets and our policy responses to it. The extraordinary nature of recent events has required an extraordinary response from both policymakers and regulators. Last week, by unanimous decision of the Commission and with the support of the Secretary of the Treasury and the Federal Reserve, as well as in close coordination with regulators around the world, the SEC took emergency action to ban short selling in financial securities to stabilize markets as you consider this legislation. At the same time, the Commission unanimously approved two additional measures to ease the crisis of confidence in the markets. One makes it easier for issuers to repurchase their own shares on the open market, thus providing additional liquidity. The second requires weekly reporting to the Securities and Exchange Commission by large investment managers of their daily short positions. In addition, the SEC recently issued new rules that more strictly enforce the ban on abusive naked short selling under our Regulation SHO. Beyond these immediate steps, the SEC is vigorously investigating how illegal activities may have contributed to the subprime crisis and the recent instability in our markets. First and foremost, the SEC is a law enforcement agency, and we already have over 50 ongoing investigations in the subprime area alone. The Division of Enforcement has undertaken a sweeping investigation into market manipulation of financial institutions, including through the use of credit default swaps, a multi-trillion-dollar market is completely lacking in transparency and is completely unregulated. Last month, the Enforcement Division, working with State regulators, entered into agreements that will be the largest settlements in SEC history, in behalf of investors who bought auction rate securities from Merrill Lynch, Wachovia, UBS, and Citigroup. Happily, the terms of these agreements would provide complete recovery for individual investors. The Commission also recently brought enforcement actions against portfolio managers at Bear Stearns Asset Management for deceiving investors about the hedge funds' overexposure to subprime mortgages. The Commission is using its regulatory authority simultaneously to ensure that the market continues to function. Last week, the Commission's Office of Chief Accountant provided guidance to clarify the accounting treatment of banks' efforts to support their money market mutual funds. This will help protect investors in those funds. And our examinations of the major credit rating agencies for mortgage-backed securities exposed weaknesses in their ratings processes and led to our sweeping new rules to regulate this industry under the new authority that this Committee and the Congress have given us. We are also moving quickly to mitigate the impact of recent events. In the past week, the SEC oversaw the sale of substantially all of the assets of Lehman Brothers, Inc., to Barclays Capital. Hundreds of thousands of Lehman's customer accounts with over $1 billion in assets can now be transferred in a matter of days, instead of going through a lengthy brokerage liquidation process. With all that has happened, it is important to keep in mind how we got here. The problems that each of these actions has addressed have their roots in the subprime mortgage crisis, which itself was caused by a failure of lending standards. The complete and total mortgage market meltdown that led to the taxpayer rescue of Fannie Mae and Freddie Mac was not built into the stress scenarios and the capital and liquidity standards of any financial institution. Bank risk models in every regulated sector, for better or for worse, failed to incorporate this scenario that has caused so much damage in financial services firms of all kinds. The SEC's own program of voluntary supervision for investment bank holding companies, the Consolidated Supervised Entity program, put in place in 2004, was fundamentally flawed because it adopted these same bank capital liquidity standards and because it was purely voluntary. It became abundantly clear with the near collapse of Bear Stearns that this sort of voluntary regulation does not work. Working with the Federal Reserve, the Division of Trading and Markets moved quickly last spring to strengthen capital and liquidity at investment bank holding companies far beyond what the banking standards require, and we immediately entered into a formal Memorandum of Understanding with the Fed to share both information and expertise. But the fact remains that no law authorizes the SEC to supervise investment bank holding companies let alone to monitor the broader financial system for risk. For the moment, this regulatory hole in the statutory scheme is being addressed in the market by the conversion of investment banks to bank holding companies. But the basic problem must still be addressed in statute by filling that regulatory hole, as I have reported to Congress on previous occasions. I will conclude, Mr. Chairman, by warning of another similar regulatory hole in statute that must be immediately addressed or we will have similar consequences. The $58 trillion notional market in credit default swaps, to which several of you have referred in your opening comments--that is double the amount that was outstanding in 2006--is regulated by absolutely no one. Neither the SEC nor any regulator has authority over the CDS market, even to require minimal disclosure to the market. This market is ripe for fraud and manipulation, and indeed we are using the full extent of our antifraud authority, our law enforcement authority, right now to investigate this market. Because CDS buyers do not have to own the bond or the debt instrument upon which the contract is based, they can effectively ``naked short'' the debt of companies without any restriction, potentially causing market disruption and destabilizing the companies themselves. As the Congress considers reform of the financial system in the current crisis, I urge you to provide in statute for regulatory authority over the CDS market. This is vitally important to enhance investor protection and to ensure the continued operation of fair and orderly markets. Mr. Chairman, I appreciate the opportunity to discuss the current market turmoil, and I look forward to answering your questions. " CHRG-110shrg50409--37 Chairman Dodd," I think Senator Bunning, I believe--no, excuse me. Senator Allard. I apologize. Senator Allard. Thank you, Mr. Chairman. Welcome to the Committee. I always look forward to hearing your comments, Chairman Bernanke. Business lending has--I want to talk about that a little bit, and a big aspect of business lending historically, I am told, has been that business plans and their ability to execute those business plans has been a big factor in assessing credit and whether they get a loan or not. I am told that in recent history that has been minimized considerably. First of all, I would like to know if that is true. And the other question, if it is true, do you think we could help confidence if we had provisions that somehow or the other brought more accountability to the business plan aspect when you apply for a loan? " fcic_final_report_full--599 Worry,” Structured Finance: Special Report, May 31, 2007, p. 2. 42. Richard Michalek, testimony before the FCIC, Hearing on the Credibility of Credit Ratings, the Investment Decisions Made Based on Those Ratings, and the Financial Crisis, session 3: The Credit Rat- ing Agency Business Model, June 2, 2010, transcript, pp. 448–49. 43. “2007 MCO Strategic Plan Overview,” presentation by Ray McDaniel, July 2007. 44. Eric Kolchinsky—retaliation complaint, Chronology Prepared by Eric Kolchinsky. 45. FCIC staff estimates based on analysis of Moody’s SFDRS; FCIC, “Preliminary Staff Report: Credit Ratings and the Financial Crisis,” June 2, 2010. 46. Eric Kolchinsky, interview by FCIC, April 27, 2010. 4838–2303–6167 (checked–BLK ); Kolchinsky— retaliation complaint. 47. Eric Kolchinsky—retaliation complaint. 48. FCIC, “PSR: Credit Ratings and the Financial Crisis,” pp. 30–33. 49. Bingham McCutchen, Fannie Mae counsel, letter to FCIC, September 21, 2010 (hereafter “Bing- ham Letter”); O’Melveny & Meyers LLP, Freddie Mac counsel, letter to FCIC, September 21, 2010 (here- after “O’Melveny Letter”). 50. Federal Housing Finance Agency, “Conservator’s Report on the Enterprises’ Financial Perform- ance: Third Quarter 2010,” tables 3.1 and 4.1. 51. Raymond Romano, interview by FCIC, September 14, 2010; Bingham Letter. 52. Bingham Letter. 53. Bingham Letter, Tab 3; Tab 1, “Repurchase Collections by Top Ten Sellers/Servicers.” 54. O’Melveny letter. 55. “Bank of America announces fourth-quarter actions with respect to its home loans and insurance business,” Bank of America press release, January 3, 2011. 56. Mortgage Insurance Companies of America, 2009–2010 Fact Book and Member Directory , Exhibit 3: Primary Insurance Activity (Insurance in Force) p 17. 57. Documents produced for the FCIC by United Guaranty Residential Insurance, MGIC, Genworth, RMIC, Triad, PMI, and Radian. 58. FCIC staff calculations based on productions from Fannie and Freddie. Figures are for Alt-A, option ARM Alt-A, and subprime loans. 59. FHFA, “Conservator’s Report: Third Quarter 2010.” Accounting changes for impairments have re- sulted in offsetting gains of $8 billion. 60. “FHFA Issue Subpoenas for PLS Documents,” Federal Housing Finance Agency news release, July 12, 2010. 61. Covington & Burling LLP, Freddie Mac counsel, letter to FCIC, October 19, 2010; see O’Melveny & Meyers LLP, letter to FCIC, dated October 19, 2010. 62. NERA Economic Consulting, “Credit Crisis Litigation Revisited: Litigating the Alphabet of Struc- tured Products,” Part VII of a NERA Insights Series, June 4, 2010, p. 1. 63. Defendants Wells Fargo Asset Securities Corp. and Wells Fargo Bank, N.A.’s Notice of Removal, Charles Schwab Corp. v. BNP Paribas Securities Corp, et al., No. cv-10-4030 (N.D. Cal. September 8, 2010). 64. Attorney General of Massachusetts, “Attorney General Martha Coakley and Goldman Sachs Reach Settlement Regarding Subprime Lending Issues,” May 11, 2009; “Morgan Stanley to Pay $102 Mil- lion for Role in Massachusetts Subprime Mortgage Meltdown under Settlement with AG Coakley’s Of- fice,” June 24, 2010. 65. Complaint, Cambridge Place v. Morgan Stanley et al., No. 10-2741 (Mass. Super. Ct. filed July 9, 2010), p. 28. 66. Sarah Johnson, “How Far Can Fair Value Go?” CFO.com, May 6, 2008. 67. Vikas Shilpiekandula and Olga Gorodetsky, “Who Owns Residential Credit Risk?” Lehman Broth- ers Fixed Income, U.S. Securitized Products Research, September 7, 2007. 68. Moody’s Investor Service, “Default & Loss Rates of Structured Finance Securities: 1993–2009,” CHRG-111shrg62643--125 Mr. Bernanke," I am sorry, I didn't understand the question. Senator Bennet. They are saying that the assets that they have to reserve that they can't lend have increased from, I think it is 9 percent to 12 percent. " FinancialCrisisReport--239 Century in December 2009. By putting an early end to Fremont’s subprime lending, the FDIC stopped it from selling additional poor quality mortgage backed securities into U.S. securitization markets. In November 2008, the OCC researched the ten metropolitan areas with the highest foreclosure rates and identified the ten lenders in each area with the most foreclosed loans; Long Beach, Countrywide, IndyMac, New Century, and Fremont all made the list of the “Worst Ten in the Worst Ten.” 943 Moody’s, the credit rating agency, later calculated that, in 2006 alone, Long Beach, New Century, and Fremont were responsible for 24% of the residential subprime mortgage backed securities issued, but 50% of the subsequent credit rating downgrades of those securities. 944 The fact is that each of these lenders issued billions of dollars in high risk, poor quality home loans. By allowing these lenders, for years, to sell and securitize billions of dollars in poor quality, high risk home loans, regulators permitted them to contaminate the secondary market and introduce systemic risk throughout the U.S. financial system. E. Preventing Regulatory Failures Regulators stood on the sidelines as U.S. mortgage lenders introduced increasingly high risk mortgage products into the U.S. mortgage market. Stated income loans, NINA loans, and so-called “liar loans” were issued without verifying the borrower’s income or assets. Alt A loans also had reduced documentation requirements. Interest-only loans, Option ARMs, and hybrid ARMs involved charging low introductory interest rates on loans that could be refinanced before much higher interest rates took effect. Negative amortization loans – loans that became bigger rather than smaller over time – became commonplace. Home equity loans and lines of credit, piggybacks and silent seconds, 100% financing – all involved loans that required the borrower to make virtually no down payment or equity investment in the property, relying instead on the value of the property to ensure repayment of the loan. All of these loans involved higher risks than the 30-year and 15-year fixed rate mortgages that dominated the U.S. mortgage market prior to 2004. When property values stopped climbing in late 2006, these higher risk loans began incurring delinquencies, losses, and defaults at record rates. A number of new developments have occurred in the past several years to address the problems highlighted throughout this Report. (1) New Developments The Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank Act), which the President signed into law on July 21, 2010, contains many changes in the law that will be implemented over the next year. The Dodd-Frank changes include abolishing OTS, banning stated income loans, and restricting negative amortization loans. Other developments include a revised interagency agreement strengthening the FDIC’s ability to conduct examinations of 943 See 11/13/2008 “Worst Ten in the Worst Ten,” document prepared by the OCC, Hearing Exhibit 4/13-58. 944 7/12/2007 “Moody’s Structured Finance Teleconference and Web Cast: RMBS and CDO Rating Actions,” prepared by Moody’s Investors Service, Hearing Exhibit 4/23-106. insured depository institutions and a new FDIC deposit insurance pricing system that requires higher risk institutions to pay higher insurance fees. CHRG-111shrg51303--120 Mr. Kohn," Exactly. Senator Warner. And that AIG's practices, whether it would be in effect a mortgage securities lending business that went from $1 billion of exposure to about $100 billion of exposure between 1999 and 2007, it was a huge rise. " CHRG-110hhrg46591--265 Mr. Yingling," Well, it is really a problem with the larger banks in the international markets. As Mr. Washburn said, it is not really a problem with community banks. The great majority of community banks are in solid shape and are willing to lend. This new program can have a positive impact. One thing we have to watch is how many strings are attached, because these are banks that can do just fine by themselves, but they need capital to support growth in lending, and the capital markets to community banks right now are not functioning very well. So you could have a situation where a bank will take some of this capital for a very short period of time, and then when the capital markets open, they will replace it with private capital. " CHRG-111hhrg56766--289 Mr. Bernanke," The discount window is for banks only. The lending we did to investment banks, we did through an emergency facility, which was opened in March 2008, and which we are offering now complete transparency on. " CHRG-111hhrg50289--65 Mr. Coffman," Would anybody comment on the fact that I often hear that the other shoe is going to drop and it is the exposure to commercial real estate, and what will that do to lending? Is that going to further tighten it up? What is your prognosis of the future here? " FOMC20080724confcall--12 10,MR. LACKER.," With the way that we currently operate the Term Securities Lending Facility now in place, is there any upper limit on the fee that some participant can bid? " CHRG-111hhrg55809--110 Mr. Bernanke," It is a loan from the banks, but it is not a loan that requires capital to back it up. And therefore, in that sense, it doesn't crowd out other lending. But there are no good solutions there, and I know the FDIC has really struggled with the right approach. " CHRG-109hhrg23738--114 Mr. Greenspan," I do think we, for example, have expanded HMDA over the years--I mean, we will be releasing HMDA data, I believe, in a couple of months for the year 2004--and there are many new sources of information in those data systems. And in that regard, it is a very large data requirement that is involved here, and there are obviously going to be continuing discussions of what types of information, what types of evidence of discrimination occurs, and how does one essentially pick it up. But it is not a simple solution. Ms. Lee. I understand, Mr. Greenspan. Before my time is up, let me just say I understand the fact that this would cost some money. But I think, long-term, the cost of discrimination and the costs of denying loans to minority potential homeowners far exceed the cost of gathering the data. When you look at small business lending, it is my understanding now--and we are looking to verify this information--that African-American-owned businesses receive less than 2 percent of the small business lending; Latino-owned businesses less than 2 percent also. And so at some point, in addition to trying to enforce fair lending laws, we have got to do something to make sure that there does not exist discrimination and that there is a level playing field in the future whether it costs the financial services industry a few dollars or not. " CHRG-111shrg52619--95 Chairman Dodd," It will be included. Senator Menendez. Mr. Chairman, I look forward to asking some questions specifically, but I want to turn first to Chairman Bair. I cannot pass up the opportunity, first to compliment you on a whole host of things you are doing on foreclosure mitigation and what not. I think you were ahead of the curve when others were not and really applaud you for that. But I do have a concern. I have heard from scores of community banks who are saying, you know, we understand the need to rebuild the Federal Deposit Insurance Fund, but I understand when they say to me, look, we are not the ones who drove this situation. We have to compete against entities that are receiving TARP funds. We are not. And in some cases, we are looking at anywhere between 50 and 100 percent of profit. Isn't there--I know that--I understand you are statutorily prohibited from discriminating large versus small, but in this once--and so I understand this is supposedly a one-time assessment. Wouldn't it be appropriate for us to give you the authority to vary this in a way that doesn't have a tremendous effect on the one entity, it seems to me, that is actually out there lending in the marketplace as best as they can? Ms. Bair. Well, a couple of things. We have signaled strongly that if Congress will move with raising our borrowing authority, we feel that that will give us a little more breathing room. Senator Menendez. With what? I am sorry, I didn't hear. Ms. Bair. If Congress raises our borrowing authority--Chairman Dodd and Senator Crapo have introduced a bill to do just that--if that can be done relatively soon, then we think we would have some flexibility to reduce the special assessment. Right now, we have built in a good cushion above what our loss projections would suggest would take us to zero because we think the borrowing authority does need to be raised. It has been at $30 billion since 1991. So we do think that needs to happen. But if it does get raised, we feel we could reduce our cushion a bit. Also, the FDIC Board just approved a phase-out of our TLGP, what we call our TLGP Debt Guarantee Program. We are raising the cost of that program through surcharges which we will put into the Deposit Insurance Fund. This could also reduce the need for the special assessment and so we will be monitoring that very closely. We have also asked for comment about whether we should change the assessment base for the special assessment. Right now, we use domestic deposits. If you used all bank assets, that would shift the burden to some of the larger institutions, because they rely less on deposits than the smaller institutions. So we are gathering comment on that right now. We will probably make a final decision in late May. Increasing the borrowing authority plus we expect to get some significant revenue through this surcharge we have just imposed on our TLGP--most of the larger banks are the beneficiaries of that Debt Guarantee program--we think that will help a lot. Senator Menendez. Well, I look forward, Mr. Chairman, to working with you to try to make this happen, because these community banks are the ones that are actually out there still lending in communities at a time in which we generally don't see much credit available. But this is a huge blow to them and however we can--I will submit my own comments for the regulatory process, but however we can lighten the load, I think will be incredibly important. Mr. Dugan, I want to pursue a couple of things with you. You recently said in a letter to the Congressional Oversight Panel, essentially defending your agency. Included in that letter is a chart of the ten worst, the lenders with the higher subprime and Alternate A foreclosure rates. Now, I see that three of them on this list have been originating entities under your supervision--Wells Fargo, Countrywide, and First Franklin. Can you tell us what your supervision of these entities told you during 2005 to 2007 about their practices? " FOMC20070321meeting--71 69,MR. STOCKTON.," In our forecast, we’re not too far from the bottom. We made the bottom a little deeper this time and put it off just a little bit longer. I said before that we saw signs that demand was stabilizing. In some sense, the adjustment that we’ve made for these recent subprime developments suggests to us that there will be another small step-down in demand going forward from where we currently are. That makes the process of working off the inventory, to which President Poole pointed, a little more prolonged. It also puts this housing downturn, in terms of magnitude, very close to the one that occurred in the early 1990s." CHRG-111hhrg54872--91 Mr. Watt," Now, the third issue I want to deal with is this whole preemption issue. You and I worked through this or tried to work through it on the predatory lending front, trying to find the appropriate balance about what got preempted and what did not get preempted. One approach that I want to sound out on you publicly today, and I haven't thought it all the way through, is similar to the approach that we used in the predatory lending area of actually going through and specifying some things that are not preempted, unfair and deceptive, State unfair and deceptive trade practices laws, State fraud laws. There was a list of them that we came up with. I don't have the list in front of me right now, civil rights laws, things that we know if a State legislates in, we ought not be preempting their standards because quite often a lot of those standards are set at the local level; is that correct? " FinancialCrisisReport--433 The failure of the Bear Stearns hedge funds triggered another decline in the value of subprime mortgage related assets. The ABX Index, which was already falling, began a steep, sharp decline. The collapse had further negative effects when the hedge funds’ massive subprime holdings were suddenly dumped on the market for sale, further depressing prices of subprime RMBS and CDO assets. The creditors of the Bear Stearns hedge funds met with Bear Stearns management in an attempt to organize a “workout” solution to stabilize the funds. 1776 While those efforts were underway, Goldman and Bear Stearns agreed to an unwind in which Goldman bought back $300 million of two AAA CDO tranches of Goldman’s Timberwolf CDO, which the hedge funds had purchased two months earlier in April 2007. Goldman paid Bear Stearns 96 and 90 cents on the dollar, respectively, for the two Timberwolf tranches. 1777 Goldman also bought a few other RMBS and CDO assets, which it immediately sold. 1778 The attempt to organize a workout solution for the funds was ultimately unsuccessful. Large blocks of subprime assets from the Bear Stearns hedge funds’ inventory began flooding the market, further depressing subprime asset values. 1779 Goldman’s Structured Product Group (SPG) took the collapse of the Bear Stearns hedge funds as the signal to begin rebuilding its net short position. As Joshua Birnbaum, the head ABX trader on the SPG Desk, later wrote: “[T]he Bear Stearns Asset Management (BSAM) situation changed everything. I felt that this mark-to-market event for CDO risk would begin a further unraveling in mortgage 1776 1777 6/12/2007 email to Craig Broderick, “BSAM Bullet Points,” GS MBS-E-009967117. See 6/22/2007 emails from David Lehman, “BSAM Repo Summary, ” GS MBS-E-001916435. See also 6/18/2007 email from David Lehman, “Today’s Bear Stearns Prices,” GS MBS-E-001919600; 6/27/2007 email from Daniel Sparks to David Viniar, “CDO^2s, ” GS MBS-E-009747489. The prices Goldman paid to Bear Stearns on the A1B and A1C tranches of Timberwolf were approximately one cent (or 100 basis points) above its own internal marks on the Timberwolf tranches in the week of June 18, which were then at 95 and 89 points, respectively. Id. In May 2007, Goldman had completed a re-evaluation of its CDO assets, which suggested on a preliminary basis that the AAA Timberwolf securities should be marked down dramatically in value. Accordingly, Goldman may have been generous toward Bear Stearns in buying back the Timberwolf positions at 96 and 90. On the other hand, repurchasing the Timberwolf securities near its own low internal marks might have reduced the price Goldman could obtain in reselling the tranches, which it identified in a June 22 sales directive to its sales force and recommended selling at 98.5 and 95, respectively. When asked about the buyback of the Timberwolf tranches, Mr. Viniar told the Subcommittee that Goldman had financed the purchase of both tranches and may have been legally entitled to seize them, but there are circumstances in which Goldman voluntarily settles a dispute on agreed terms, rather than going through the legal process entailed in seizing and selling collateral. Subcommittee interview of David Viniar. (4/13/2010). 1778 6/22/2007 email from Tom Montag to Daniel Sparks, “Few Trade Posts,” GS M BS-E-010849103 (Mr. Montag: “Can I get a complete rundown on everything we bought from BSAM and what ’s left? ” Mr. Sparks: “Yes – main thing left is 300mm timberwolfs Other large positions were tmts - gone, octan - gone, abacus - we will collapse against short There were some small rmbs positions.”). 1779 At the time, a trader from another bank stated in a market update: “[T]he BSAM [Bear Stearns Asset Managment] story will dictate the tone in the market in the short term, as a continued liquidation of their holdings will put further downward price pressure on ... ABX trading.” 6/18/2007 email to Edwin Chin, “ABX Open,” GS MBS-E-021890868. credit. Again, when the prevailing opinion in the department was to remain close to home, I pushed everyone on the [SPG] desk to sell risk aggressively and quickly. We sold billions of index and single name risk.” 1780 FinancialCrisisReport--366 RMBS securities. 1449 These and other events affected both the RMBS and CDO markets, since so many CDOs included or referenced subprime RMBS securities. Emails reviewed by the Subcommittee show that CDO personnel at Deutsche Bank were well aware of the worsening CDO market and were rushing to sell Gemstone 7 before the market collapsed. On February 7, 2007, Mr. Lippmann, reacting to the New Century developments, raised concerns with Mr. Lamont about the ability of Deutsche Bank to continue to sell CDO securities: “I was calling about warehouse marks and distribution risk b/c [because] hearing rumors about other dealers having big trouble placing this stuff.” 1450 The next day, February 8, 2007, Mr. Lamont told Abhayad Kamat, the CDO Group employee structuring Gemstone 7: “[R]egardless we need to sell it [Gemstone 7] now while we still can.” 1451 The same day, Mr. Lamont wrote to Mr. Jenks at HBK: “Keep your fingers crossed but I think we will price this just before the market falls off a cliff.” 1452 The next day, February 9, 2007, Ilinca Bogza, of the Deutsche Bank syndicate group, wrote to Mr. Lamont: “Jenks just called me. … He is frightened that accounts will pull their orders given the widening in abx today. … He mentioned he was going to give you a call. He is very nervous.” 1453 On February 13, 2007, the head of Deutsche Bank’s syndicate group, Anthony Pawlowski, wrote to Mr. Lamont: “I am not sure how to push guys upstairs without having them crack. Everyone wants to price this deal asap (Sean Whelan [co-head of Deutsche Bank’s CDO sales force] is pushing for Friday to lock up his guys on the AAA and AA)[.] Let me know.” 1454 A week later, on February 20, 2007, Mr. Lamont wrote to Deutsche Bank syndicate to ask: “[O]n our managed mezz[anine] abs [asset backed security] CDOs last year what was the split by risk tranche across deals between real money and cdo warehouses. The street may be pulling back so this would be good info to have as we think about how we are going to place risk.” 1455 1449 On Feb. 23, 2007, MarketWatch announced: “The ABX.HE index that tracks CDS on the riskiest subprime loans, rated BBB-, that were sold in the second half of 2006 fell to $0.69 on Friday, according to Markit.com, which administers the indexes. That’s down from $0.72 on Thursday and $0.79 at the beginning of the week. In early February, this index was above 90.” “Subprime mortgage derivatives index plunges; Bankruptcies, losses in subprime home loan industry spark drop,” MarketWatch (2/23/2007), http://www.marketwatch.com/story/index-of- subprime-mortgage-derivatives-plunges-on-sector-woes . 1450 2/7/2007 email from Greg Lippmann to Michael Lamont, DBSI_PSI_EMAIL02366193-96, at 94. When Mr. Lamont heard about the New Century developments he wrote: “yikes. I think we will stay short a while.” 2/7/2007 email from Michael Lamont to Greg Lippmann, DBSI_PSI_EMAIL02366194. 1451 2/8/2007 email from Michael Lamont to Abhayad Kamat, DBSI_PSI_EMAIL04045219-24. 1452 2/8/2007 email from Michael Lamont to Kevin Jenks, DBSI_PSI_EMAIL04045360. 1453 2/9/2007 email from Ilinca Bogza to Michael Lamont, DBSI_PSI_EMAIL04047421-23. 1454 2/13/2007 email from Anthony Pawlowski at Deutsche Bank to Michael Lamont, DBSI_PSI_EMAIL04049521. 1455 2/20/2007 email from Michael Lamont to Ilinca Bogza, DBSI_PSI_EMAIL04054492. On February 20, 2007, a client of Mr. Lippmann’s who was looking to short more RMBS commented in an email to him about the negative news concerning Novastar Financial Inc., which announced losses that day. His client described the situation in the market “like the plague.” 2/20/2007 email from Steven Eisman at Frontpoint Partners to Greg Lippmann, DBSI_PSI_EMAIL02008182. CHRG-111hhrg52261--98 Mr. Robinson," Congresswoman, perhaps there is a parallel in the financial services--noninsurance financial service area you that might consider. I mentioned earlier about underwriting, or identifying the risk, underwriting it and pricing it properly. And you do the best job you can, whether it be a house on a beach or a subprime mortgage or whatever. And then, when the hurricane comes or the collapse happens, management meetings happen that say, We are not going to do that again. And then we have to recast our expectations, and that usually results in underwriting tightening up, which could mean change in credit score or unwillingness to put out lines of credit. Also, a bad result could result in an organization being overleveraged. We have too much out there and so we have to pull back. Ms. Fallin. Thank you, Madam Chairwoman. " CHRG-110shrg50420--260 Mr. Nardelli," Senator, let me just offer a thought. Again, bankruptcy was something I was hoping never to become an expert in, in my 38 years, and certainly not today. But your point is correct, that as I try to understand it, we cannot just make unilateral rejections, for example, with the union, certainly with the banks that have secured lending. I think certainly this Committee would understand that more than anybody. If that was breached, who would go out and lend money unsecured and not have recovery? I would say that one of the things that was discussed with the Government Accounting Office, I would suggest that we put a date--March 31st as a benchmark data that says give us the funding, allow us to survive, and then by March 31st, have the toll gate to see where we are against those negotiations. At least I am speaking for Chrysler. Senator Crapo. Mr. Wagoner. " CHRG-111shrg51303--41 Mr. Dinallo," Well, for the--no. For the 10 percent--our companies had 8 percent exposure to it. For that 8 percent, we did monitor it, yes. So we were not responsible for the whole securities lending program, sir. I just--I am just telling you what we did was about 8 percent. As I said, we have about 10 percent of the life insurance companies we regulate in the AIG holding empire and we monitored that 8 percent exposure. Senator Shelby. Your testimony, I believe, is ambiguous as to whether you believe AIG's securities lending facilities were activities of its insurance companies or of a non-insurance subsidiary. I think it is clear that they were activities of the insurance companies. Do you agree with that or disagree? " Mr. Dinallo," I, in part, disagree. Senator Shelby. And how do you disagree? " CHRG-111hhrg54872--231 Mr. Ellison," Let me ask you this. There has been an argument out there that the CFPA should only apply to presently unregulated entities. I found a little information that I want to ask you about, and it suggests that while there is no question that independent mortgage finance companies were major players in the subprime marketplace, the affiliates of national banks and other insured depositories also played an important role. Indeed, HMDA data show that depository institutions and their affiliate subsidiaries originated 48 percent of the higher-priced loans in 2005 and 54 percent of the higher-priced loans of 2006. Can somebody help me understand what this means, for the record? " FOMC20070321meeting--34 32,MR. DUDLEY.," When people are in risk-reduction mode, they don’t want to take on more risk. So there may be an imbalance temporarily between those who want to hedge versus those who want to take more risk. To take the other side of that bet, they’re basically increasing their risk. The ABX market is another example of that. Why did the ABX index go to a 2,000 yield spread? Well, it was partly because a lot more people wanted to buy protection in the subprime mortgage market than wanted to sell it. In a perfect economic world, it should be arbitraged away, but I think there are cases where that just doesn’t necessarily happen." CHRG-111hhrg51591--63 Chairman Kanjorski," I like that pun. We now have Ms. Bean for 5 minutes. Ms. Bean. Thank you, Mr. Chairman. My first couple of questions are for Mr. Webel. And I am going to give you a couple of them and let you answer them together in the interest of time. The subcommittee has talked a lot about the $200 billion in Federal tax dollars that have gone to AIG, and how it was essentially focused on the financial products unit. But almost $70 billion in taxpayer money did go to bailing out AIG insurance subsidiaries and their securities lending program. In the current State-based system, who is responsible for overseeing the insurance subsidiaries' securities lending program? " CHRG-109hhrg31539--244 The Chairman," The gentlelady from California, Ms. Lee. Ms. Lee. Thank you, Mr. Chairman. Good to see you again Mr. Chairman. I don't want to have to get back on my soap box on this, but I guess I will because I have been trying to get, since Chairman Greenspan, some real answers to this issue so that we can move forward. So in the past, and I think I have talked to you a little bit about this the last time you were here, I have sought to work with Chairman Greenspan to address the obvious racial and ethnic disparities in small business lending and home mortgage lending as well as I have talked with the CEO of our local Federal Reserve, Janet Yellen. Now, unfortunately, the response that I have received in each case has been totally inadequate. And this has been going on for several years. Mr. Greenspan suggested that the cost to business would prohibit stronger data collection, discounting the positive effects to the economy of increasing minority homeownership and small business lending. And Ms. Yellen also indicated that it would be way beyond the capacity of the Federal Reserve to undertake a community survey of minority homeownership and suggested that we wait until the 2010 Census. I think the Federal Reserve must do more to ensure accountability to these unfair lending practices and to meaningfully address the tremendous gap, and it is tremendous in minority homeownership. Toward that end, I am interested in looking at ways to link the Community Reinvestment Act ratings with lending practices, and I have written you a letter--you probably haven't seen it yet--on July 12th, summarizing all this. CRA, of course as you know, was written to address how banking institutions meet the credit needs of their low- and moderate-income neighborhoods and ensure that banks invested in and strengthened the communities in which they were doing business. And part of this goal also was to reach out to traditionally underserved communities and provide them with access to capital if they needed it so that they could grow with their community bank. But disappointingly, according to much of the data that we have received, and I am sure you know this data, most banks provide on average--now this is on average--about a 1 to 2 percent conventional loan rating to their--in terms of home loans to African-Americans and to Latinos and yet the CRA ratings are ``A's'', and ``outstandings'', and what have you. And so what I am trying to figure out is, understanding the CRA doesn't currently focus on lending to minorities, don't you think that it makes sense to strengthen the statute to do so or at least to increase the amount of data, just increase the amount of data that is collected based on race and ethnicity because I believe--and I wanted to get your sense of this--that the potential economic benefits would definitely outweigh the minimal costs posed to businesses for collecting such information. And again, I hope to hear from you in writing because I did write this up again on July 12th. And just the second question is--or well, yes, it is a question. I wanted to get your sense of the Wachovia regulatory approval of its acquisition of World Savings. That is located in my district, and we, since I have been in Congress, haven't been through this type of acquisition, and I wanted to hear what the underlying factors are in the Federal Reserve's decision and what your timetable is for the approval. " fcic_final_report_full--498 Table 4. 81 High LTVs enhance the risk of low FICO scores Column 1 Column 2 Column 3 Column 4 Column 5 Column 6 Row 1 FICO Score ≤ 70% LTV 71-80% LTV 81-90% LTV 91-95% LTV Relation of Column 5 to Column 3 Row 2 < 620 1.0 4.8 11 20 4.2 times Row 3 620-679 0.5 2.3 5.3 9.4 4.1 times Row 4 680-720 0.2 1.0 2.3 4.1 4.1 times Row 5 > 720 0.1 0.4 0.9 1.6 4 times Despite these obvious dangers, HUD saw the erosion of downpayment requirements imposed by the private sector as one of the keys to the success of its strategy to increase home ownership through the “partnership” it had established with the mortgage financing community: “The amount of borrower equity is an important factor in assessing mortgage loan quality. However, many low-income families do not have access to suffi cient funds for a downpayment. While members of the partnership have already made significant strides in reducing this barrier to home purchase, more must be done. In 1989 only 7 percent of home mortgages were made with less than 10 percent downpayment. By August 1994, low downpayment mortgage loans had increased to 29 percent.” 82 [emphasis supplied] HUD’s policy was highly successful in achieving the goals it sought. In 1989, only one in 230 homebuyers bought a home with a downpayment of 3 percent or less, but by 2003 one in seven buyers was providing a downpayment at that level, and by 2007 the number was less than one in three. The gradual increase in LTVs and CLTVs (first and second loans combined to produce a lower downpayment) under HUD’s policies is shown in Figure 4. Note the date (1992) when HUD began to have some influence over the downpayments that the GSEs would accept. That HUD’s AH goals were the reason Fannie increased its high LTV (low downpayment) lending is clearly described in a Fannie presentation to HUD assistant secretary Albert Trevino on January 10, 2003: “Analyses of the market demonstrate the greatest barrier to home ownership for most renters are related to wealth—the lack of money for a downpayment…our low-downpayment lending— negligible until 1994—has grown considerably. It is a key part of our strategy to serve low-income and minority borrowers.” The figure that accompanied that statement showed that Fannie’s home purchase loans over 95 percent LTV had increased from one percent in 1994 to 7.9 percent in 2001. 83 81 “Deconstructing the Subprime Debacle Using New Indices of Underwriting Quality and Economic Conditions: A First Look,” by Anderson, Capozza, and Van Order, found at http://www.ufanet.com/ DeconstructingSubprimeJuly2008.pdf. 82 HUD’s “National Homeownership Strategy – Partners in the American Dream,” http://web.archive. org/web/20010106203500/www.huduser.org/publications/affh sg/homeown/chap1.html. 83 ”Fannie Mae’s Role in Affordable Housing Finance: Connecting World Capital Markets and America’s Homebuyers,” Presentation to HUD Assistant Secretary Albert Trevino, January 10, 2003. CHRG-111hhrg53240--127 Mr. Cleaver," Lord help us. Ms. McCoy. Exactly. I think it makes sense for the Community Reinvestment Act to be part of the new agency because the agency is so concerned with access to credit and credit quality. And those two things are at the core of CRA. Ms. Saunders. My organization does not really work on CRA issues. But I can tell you that as I was writing my testimony and the particular history on Rent-a-Bank, payday lending where the banks are lending their preemption rights to the payday lenders, I was struck--I had help on the testimony from Jean Ann Fox at the Consumer Federation. I was struck by the important role that CRA played in eventually bringing--eventually, it was one of the rare successes, all four of the banking agencies, to realize that this was not appropriate and shutting it down. " CHRG-111shrg57322--808 Mr. Viniar," There is no policy that I am aware of. Senator Coburn. All right. Thank you. Mr. Broderick, I want to spend some time with you, if I may. Would you go to Exhibit 63, please.\1\ I will just read it, if you have found it. This is from Patrick Welch to you, Mike Dinias, Robert Berry, Lee Hemphill, Wildermuth, and I guess that is Rapfogel.--------------------------------------------------------------------------- \1\ See Exhibit No. 63, which appears in the Appendix on page 477.--------------------------------------------------------------------------- ``Craig, I realize this may be too late, but two comments: Just fyi not for the memo, my understanding is that the desk is no longer buying subprime. (We are low balling on bids.)'' Why would this be excluded from the memo? " CHRG-111hhrg55814--393 The Chairman," You do us no service when you tell us the problem-- Ms. D'Arista. Leverage will help, and if you were to extend the idea of the National Bank Act to limit lending to financial institutions, that would be very helpful. " CHRG-111hhrg56766--258 Mr. Lance," Yes. The rhetoric of the President when announcing this was in direct relationship to the fact that funds were used for TARP and they are being paid back. I just have the greatest concerns that this would mean less lending than would otherwise be the case. " CHRG-111hhrg56766--246 Mr. Paulsen," How long do you think it will be before the Federal funds rate becomes the benchmark again for overnight lending, and how tested are these tools that you have to employ or you plan on employing in the near future, I guess? " CHRG-111hhrg56241--202 Mr. Stiglitz," Yes. We were talking about that at the beginning of the hearing, that money that goes out in bonuses is money that is not available in, you might say, the net worth of the bank and therefore not available as the basis of the leverage that the bank can lend out. " CHRG-111hhrg52406--175 Mr. Yingling," How can they be generated by one agency? One is the Bank Secrecy Act. One has to do with account opening and truth in lending, and one has to do with antifraud. They are different rules. Ms. Seidman. They could be harmonized much better if one agency is harmonizing them instead of many of them. " CHRG-110hhrg46596--179 Mr. Scott," Thank you, Mr. Chairman. Let me just encourage you to move ahead with all deliberate speed to get these CEOs before our committee. There are pertinent questions that we have to ask and get that answer as to why they are not lending. " CHRG-111hhrg56241--182 Mr. Bachus," Yes, I do want to say this. I think we are dealing with executive compensation, and I think one thing that does trouble most Americans and Members on both sides of the aisle is that some of the very large banks do borrow very cheaply from the Fed, and that is taxpayer subsidized in one way or the other. Whether they invest them in Treasury bonds or carry trade, or whether they use them to trade and make additional profits, the original premise was that money would be loaned, and it is not. Now, I will say this: The flip side of the argument is that they are using those trading profits to cover some of their lending losses, and in some ways that makes the banks stronger and it may avoid the government having to come up and pick up liability. You know, that is one of their answers. Another one that they say is that there are no borrowers; they can't find borrowers who are qualified. Now, I talk to many people back in Alabama, and they say when they deal with the large banks, they say they are not interested in loaning someone $200,000. They are interested in $100 million deals. So I think that is a real problem. Particularly as banks get bigger and bigger, they are not lending on Main Street. They are lending to large corporations, but smaller businesses can't get loans. And I do think the American people do believe that by being able to borrow cheaply from the Fed and some of the guarantees that have been extended, that money is finding its way into compensation, which gives the appearance of being excessive. And so I think these are valid concerns. And also, the last concern, and I will close with this, and I think it is a concern we all have, as they do this trading they tend to be going back and doing what got them in trouble in the first place, and that is speculating, leveraging, and what happens, do we get right back into the problem we had? And if they are going to get in trouble, they say, you know, you don't want us to make bad loans. That is true. We also don't want them to make trades that are risky. And if anything, the trades benefit themselves, proprietary trading, whereas the lending at least gets the economy going. " CHRG-111shrg52619--195 RESPONSE TO WRITTEN QUESTIONS OF SENATOR HUTCHISON FROM MICHAEL E. FRYZELQ.1. Will each of you commit to do everything within your power to prevent performing loans from being called by lenders? Please outline the actions you plan to take.A.1. NCUA has strongly encouraged federally insured credit unions to work with borrowers under financial stress. While credit unions must be prudent in their approach, there are avenues they need to explore in working through these situations that can result in positive outcomes for both parties. In April of 2007, NCUA issued Letter to Credit Unions 07-CU-06 titled ``Working with Residential Mortgage Borrowers,'' which included an FFIEC initiative to encourage institutions to consider all loan workout arrangements. NCUA subsequently issued Letter to Credit Unions 08-CU-05 in March of 2008 supporting the Hope NOW alliance, which focuses on modifying qualified loans. More recently, NCUA Letter to Credit Unions 09-CU-04, issued in March 2009, encourages credit union participation in the Making Home Affordable loan modification program. NCUA is currently in the process of developing a Letter to Credit Unions that will further address loan modifications. NCUA has been, and will remain, supportive of all prudent efforts to avoid calling loans and taking foreclosure actions. While NCUA remains supportive of workout arrangements in general, the data available does not suggest performing loans are being called at a significant level within the credit union industry. What is more likely to occur is the curtailing of existing lines of credit for both residential and construction and development lending. It is conceivable that underlying collateral values supporting such loans have deteriorated and no longer support lines of credit outstanding or unused commitments. In those instances, a business decision must be made regarding whether to curtail the line of credit. There likely will be credit union board established credit risk parameters that need to be considered as well as regulatory considerations, especially as it relates to construction and development lending. Credit union business lending is restricted by statute to the lesser of 1.75 times the credit union's net worth or 12.25 percent of assets (some exceptions apply). There are further statutory thresholds on the level of construction and development lending, borrower equity requirements for such lending, limits on unsecured business lending, and maximum loan to value limitations (generally 80 percent without insurance or up to 95 percent with insurance). While business lending continues to grow within credit unions, the level of such lending as of December 31, 2008, is 3.71 percent of total credit union assets and 5.32 percent of total credit union loans. Only 6.15 percent of outstanding credit union business loans, or $1.95 billion, are for construction and development, which is a very small piece of the overall construction and development loan market. Credit union loan portfolios grew at a rate of over 7 percent in 2008. The level of total unfunded loan commitments continues to grow, which suggests there is not a pervasive calling of lines of credit. Credit unions need to continue to act independently in regard to credit decisions. Each loan will involve unique circumstances including varying levels of risk. Some markets have been much more severely impacted by the change in market conditions, creating specific risk considerations for affected loans. Additionally, there are significant differences between loans to the average residential home owner who is current on their loan even though their loan to value ratio is now 110 percent, versus the developer who has a line of credit to fund his commercial use or residential construction project. Continued funding for the developer may be justified or may be imprudent. Continued funding may place the institution at additional risk or beyond established risk thresholds, depending on the circumstances. The agency continues to support the thoughtful evaluation by credit union management of each performing loan rather than a blanket approach to curtailing the calling of performing loans. ------ CHRG-111hhrg74855--355 Mr. Shelk," So under the version that you have suggested essentially the tier one bank wouldn't post the collateral, we would have to post the collateral as the counterparty to the tier one institution and as I indicated earlier, the problem with that is it would tie-up, and the examples we have come up with about an average a quarter of the capital of the end user so we fully agree with your comments that the electric utilities and other generators didn't cause the problem. We think the way to get to your transparency goal which we share because we are in the market too, is to have a data repository so that information on these trades would be available to the CFTC and others, and the problem with electricity is it is very customized. These products are traded over hundreds of different nodes around the country so it doesn't really lend itself, the CFTC doesn't lend itself to the corn example, and the T-bill example and kinds of commodities that the chairman indicated. " CHRG-111hhrg56778--56 Mr. Royce," Thank you, Mr. Chairman. Mr. Chairman, despite Mr. Garrett's opening comments, I have never argued that AIG's securities lending losses are a reason for Federal regulation. What I have said, and what I'll say again, is that the State insurance commissioners had the ability to prevent those losses and they did not. There is a lot of blame to go around in the case of AIG, but to say the various State insurance commissioners are not to be included in that group is a failure to look at the facts. AIG's Securities Lending Division used capital directly from the insurance subsidiaries. To date, the losses derived from the Securities Lending Division amount to over $40 billion. Mr. Garrett mentioned that AIG would have been okay, despite these losses. I think $40 billion would cripple any institution. Further, there are at least seven State-regulated insurance subsidiaries that were participating in AIG's Securities Lending Division that would have been insolvent but for the American taxpayers. I would like to ask the insurance commissioners, I understand that every State has an insurance company, holding company law, and that those laws give the insurance regulator the authority to examine the activities of the holding company or other affiliates to ensure the ongoing health of the insurer itself. With regard to AIG, how were those holding company laws and the authority they granted to insurance commissioners used prior to the time the AIG crisis came t a head? Ms. Frohman. Although I did not have an AIG company domesticated in my State, I can speak to the terms of what the holding company framework requires; and in terms of agreements involving U.S.-based AIG companies that are insurance operating entities, we have a number of requirements we're dealing with affiliated agreements and material transactions that would have touched the insurance company or involved the insurance company's operations. We would have required prior review of those agreements to the extent that they had a material threshold. " CHRG-110hhrg46593--83 Secretary Paulson," Let me just say three things here. First of all, the key to turning around the housing situation and avoiding foreclosures is going to be to keep lending going. If the financial system collapsed, we would have many more foreclosures, number one. Number two, you are seeing a number of big banks take extraordinary actions, and they have announced them, and you could just tick them off, announcing actions they are taking. So they are doing things, number one. And number two, I would say that I believe that our actions to stabilize Fannie Mae and Freddie Mac, who are the biggest source of home financing in America today, have been critical. So there have been real steps that have been taken that make a difference. More needs to be done. I hear your frustration; more needs to be done. And we are going to keep working on it. Ms. Velazquez. Yes, you hear my frustration. And I hope that you understand the pain and the suffering of so many homeowners in this country who are losing their homes. So it is just not enough to say to the banks, ``Here is the money. And, by the way, I trust you.'' Because they are not lending; they are not lending to small businesses. They are not working on a loan modification strategy. You just told Mr. Frank here that you are examining strategy to mitigate foreclosures. You don't have the strategy to mitigate foreclosures; you are examining. Chairwoman Bair does. Are you willing to support her plan? " FinancialCrisisReport--478 On March 3, 2007, Mr. Sparks made notes after a telephone call: “Things we need to do .... Get out of everything.” 2016 On March 7, 2007, Mr. Sparks again reported to Goldman’s Firmwide Risk Committee on accelerating problems in the subprime mortgage market: “– ‘Game Over’ – accelerating meltdown for subprime lenders such as Fremont and New Century. – The Street is highly vulnerable . ... Current strategies are to ‘put back’ inventory and liquidate positions. – The Mortgage business is currently closing down every subprime exposure possible.” 2017 On March 8, 2007, Mr. Sparks emailed several senior executives, including Mr. Viniar and Mr. Cohn about “Mortgage Risk”: “[W]e are trying to close everything down, but stay on the short side.” 2018 Other Mortgage Department personnel gave similarly bleak assessments of the subprime mortgage market. As early as January 2007, Jonathan Egol, head of the Correlation Trading Desk, wrote to a colleague expressing his clients’ views: “The mkt is dead.” 2019 In February 2007, when discussing plans to issue an Abacus CDO with a Correlation Desk Trader, Fabrice Tourre, Mr. Egol repeated that assessment as his own: Mr. Egol: [T]he paulson trade may already be dead (although given it is baa2 it may still have a decent shot). Mr. Tourre: Don’t think the Paulson trade is dead. Supersenior pretty much done with ACA, AAAs could be placed in 2 shots, this is sufficient. Remember we make $$$ per tranche placed. ... Mr. Egol: You know I love it all I’m saying is the cdo biz is dead we don’t have a lot of time left. 2020 2016 2017 3/3/2007 email from Daniel Sparks, “Call,” Hearing Exhibit 4/27-14. 3/12/2007 Goldman Firmwide Risk Committee, “March 7th FW R Minutes,” GS M BS-E-00221171, Hearing Exhibit 4/27-19; see also 3/7/2007 email from Daniel Sparks to himself, “Risk Comm, ” GS MBS-E-002212223. 2018 2019 3/8/2007 email from Daniel Sparks, “Mortgage risk,” Hearing Exhibit 4/27-75. 1/29/2007 email from Jon Egol to Fabrice Tourre, GS M BS-E-002620292. Mr. Tourre responded: “ ‘The market is dead ’??? Ouahhh, what do you mean by that? Do you have any insight I don ’t? ” Mr. Egol replied: “LDL [let ’s discuss live] tomorrow. ” Id. Mr. Egol later wrote: “This is not my personal opinion – just a synopsis of the views of the customers we have seen today. ” 1/29/2007 email from Jon Egol to Daniel Sparks, GS MBS-E- 003249991. 2020 2/11/2007 email from Jon Egol, “Index Tranche Pricing Study - 08Feb07.xls,” GS MBS-E-002640951. See also 2/20/2007 email from Fabrice Tourre to Jon Egol, GS MBS-E-009332408 (Mr. Tourre: “By the way, quote from an ABS correlation trader (non-GS): “the mezz ABS CDO business is dead.” Mr. Egol responded: “who.” Mr. Tourre replied: “LDL. ” “LDL, ” which means “let ’s discuss live, ” is an abbreviation that appears throughout the Goldman documents produced to the Subcommittee.); 3/27/2007 email from a Goldman analyst, GS MBS-E- 009685430 ( “The housing slowdown has the risk now not be[ing] offsetting [sic] by stronger capital spending. Both FOMC20080130meeting--411 409,MR. PETERS.," Yes. My perception is that the people who were further down on the list made active decisions to get out of the business or reduce their scale of the business, not necessarily just on gut feeling but because they had invested earlier on in the staff and the models to evaluate the product space. So they understood that the economics of the subprime business had deteriorated and that the risk relative to the return was rising, and they made an active decision, usually, to retract a bit from that space. Now, they may have made those decisions gradually and incrementally over the year from mid-2006 forward. It wasn't one stress test, but it was a thorough understanding of the economics of the actual business that drove their decisionmaking. " FinancialCrisisReport--261 To enable subprime borrowers to buy homes that they would not traditionally qualify for, lenders began using exotic mortgage products that reduced or eliminated the need for large down payments and allowed monthly mortgage payments that reflected less than the fully amortized cost of the loan. For example, some types of mortgages allowed borrowers to obtain loans for 100% of the cost of a house; make monthly payments that covered only the interest owed on the loan; or pay artificially low initial interest rates on loans that could be refinanced before higher interest rates took effect. In 2006, Barron’s reported that first-time home buyers put no money down 43% of the time in 2005; interest only loans made up approximately 33% of new mortgages and home equity loans in 2005, up from 0.6% in 2000; by 2005, 15% of borrowers owed at least 10% more than their home was worth; and more than $2.5 trillion in adjustable rate mortgages were due to reset to higher interest rates in 2006 and 2007. 1012 These new mortgage products were not confined to subprime borrowers; they were also offered to prime borrowers who used them to purchase expensive homes. Many borrowers also used them to refinance their homes and take out cash against their homes’ increased value. Lenders also increased their issuance of home equity loans and lines of credit that offered low 1012 “The No-Money-Down Disaster,” Barron’s (8/21/2006). initial interest rates or interest-only features, often taking a second lien on an already mortgaged home. 1013 CHRG-111shrg57319--302 Mr. Schneider," As we got into 2007, three or four things happened. The subprime market was increasingly challenged. We saw signs that home prices were starting to deteriorate. Long Beach, as I showed you on the numbers earlier, as a percentage of our business was relatively small, actually very small as a percentage of our business, and it simply was not worth the management attention required at that point. Senator Kaufman. But you have been getting reports--and I know you just came in 2005, right? You are getting reports, I mean just terrible things are going on down at Long Beach. I mean, based on the previous panel and just what you have said, it was such a small portion of the business, and there was so much problem with that area, I just wonder why you waited until 2007 to close it down? " FOMC20051213meeting--35 33,CHAIRMAN GREENSPAN.," Well, that’s actually a fairly encompassing explanation. It implies that the lessons from 1998, when they were trying to fund in dollars and lend in the domestic currency—trying to unwind the rules of accounting, which got them all into very serious trouble— have been learned, essentially." CHRG-111hhrg56241--86 Mr. Stiglitz," I would like to emphasize two things that we did not do when we turned over money to these banks. First, we didn't relate giving them money to their behavior, not just with respect to the issue of compensation schemes, but also with respect to lending, which was the reason we were giving them money. That relates to the issue of jobs that has come up here a number of times. The fact that compensation went out meant there was less money inside the banks and therefore less ability or willingness to lend. The second point is that the U.S. taxpayer was not, when it gave the banks money, compensated for the risk that they bore. In some cases, we got repaid. But we ought to look at the transaction that Warren Buffet had with Goldman Sachs, which was an arm's-length transaction. If we wanted what would have been a fair compensation to the taxpayer, the bailouts would have reflected the same terms, and we would have gotten back a lot more. Mr. Moore of Kansas. Thank you, sir. I am interested in better understanding how the culture of excessive lending, abusive leverage, and excessive compensation contributed to the financial crisis. This applies across-the-board for consumers who are in over their head with maxed-out credit cards and homes they couldn't afford, to major financial firms leveraged 35 to 1. Is there anything the government can and should do in the future to prevent a similar carefree and irresponsible mindset from taking hold and exposing our financial system to another financial crisis? Professor Bebchuk? " CHRG-111hhrg50289--5 STATEMENT OF CYNTHIA BLANKENSHIP Ms. Blankenship. Thank you, Chairman Velazquez and Ranking Member Graves. I appreciate the opportunity to be here today and present the views of the nation's community banks on both capital markets and small business lending. In addition to small business lending, Bank of the West has been a long time partner with the Small Business Administration and is strongly committed to helping our communities, using the SBA's 7(a) program and the 504 loan program. Bank of the West has more than $10 million in SBA loans in its portfolio, and we service these loans. This represents six percent of our total loans. Notably, as of May, our total small business lending and SBA lending are running ahead of the amount last year in 2008. So we are doing our part and working hard to get capital out there to the deserving small businesses. My bank's SBA loans create hundreds of jobs by financing the local preschool, health center, hardware store, and auto dealer. Community banks represent the other side of the financial story. Community banks like Bank of the West experienced difficult economic times before, and like always, we stick with our communities and our small business customers. As Chairman of the ICBA, I was recently honored to participate with President Obama and Treasury Secretary Geithner, as well as Chairman Velazquez and Ranking Member Graves, in advancing important policy initiatives to small business lending. ICBA strongly supports the recent initiatives to bolster small business loan program included in the American Recovery and Reinvestment Act of 2009. SBA lending program must serve as a counterbalance during these challenge credit markets for small businesses. Unfortunately, at a time when the economy is faltering, the sharp 2009 decline in the number of SBA loans is troubling. The recent uptick in SBA loans is a positive and welcome sign, but we still have a very long way to go before it reaches solid levels again. Community banks are well positioned and willing to help get our economy back on track. While community banks represent 12 percent of all bank assets, they make 20 percent of all business loans and more than half of all business loans under $100,000. Some 48 percent of small businesses get their financing from banks with one billion dollars and less in assets. Therefore, we encourage policy makers to be mindful and supportive of the community banking sector's important role in supplying credit to small business. To that end, ICBA supports strong SBA programs, fair regulatory treatment and tax policies that will foster robust community bank small business lending. Specifically, ICBA appreciates your work, Chairman Velazquez, and the work of the Committee in enacting $730 million in ICBA-backed SBA-related funding in the American Recovery and Reinvestment Act. This included reduced fees for borrowers and lenders and increased guaranty levels, a new deferred payment program, and a secondary market initiative. Given the prolonged length and depth of the recession, the credit crunch, ICBA encourages Congress to extend or make permanent the SBA fee reductions beyond 2009. We urge SBA to follow the statute and Congress' intent to give priority to small banks in implementing the 7(a) lender fee reduction. ICBA is encouraged to see the SBA finishing the implementation of the ARC loan program. This program will allow existing small business bank customers to better service their debt and ride out the economic slowdown. The SBA market must be restored. I know first hand that my bank would be able to make more small business loans if I was able to sell my existing inventory into the secondary market. ICBA offers several additional policy recommendations aimed at returning more community banks to SBA lending. These include insuring SBA makes good on their loan guarantees and provides more flexibility in small business size standards and market-based loan pricing. ICBA also believes the bank regulatory pendulum has swung too far and is crushing many community banks' ability to lend to small businesses. In conclusion, the need for affordable small business capital is greater than ever. Community bankers run small businesses themselves, live and work in the communities with their small business customers, and we will do everything we can to insure that we meet the credit needs of our local community. Thank you. [The prepared statement of Ms. Blankenship is included in the appendix.] " FinancialCrisisReport--386 In late February, Goldman’s Operating Committee, a subcommittee of its Firmwide Risk Committee, became concerned about the size of the $10 billion net short position. The Firmwide Risk Committee was co-chaired by Mr. Viniar, and Messrs. Cohn and Blankfein regularly attended its meetings. 1560 The concern arose, in part, because the $10 billion net short position had dramatically increased the Mortgage Department’s Value-at-Risk or “VAR,” the primary measure Goldman used to compute its risk. The Committee ordered the Department to lock in its profits by “covering its shorts,” as explained above. The Mortgage Department complied by covering most, but not all, of the $10 billion net short and brought down its VAR. It then maintained a relatively lower risk profile from March through May 2007. Attempted Short Squeeze. In May 2007, the Mortgage Department’s Asset Backed Security (ABS) Trading Desk attempted a “short squeeze” of the CDS market that was intended to compel other market participants to sell their short positions at artificially low prices. 1561 Goldman’s ABS Desk was still in the process of covering the Mortgage Department’s shorts by offering CDS contracts in which Goldman took the long side. The ABS Desk devised a plan in which it would offer those CDS contracts to short parties at lower and lower prices, in an effort to drive down the overall market price of the shorts. As prices fell, Goldman’s expectation was that other short parties would begin to sell their short positions, in order to avoid having to sell at still lower prices. The ABS Desk planned to buy up those short positions at the artificially low prices it had caused, thereby rebuilding its own net short position at a lower cost. 1562 The ABS Desk initiated its plan, and during the same period Goldman customers protested the lower values assigned by Goldman to their short positions as out of line with the market. Despite the lower prices, the parties who already held short positions generally kept them and did not try to sell them. In June, after learning that two Bear Stearns hedge funds specializing in subprime mortgage assets might collapse, the ABS Desk abandoned its short squeeze effort and recommenced buying short positions at the prevailing market prices. The Big Short. In mid-June 2007, the two Bear Stearns hedge funds did collapse, triggering another steep decline in the value of subprime mortgage assets. In response, Goldman immediately went short again, to profit from the falling prices. Within two weeks, Goldman had massed a large number of CDS contracts shorting a variety of subprime mortgage assets. On 1558 3/10/2007 email to Daniel Sparks, “Mortgage Presentation to the board, ” GS M BS-E-013323395, Hearing Exhibit 4/27-17. 12/13/2006 Goldman email, “Subprime Mortgage Risk,” Hearing Exhibit 4/27-2. 1559 1560 8/23/2007 email from Tom Montag, “Current Outstanding Notional SN ames,” GS MBS-E-010621231. 11/13/2007 Goldman email, GS MBS-E-010023525 (attachment, 11/14/2007 “Tri-Lateral Combined Comments, ” GS MBS-E-010135693-715 at 695). 1561 9/7/2007 Fixed Income, Currency and Commodities Annual Individual Review Book, Self-Review of Deeb Salem, GS-PSI-03157-80 at 72 (hereinafter “Salem 2007 Self-Review ”). 1562 Id. CHRG-111hhrg67816--30 REPRESENTATIVE IN CONGRESS FROM THE STATE OF ILLINOIS Ms. Schakowsky. Thank you, Mr. Chairman, for holding this hearing. And congratulations to you, Mr. Leibowitz. We are glad to have you here. The repercussions of years of irresponsible mortgage lending continued to unfold. According to the Center for Responsible Lending, there have been nearly 550,000 new foreclosure filings since 2009 began, 6,600 each day or 1 every 13 seconds. We were trying to calculate how many since this hearing began. It is more than 100, in every 13 seconds yet another. In my State of Illinois more than 100,000 families are projected to lose their homes to foreclosure this year, and this Administration and this Congress are obviously taking steps to mitigate this crisis and ensure it never happens again. But to do that, I really think we have to ask how did we get here. We are here not just because the banks were a problem, and it is not just bank lending that is responsible for billions of dollars worth of bad loans that now must be dealt with in order to put our economy back on track. Lending by non-bank entities has exploded in recent years and a major factor in today's financial crisis Country Wide and other non-bank mortgage lenders are responsible for 40 percent of the home loans made in 2007 and 55 percent of the sub prime loans. It was the Federal Trade Commission's responsibility to exercise oversight of these mortgages where abusive practices have hurt consumers. Clearly, they missed something. The FTC's authority extends to, it is my understanding, auto loans, pay-day loans, car title loans, and other non-traditional forms of credit that often flows to non-bank entities and currency exchanges. We have those in Chicago big time. It is a vital role of this subcommittee to exercise oversight over FTC and its rulemaking enforcement actions over non-bank lenders, and I look forward to working with you, our committee does, to make sure that these improvements are made as we move forward. I thank you again, Mr. Chairman. " CHRG-111hhrg48874--16 Mr. Polakoff," Good morning, Chairman Frank, Ranking Member Bachus, and members of the committee. Thank you for the opportunity to testify on behalf of OTS on finding the right balance between ensuring safety and soundness of U.S. financial institutions and ensuring that adequate credit is available to creditworthy consumers and businesses. Available credit and prudent lending are both critical to our Nation and its economic wellbeing. Neither one can be sacrificed at the expense of the other, so striking the proper balance is key. I understand why executives of financial institutions feel they are receiving mixed messages from regulators. We want our regulated institutions to lend, but we want them to lend in a safe and sound manner. I would like to make three points about why lending has declined: number one, the need for prudent underwriting. During the recent housing boom, credit was extended to too many borrowers who lacked the ability to repay their loans. For home mortgages, some consumers received loans based on introductory teaser rates, unfounded expectations that home prices would continue to skyrocket, inflated income figures, or other underwriting practices that were not as prudent as they should have been. Given this recent history, some tightening in credit is expected and needed. Number two, the need for additional capital and loan loss reserves. Financial institutions are adding to their loan loss reserves and augmenting capital to ensure an acceptable risk profile. These actions strain an institution's ability to lend, but they are necessary due to a deterioration in asset quality and increases in delinquencies and charge-offs for mortgages, credit cards, and other types of lending. Number three, declines in consumer confidence and demand for loans. Because of the recession, many consumers are reluctant to borrow for homes, cars, or other major purchases. In large part, they are hesitant to spend money on anything beyond daily necessities. Also, rising job losses are making some would-be borrowers unable to qualify for loans. Steep slides in the stock market have reduced many consumers' ability to make downpayments for home loans and drain consumers' financial strength. Dropping home prices are cutting into home equity. In reaction to their declining financial net worth, many consumers are trying to shore-up their finances by spending less and saving more. Given these forces, the challenges ensuring that the pendulum does not swing too far by restricting credit availability to an unhealthy level, I would like to offer four suggestions for easing the credit crunch: Number one: Prioritize Federal assistance. Government programs such as TARP could prioritize assistance for institutions that show a willingness to be active lenders. The OTS is already collecting information from thrifts applying for TARP money on how they plan to use the funds. As you know, the OTS makes TARP recommendations to the Treasury Department. The Treasury makes the final decision. Number two: Explore ways to meet institutions' liquidity needs. Credit availability is key to the lending operations of banks and thrifts. The Federal Government has already taken significant steps to bolster liquidity through programs such as the Capital Purchase Program under TARP, the Commercial Paper Funding Facility, the Temporary Liquidity Guarantee Program, and the Term Asset-backed Securities Loan Facility. Number three: Use the power of supervisory guidance. For OTS-regulated thrifts, total loan originations and purchases declined about 11 percent from 2007 to 2008. However, several categories of loans, such as consumer and commercial business loans, and non-residential and multi-family mortgages increased during this period. The OTS and the other Federal banking regulators issued an ``Inter-agency Statement on Meeting the Needs of Creditworthy Borrowers'' in November 2008. It may be too soon to judge the effectiveness of the statement. And, number four: Employ countercyclical regulation. Regulators should consider issuing requirements that are countercyclical, such as lowering loan to value ratios during economic upswings. Conversely, in difficult economic times, when home prices are not appreciating, regulators could permit loan to value ratios to rise, thereby making home loans available. Also, regulators could require financial institutions to build their capital and loan lost reserve during good economic times, making them better positioned to make resources available for lending when times are tough. Thank you, Mr. Chairman. I look forward to answering your questions. [The prepared statement of Mr. Polakoff can be found on page 163 of the appendix.] " CHRG-111shrg57319--199 Mr. Cathcart," Well, this report was obviously written 6 months after I left, but I can certainly understand the language. ``Repeat findings, if any, are significant'' is-- and ``requires improvement rating'' is really the only tool that this team and risk management had to be able to bring senior management's attention to these problems. Senator Levin. I have a number of questions that I will have to withhold asking because of the time issue here. But basically I would refer in terms of how this higher-risk lending strategy came into existence, Exhibit 2a,\1\ which is a January 2005 presentation to the Finance Committee of the Board of Directors about the higher-risk lending strategy. Page B1.2 says, ``In order to generate more sustainable, consistent higher margins within Washington Mutual, the 2005 Strategic Plan calls for a shift in our mix of business, increasing our Credit Risk Tolerance while continuing to mitigate our Market and Operational Risk positions.'' It then tasked the Corporate Credit Risk Management ``to develop a framework for execution of the strategy.''--------------------------------------------------------------------------- \1\ See Exhibit No. 2a, which appears in the Appendix on page 229.--------------------------------------------------------------------------- Mr. Vanasek, did you get necessary institutional support to effectively manage the credit risk that is inherent in a higher-risk lending strategy such as that? Did you get institutional support to carry out this kind of a higher-risk strategy? " FOMC20071206confcall--75 73,MR. LACKER.," I have strong reservations about this term auction facility. I oppose proceeding at this time. I expressed many of my concerns in a letter that I circulated yesterday. The gist of it is that I questioned the need for this. I don’t think our willingness to keep the overnight fed funds rate low and near the target, especially over year-end, is in question. If it were in question, I think something more like what we did about the millennium change would be appropriate. It’s not obvious that there’s an apparent inefficiency in markets. Banks are paying a lot for insurance against term funding costs to them going up, and a lot of banks are forgoing large spreads in order to marshal their resources. It seems as though they have potentially very legitimate reasons to do so. Now LIBOR is 50 basis points over the discount rate, so it’s not obvious that the rate we charge for discount window lending is a significant factor and is germane here. The Europeans and the British markets have the same problem, and they have very different ways of injecting reserves that suggest that maybe this isn’t something that our discount window really needs to address. I pointed out in my letter that the Federal Home Loan Banks are a very significant source of liquidity to banks, and some of the largest banks are some of the largest borrowers at the Federal Home Loan Banks. They’ve increased their lending tremendously. The lending is on virtually the same terms as the lending we propose here. So it’s not obvious to me that banks have any inability to obtain term funding from a government-subsidized entity. I don’t think this lending is going to alleviate balance sheet pressure, and I think balance sheet pressure is at the heart of what’s going on here. More broadly, this sets an unfortunate precedent, I think. It is targeting credit to a narrow segment of the market—it will be subsidized credit to the riskiest borrowers, who are obviously going to be willing to pay the most for this. It harkens back to Operation Twist in the early 1960s, which I don’t think was a well-thought-out policy initiative. I understand that the urge to act is strong at times like this, but I think we might need to recognize that the financial system is coping with genuinely serious and difficult issues, and this might be the normal way a financial system copes with very serious difficulties such as they are coping with now. So while we’d like to see financial systems exhibit the behavior they exhibit in normal times, I’m not sure the fundamentals are normal right now, and I’m not sure this isn’t the way financial markets normally ought to be expected to behave at a time like this. So I oppose this facility at this time." CHRG-111hhrg50289--30 Mr. Graves," And my next question is for the lenders out there, and we can start with Mr. McGannon, and it is the same question as far as your lending practices go in light of the economy. Have you all backed off? Have you increased? I mean, are you requiring more from investors? " CHRG-110shrg50417--32 Mr. Campbell," Mr. Chairman and Members of the Committee, I am Jon Campbell. I am Executive Vice President of Wells Fargo's Regional Banking group. Thank you for allowing me to comment on Wells Fargo's participation in the Capital Purchase Program. Wells Fargo believes that our financial system is more important than any one individual company. We believe the Capital Purchase Program is a positive step toward stimulating the United States' economy. It is Wells Fargo's intention to use the CPP funds for additional lending and to facilitate appropriate home mortgage solutions. Wells Fargo continues to be one of the strongest and best capitalized banks in the world. The investment from the U.S. Government adds to our already strong balance sheet and will enable Wells Fargo to offer appropriately priced credit at a time when several sectors of the financial industry have shut down. Since mid-September when capital markets froze, Wells Fargo has led the industry in lending to existing and new creditworthy customers. During this time nonprofit organizations, hospitals, universities, municipalities, small businesses, farmers, and many others had nowhere to turn when their existing capital market channels vanished. We were there to provide credit so they could continue to offer the services that our communities depend upon. We are able to lend through these difficult times because of our emphasis on prudent and sound lending which includes understanding what our customers do and what their financing needs are. As demonstrated over the past several years, we are willing to give up market share if a product is not in the best interest of our customers. And simply put, those companies that didn't put the customer at the center of every decision they made are no longer here today. We intend to expand lending in all of our markets. As demand warrants, we will have more than adequate capital to lend to creditworthy customers in an appropriate manner and, as required, will pay back the CPP investment with interest. Wells Fargo remains a strong lender in areas such as small business and agriculture. By volume, we are the No. 1 commercial real estate lender in this country. In fact, we grew commercial real estate loans 37 percent year to date in 2008. And our middle market commercial loans--made to Fortune 1500-sized companies across the country--are up 24 percent from this same time last year. As far as consumer lending is concerned, we are certainly open for business. Our consumer loan outstandings have increased almost 9 percent in the third quarter of 2008 in comparison to the same quarter in the previous year. The Committee has asked whether CPP funds would be spent on executive compensation. The answer is no. Wells Fargo does not need the Government investment to pay for bonuses or compensation. Wells Fargo's policy is to reward employees through recognition and pay based on their performance in providing superior service to our customers. That policy applies to every single employee, starting with our Chairman and our CEO. For example, the disclosures in our 2008 proxy statement show that the bonuses for all Wells Fargo named executive officers were reduced based on lower 2007 performance. Mr. Chairman, since the middle of 2007 when you convened your Housing Summit, Wells Fargo has implemented the principles you laid out by working with borrowers at each step of the mortgage crisis. With the changes in our economy and the continuing declines in property values across many parts of the country, even more people do need our help. As a number of new foreclosure relief programs require capital to implement, the availability of CPP funds will make it easier to successfully reach delinquent homeowners. This capital, leveraged with the announcement this week of a streamlined large-scale loan modification process that applies to loans serviced for Fannie Mae and Freddie Mac, will enable Wells Fargo to utilize a variety of programs quickly and also institutionalize an approach that servicers can rely on going forward. The strength of our franchise, earnings, and balance sheet positions us well to continue lending across all sectors and satisfying all of our customers' financial needs, which is in the spirit of the Capital Purchase Program. Mr. Chairman and Members of the Committee, thank you, and I look forward to your questions. " CHRG-111shrg55739--117 Mr. Coffee," Let me say you are right, Senator. You probably wanted to hear that. You are right. And I have some charts in my statement that show that the percentage of liar loans, no-document and low-document loans, in subprime mortgages went from in the year 2001 about 28 percent to the year 2006 about 51 percent. That is a very sharp jump, and no one noticed because no one really wanted to look. The loan originators had no interest because they got rid of the entire loan. Senator Bunning. But the Federal Reserve was responsible for overseeing the banks that made those loans, and/or the mortgage brokers, we gave that power to the Fed and just because they did not write any regulations, we ran into all this mischief. And so the housing bubble and the bursting of it was caused by some not doing their homework. " CHRG-111hhrg55814--142 Secretary Geithner," Before they need money from the government. Ms. Waters. Let me just finish. As we take a look at what has happened in the past, with the bailout that we have supported, and we have found that these institutions that we bailed out, froze the credit, didn't make credit available, they increased interest rates, they did all of that, perhaps we had the power to put some mandates on them, some dictates on them about what they should do in exchange for getting the bailout. For example, our small regional community banks don't have capital now. And you say to them, ``You have to go out and you have to get capital, or we're going to close you down.'' Or FDIC or somebody says that. And we have bailed out some of these big banks, who are now richer. Goldman Sachs is a lot richer, because we bailed them out. Banks lend money to each other, but they're not lending money to the small community banks and regional banks and minority banks. What can you do, or what have you done to make that happen? " FinancialCrisisReport--382 This Report looks at two activities undertaken by Goldman in 2006 and 2007. The first is Goldman’s intensive effort, beginning in December 2006 and continuing through 2007, to profit from the subprime mortgage market collapse, particularly by shorting subprime mortgage assets. The second is how, in 2006 and 2007, Goldman used mortgage related CDOs to unload the risk associated with its faltering high risk mortgage assets onto clients, help a favored client make a $1 billion gain, and profit from the failure of the very CDO securities it sold to its clients. These activities raise questions related to Goldman’s compliance with its obligations to provide suitable investment recommendations to its clients and disclose its material adverse interests to potential investors. They also raise questions about whether some of Goldman’s incomplete disclosures were deceptive, and whether some of its activities generated conflicts of interest in which Goldman placed its financial interests before those of its clients. They also raise questions about the high risk nature of some structured finance products and their role in U.S. financial markets. ( a) Overview of How Goldman Shorted the Subprime Mortgage Market Beginning in December 2006 and continuing through 2007, Goldman twice built and profited from large net short positions in mortgage related securities, generating billions of dollars in gross revenues for the Mortgage Department. Its first net short peaked at about $10 billion in February 2007, and the Mortgage Department as a whole generated first quarter revenues of about $368 million, after deducting losses and writedowns on subprime loan and warehouse inventory. 1545 The second net short, referred to by Goldman Chief Financial Officer David Viniar as “the big short,” 1546 peaked in June at $13.9 billion. As a result of this net short, the SPG Trading Desk generated third quarter revenues of about $2.8 billion, which were offset by losses on other mortgage desks, but still left the Mortgage Department with more than $741 million in profits. 1547 Altogether in 2007, Goldman’s net short positions from derivatives generated net revenues of $3.7 billion. 1548 These positions were so large and risky that the Mortgage Department repeatedly breached its risk limits, and Goldman’s senior management responded by repeatedly giving the Mortgage Department new and higher temporary risk limits to accommodate its trading. 1549 At one point in 2007, Goldman’s Value-at-Risk measure 1545 See net short chart prepared by the Subcommittee, below; 9/17/2007 Presentation to GS Board of Directors, Residential Mortgage Business at 5, GS MBS-E-001793845, Hearing Exhibit 4/27-41; 3/10/2007 email to Daniel Sparks, “Mortgage Presentation to the board, ” GS MBS-E-013323395, Hearing Exhibit 4/27-17. 1546 7/25/2007 email from Mr. Viniar to Mr. Cohn, “Private & Confidential: FICC Financial Package 07/25/07,” GS MBS-E-009861799, Hearing Exhibit 4/27-26. 1547 1548 1549 10/2007 Global Mortgages, Business Unit Townhall at 4-5, GS MBS-E-013703463, Hearing Exhibit 4/27-47. 4Q07 Fact Sheet prepared for David Viniar, GS MBS-E-009724276, Hearing Exhibit 4/27-159. See discussion of risk limits, VAR measurements, and risk reports, below. indicated that the Mortgage Department was contributing 54% of the firm’s total market risk, even though it ordinarily contributed only about 2% of its total net revenues. 1550 FinancialCrisisReport--235 General, OTS typically relied on the “cooperation of IndyMac management to obtain needed improvements” – which was usually not forthcoming – to remedy identified problems. 909 In February 2011, the SEC charged three former senior IndyMac executives with securities fraud for misleading investors about the company’s deteriorating financial condition. 910 The SEC alleged that the former CEO and two former CFOs participated in the filing of false and misleading disclosures about the financial stability of IndyMac and its main subsidiary, IndyMac Bank F.S.B. One of the executives – S. Blair Abernathy, former CFO – has agreed to settle the SEC’s charges without admitting or denying the allegations for approximately $125,000. The SEC’s complaint against former CEO Michael W. Perry and former CFO A. Scott Keys seeks, among other things, disgorgement, financial penalties, and a bar on their acting as an officer or director of a publicly traded corporation. 911 IndyMac was the third-largest bank failure in U.S. history and the largest collapse of a FDIC-insured depository institution since 1984. 912 At the time of its collapse, IndyMac had $32 billion in assets and $19 billion in deposits, of which approximately $18 billion were insured by the FDIC. 913 IndyMac’s failure cost the FDIC $10.7 billion, 914 a figure which, at the time, represented over 10% of the federal Deposit Insurance Fund. 915 (c) New Century New Century Financial Corporation is an example of a failed mortgage lender that operated largely without federal or state oversight, other than as a publicly traded corporation overseen by the SEC. New Century originated, purchased, sold, and serviced billions of dollars in subprime residential mortgages, operating not as a bank or thrift, but first as a private corporation, then as a publicly traded corporation, and finally, beginning in 2004, as a publicly traded Real Estate Investment Trust (REIT). 916 By 2007, New Century had approximately 7,200 employees, offices across the country, and a loan production volume of $51.6 billion, making it 909 Id. at 38. 910 2/11/2011 SEC press release, “SEC Charges Former Mortgage Lending Executives With Securities Fraud,” http://www.sec.gov/news/press/2011/2011-43.htm. 911 Id. 912 “The Fall of IndyMac,” CNNMoney.com (7/13/2008). 913 Id. 914 3/31/2010 Office of Inspector General, Dept. of the Treasury, “Semiannual Report to Congress,” http://www.treasury.gov/about/organizational- structure/ig/Documents/March%202010%20SAR%20Final%20%20(04-30-10).pdf. 915 “Crisis Deepens as Big Bank Fails; IndyMac Seized in Largest Bust in Two Decades,” Wall Street Journal (7/12/2008). 916 See SEC v. Morrice , Case No. SACV09-01426 (USDC CD Calif.), Complaint (Dec. 7, 2009), ¶¶ 12-13 (hereinafter “SEC Complaint against New Century Executives”). See also In re New Century , Case No. 2:07-cv- 00931-DDP (USDC CD Calif.), Amended Consolidated Class Action Complaint (March 24, 2008), at ¶¶ 55-58 (hereinafter “New Century Class Action Complaint”). the second largest subprime lender in the country. 917 Because it did not accept deposits or have insured accounts, it was not overseen by any federal or state bank regulator. CHRG-111shrg55117--134 RESPONSE TO WRITTEN QUESTIONS OF SENATOR KYL FROM BEN S. BERNANKEQ.1. As I recall at the Republican Policy Lunch a few weeks ago you acknowledged that some or the regional offices of Federal bank regulators may be too strict in their examinations and may have inadvertently discouraged some institutions from making certain loans that would otherwise be viable. Have you been able to make any progress in addressing this problem?A.1. In response to your concerns that actions of our examiners may be inadvertently discouraging bank lending, it is important to remember that the role of the examiner is to promote safety and soundness at financial institutions. To ensure a balanced approach in our supervisory activities, we have reminded our examiners not to discourage bank lending to creditworthy borrowers. In this environment, we are aware that lenders have been tightening credit standards and terms on many classes of loans. There are a number of factors involved in this, including the continued deterioration in residential and commercial real estate values and the current economic environment, as well as the desire of some depository institutions to strengthen their balance sheets. To ensure that regulatory policies and actions do not inadvertently curtail the availability of credit to sound borrowers, the Federal Reserve has long-standing policies in place to support sound bank lending and the credit intermediation process. Guidance, which has been in place since 1991, specifically instructs examiners to ensure that regulatory policies and actions do not inadvertently curtail the availability of credit to sound borrowers. \1\ The 1991 guidance also states that examiners are to ensure that supervisory personnel are reviewing loans in a consistent, prudent, and balanced fashion and emphasizes achieving an appropriate balance between credit availability and safety and soundness.--------------------------------------------------------------------------- \1\ ``Interagency Policy Statement on the Review and Classification of Commercial Real Estate Loans'', (November 1991); www.federalreserve.gov/boarddocs/srletters/1991/SR9124.htm.--------------------------------------------------------------------------- As part of our effort to help stimulate appropriate bank lending, the Federal Reserve and the other Federal banking agencies issued a statement in November 2008 reinforcing the longstanding guidance encouraging banks to meet the needs of creditworthy borrowers. \2\ The guidance was issued to encourage bank lending in a manner consistent with safety and soundness, specifically by taking a balanced approach in assessing borrowers' ability to repay and making realistic assessments of collateral valuations.--------------------------------------------------------------------------- \2\ ``Interagency Statement on Meeting the Needs of Creditworthy Borrowers'', (November 2008); www.federalreserve.gov/newsevents/press/bcreg/20081112a.htm.Q.2. If so, how is the Federal Reserve facilitating coordination among the regional offices of our regulators to ensure standards are applied in a way that protects the safety and soundness of the banking system without discouraging viable ---------------------------------------------------------------------------lending?A.2. Federal Reserve Board staff has consistently reminded field examiners of the November guidance and the importance of ensuring access to loans by creditworthy borrowers. Across the Federal Reserve System, we have implemented training and outreach to underscore these intentions. We have prepared and delivered targeted Commercial Real Estate training across the System in 2008, and continue to emphasize achieving an appropriate balance between credit availability and safety and soundness during our weekly conference calls with examiners across the regional offices in the System. Weekly calls are also held among senior management in supervision to discuss issues on credit availability to help ensure examiners are not discouraging viable safe and sound lending. Additional outreach and discussions occur as specific cases arise and as we participate in conferences and meetings with various industry participants, examiners, and other regulators. Additional Material Supplied for the Record" FinancialCrisisReport--51 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 contributed to a mortgage time bomb. Those practices included qualifying high risk borrowers for larger loans than they could afford; steering borrowers to higher risk loans; accepting loan applications without verifying the borrower’s income; using loans with 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 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. WaMu’s combination of high risk loans, shoddy lending practices, and weak oversight produced hundreds of billions of dollars of poor quality loans that incurred early payment defaults, high rates of delinquency, and fraud. Long Beach mortgages experienced some of the highest rates of foreclosure in the industry and their securitizations were among the worst performing. Senior WaMu executives 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 knew of evidence of deficient lending practices, as seen in internal emails, audit reports, and reviews. Internal reviews of WaMu’s loan centers, for example, described “extensive fraud” from employees “willfully” circumventing bank policy. An internal review found controls to stop fraudulent loans from being sold to investors were “ineffective.” On at least one occasion, senior managers knowingly sold delinquency-prone loans to investors. Aside from Long Beach, WaMu’s President Steve Rotella 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 they 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. From 2004 to 2008, WaMu originated a huge number of poor quality mortgages, most of which were then resold to investment banks and other investors hungry for mortgage backed securities. For a period of time, demand for these securities was so great that WaMu formed its own securitization arm on Wall Street. Over a period of five years, WaMu and Long Beach churned out a steady stream of high risk, poor quality loans and mortgage backed securities that later defaulted at record rates. Once a prudent regional mortgage lender, Washington Mutual tried – and ultimately failed – to use the profits from poor quality loans as a stepping stone to becoming a major Wall Street player. CHRG-111hhrg58044--79 Mr. Price," In the remaining seconds, what factors did Congress rely on when examining and endorsing the non-lending uses of credit information while amending the Fair Credit Reporting Act in 1996 and the FACT Act in 2003? Mr. Snyder? " FinancialCrisisReport--483 To manage its loan repurchase campaign, Goldman expanded an operations center in St. Petersburg, Florida, 2039 and made extensive use of third party due diligence firms hired to review its securitized loan pools. 2040 Goldman instructed the firms to “re-underwrite” every loan in pools of mortgages purchased from specific lenders, including New Century, Fremont, Long Beach, and later Countrywide. 2041 By March 2007, the average EPD rate for subprime loans in Goldman’s inventory had climbed from 1% of aggregate volume to 5%, a dramatic increase. 2042 On March 7, 2007, Mr. Sparks described Goldman’s exposure as follows: “As for the big 3 originators – Accredited, New Century and Fremont, our real exposure is in the form of put-back claims. Basically, if we get nothing back we would lose around $60mm vs loans on our books (we have a reserve of $30mm) and the loans in the [CDO and RMBS] trusts could lose around $60mm (we probably suffer about 1/3 of this in ongoing exposures). ... Rumor today is that the FBI is in Accredited.” 2043 Five days later, on March 12, 2007, Mr. Sparks wrote: “The street is aggressively putting things back, like a run on the bank before there is no money left to fulfill the obligations.” 2044 One of the lenders that was an initial focus of Goldman’s loan repurchase effort was New Century, a subprime lender whose loans Goldman had used in many Goldman-originated RMBS securitizations. After completing a review of one New Century loan pool, an analyst recommended “putting back 26% of the pool ... if possible.” 2045 A putback rate of 26% meant that about one in 2039 2/27/2007 email from Christopher Gething, “Our Expansion, ” GS MBS-E-010387242 (expansion of St. Petersburg office to accommodate staff for loan repurchase effort). 2040 See, e.g. 3/2007 Goldman email chain, “RE: NC Visit ,” GS M BS-E-002048050 (mentioning four different third party “vendors ” conducting loan reviews for the loan repurchase effort and stating: “W e ’re off to other vendors at this point.”). 2041 See 3/9/2007 email from Kevin Gasvoda, “priorities,” GS M BS-E-002211055 (listing priority mortgage originators as Accredited, Fremont, New Century, and Novastar); 3/14/2007 Goldman email, “NC Visit,” GS MBS- E-002048050 (identifying New Century, Fremont and Long Beach); 6/29/2007 email from Ed Chavez, “Countrywide Investigation Review Update,” GS MBS-E-002134411. 2042 3/2/2007 email to Craig Broderick, “Audit Committee Package_Feb 21_Draft_Page.ppt,” GS MBS-E- 009986805, Hearing Exhibit 4/27-63. 2043 2044 3/7/2007 email from Daniel Sparks, “Originator exposures,” GS MBS-E-002206279, Hearing Exhibit 4/27-75. 3/12/2007 email from Daniel Sparks, “Subprime Opportunities,” GS MBS-E-004641002. See also 4/15/2007 email, “March 2007 Counterparty Surveillance,” GS MBS-E-002135667 (forwarding report to loan repurchase team, “Please find attached the March counterparty surveillance report (and boy, is it a doozy).”); 3/26/2007 “Subprime Mortgage Business, ” Goldman presentation to Board of Directors, at 5, GS MBS-E-005565527, Hearing Exhibit 4/27-22 (list of subprime related businesses bankrupted, suspended, closed, sold, or put up for sale). 2045 3/13/2007 email from Manisha Nanik, “New Century EPDs,” GS MBS-E-002146861, Hearing Exhibit 4/27-77. The review of the New Century loan pool found: “ – approx 7% of the pool has material occupancy misrepresentation where borrowers took out anywhere from 4 to 14 loans at a time and defaulted on all. ... – approx 20% of the pool has material compliance issues. These are mainly missing HUDs. ... – approx 10% of the pool is flagged as potential REO [Real Estate Owned by lender] or potential unsecured four of the loans in the New Century pool had EPDs, were fraudulent, or otherwise breached New Century’s contractual warranties. It also implied that about 25% of the expected mortgage payments might not be made to the relevant RMBS securitization. Unless the problem loans could be successfully “put back” to New Century in exchange for a refund, a fail rate of that magnitude would likely impair the performance of all of the securities dependent upon that pool of mortgages. FinancialCrisisReport--486 GSAMP securities had been downgraded to junk status. 2059 On March 26, 2007, the Mortgage Department sought permission from Goldman’s Mortgage Capital Committee to securitize and underwrite a new RMBS called GSAMP Trust 2007- HE2, which contained nearly $1 billion in subprime mortgage loans in a Goldman warehouse account, over 70% of which had been purchased from New Century. 2060 Goldman approved this securitization even though it knew at the time that New Century’s subprime loans were performing poorly, many of the New Century loans in Goldman’s inventory were problematic, and New Century was in financial difficulty. 2061 The securitization was approved for issuance in April 2007, the same month New Century declared bankruptcy. 2062 Goldman marketed and sold the RMBS securities to its clients. The securities first began to be downgraded in October 2007, and all of the securities have since been downgraded to junk status. 2063 Had Goldman not securitized the $2 billion in Fremont and New Century loans, the Mortgage Department would likely have had to liquidate the warehouse accounts containing them and either sell the loan pools or keep the high risk loans on its own books. On April 11, 2007, a Goldman salesman forwarded to Mr. Egol a scathing letter from a customer, a Wachovia affiliate, which had purchased $10 million in RMBS securities backed by Fremont loans and underwritten by Goldman. The client wrote that it was “shocked” by the poor performance of the securities “right out of the gate,” and concerned about Goldman’s failure to have disclosed information about the poor quality of the underlying loans in the deal termsheet: 2057 See discussion of Goldman ’s loan repurchase effort, above. In addition, in the prior month, a Goldman employee in the mortgage credit trading department sent senior Mortgage Department officials a lengthy email on the deteriorating subprime mortgage market and observed: “Subprime originators, large and small, ha[ve] exhibited a notable increase in delinquencies and defaults, however, deals backed by Fremont and Long Beach collateral have generally underperformed the most. ” 2/8/2007 email from Fabrice Tourre, “FW : 2006 Subprime 2nds Deals Continue to Underperform **INTERNAL ONLY**,” at GS MBS-E-003775340, Hearing Exhibit 4/27-167d. 2058 2059 2060 In re Fremont Investment & Loan , Docket No. FDIC-07-035b, Order to Cease and Desist (M arch 7, 2007). See Standard & Poor ’s www.globalcreditportal.com. 3/23/2007 Goldman memorandum to members of the Mortgage Capital Committee, “Agenda for M onday, March 26, 2007, ” Hearing Exhibit 4/27-79 ( “GSAMP 2007-HE2 – Goldman to securitize $960 million of subprime mortgage loans purchased by Goldman Sachs from New Century (71.9%) ” and other mortgage originators. “The securitization is scheduled to be completed by April 12, 2007.”). 2061 See discussion of Goldman ’s loan repurchase effort, above. Earlier in March, a Goldman review of a different New Century loan pool had found that 26% of the loans were deficient and ought to be returned to New Century for a refund. 3/13/2007 email from Manisha Nanik, “New Century EPDs, ” GS MBS-E-002146861, Hearing Exhibit 4/27-77. In addition, New Century had already informed Goldman that it had insufficient cash to pay any loan repurchase requests. 3/14/2007 Goldman email, “NC Visit,” GS-MBS-E-002048050. 2062 2063 In re New Century TRS Holdings, Inc. , Case No. 07-10416 (KJC) (US Bankruptcy Court, District of Delaware). See Standard & Poor ’s www.globalcreditportal.com. “ As you know, we own $10mm of the GSAMP 06-S3 M2 bond. ... We are shocked by how poorly this bond has performed right ‘out of the gate’ and had asked [Goldman] to send us the attached ProSupp [Prospectus Supplement]. After having read the ProSupp and compared it to the termsheet we have several concerns: * According to the Prosupp, approximately $2.2mm ... of loans were delinquent when they were transferred to the trust. However, there is no mention of delinquent loans anywhere in the termsheet that was sent to investors when the deal was priced. * According to the Prosupp, approximately $3.3mm ... are re-performing loans. However, there is no mention of reperforming loans anywhere in the termsheet. * Approx. 53.14% of the loans in the deal allow for a Prepayment Premium and that all Prepayment Premiums collected from borrowers are paid to the Class P certificateholders. None of this was disclosed in the termsheet and my concerns are two-fold: (1) The presence of Prepayment Premiums effects prepayment speeds which affects ... [the deal’s performance]; (2) Prepayment Premiums are not staying inside the deal for the benefit of all investors but are being earmarked for the Class P holder (which is not mentioned in the termsheet). Note that ... $1.2mm in Prepayment Premiums has already been paid out to the Class P holder. * ... [T]he servicer must charge off any loan that becomes 180 days delinquent, giving rise to a Realized Loss inside the deal. Currently losses are at 9.71% of the original deal balance, or approximately $48mm despite the fact that the deal is only 11 months old (note that this figure already exceeds Moody's expec[ta]tion for cumulative losses for the deal over the ENTIRE LIFE of the deal). I will also note that there are an additional $57.5mm of loans in the delinquency pipeline. This seems to indicate significant fraud at either the borrower or lender level .... * ... [A]ny subsequent recoveries on the charged-off loans do not inure to the benefit of all investors in the deal but ONLY to the Class X1 certificateholder. This is not mentioned anywhere in the termsheet. Who owns the Class X1 notes? Is that Goldman or an affiliate? How much has been recovered so far? This is a material fact to me especially considering that loss severities are coming in at around 105% on the charged-off loans.” 2064 CHRG-111shrg57320--67 Mr. Rymer," I do not think they should be allowed. I think that if a bank is going to advance funds, secured or unsecured, they certainly need to verify who they are lending to and verify the repayment sources. Senator Kaufman. Mr. Thorson " CHRG-111hhrg74090--188 Mr. Stinebert," Well, I think when you go back, and there is plenty of history to point fingers at what was the cause of the subprime mortgage crisis and currently economic crisis but I don't think you would get anybody that would predict that whatever is done here today or by Congress that you can control every bubble that is going to occur in the future. Most economists would agree that yes, this bubble is a housing bubble, before it was a tech bubble, before that it was a savings and loan bubble. You cannot have government totally controlling financial markets unless they can totally control potential bubbles, unless you totally stymie innovation and all you have is a plain vanilla standard product out there, and I don't think that is good for the very consumers that we are trying to protect here. " FinancialCrisisReport--339 Bank’s Securitized Product Group: “I was going to reject this [long purchase of a synthetic CDO] because it seems to be a pig cdo position dump 60^ but then I noticed winchester [Deutsche Bank affiliated hedge fund] is the portfolio selector……any idea???” 1279 (8/4/2006) • Email responding to a hedge fund trader at Spinnaker Capital asking about a subprime RMBS security issued by Credit Based Asset Servicing and Securitization, LLC (“cbass”): “That said I can probably short this name to some CDO fool.” 1280 (8/30/2006) • Email responding to a hedge fund trader at Spinnaker Capital asking about MABS 2006-FRE1, a subprime RMBS security that contained Fremont loans and was issued by Mortgage Asset Securitization Transactions Asset-Backed Securities Trust: “This kind of stuff rarely trades in the synthetic market and will be tough for us to cover i.e. short to a CDO fool. That said if u gave us an order at 260 we would take it and try to dupe someone.” 1281 (9/1/2006) • Email describing MABS 2006-FRE1, a subprime RMBS security that contained Fremont loans and was issued by Mortgage Asset Securitization Transactions Asset- Backed Securities Trust, as a “crap bond.” 1282 (9/01/2006) • Email describing MSHEL 2006-1 B3, an RMBS security issued by Morgan Stanley as “crap we shorted”; referring to GSAMP 2006-HE3 M9, an RMBS security issued by Goldman Sachs, as “this bond sucks but we are short 20MM”; and noting with regard to ACE, which was created by and associated with Deutsche Bank, that “ace is generally horrible.” 1283 (9/21/2006) • Email responding to a hedge fund trader at Mast Capital: “Long Beach is one of the weakest names in the market.” 1284 (10/20/2006) • Email to a client selecting bonds to short: “u have picked some crap right away so u have figured it out.” 1285 (12/04/2006) 1279 8/23/2006 email from Greg Lippmann to Michael Lamont and Richard D’Albert, DBSI_PSI_EMAIL01605465. 1280 8/30/2006 email from Greg Lippmann to Bradley Wickens at Spinnaker Capital, DBSI_PSI_EMAIL01634802. 1281 9/1/2006 email from Greg Lippmann to Bradley Wickens at Spinnaker Capital, DBSI_PSI_EMAIL02228884. 1282 9/1/2006 email from Greg Lippmann to Bradley Wickens at Spinnaker Capital, DBSI_PSI_EMAIL01645016. 1283 9/21/2006 email from Greg Lippmann to Deutsche Bank employee, DBSI_PSI_EMAIL01689001-02. In an October 2006 email, a Deutsche Bank employee wrote to Mr. Lippmann and others that a number of RMBS such as LBMLT, HEAT, INABS, AMSI/ARSI, RAMP/RASC, and CWL “would be impossible to sell to the public” due to their poor quality. 10/2/2006 email from Axel Kunde at Deutsche Bank to Sean Whelan with copy to Mr. Lippmann, DBSI_PSI_EMAIL02255361. 1284 10/20/2006 email from Greg Lippmann to Craig Carlozzi at Mast Capital, DBSI_PSI_EMAIL01774820-21. • Email regarding GSAMP 06-NC2 M8, an RMBS security that contained New Century loans and was issued by Goldman Sachs: “[T]his is an absolute pig.” 1286 (12/8/2006) • Email describing ABSHE 2006-HE1 M7, a subprime RMBS security issued by Asset fcic_final_report_full--171 All along the assembly line, from the origination of the mortgages to the creation and marketing of the mortgage-backed securities and collateralized debt obligations (CDOs), many understood and the regulators at least suspected that every cog was reliant on the mortgages themselves, which would not perform as advertised. THE BUBBLE: “A CREDITINDUCED BOOM ” Irvine, California–based New Century—once the nation’s second-largest subprime lender—ignored early warnings that its own loan quality was deteriorating and stripped power from two risk-control departments that had noted the evidence. In a June  presentation, the Quality Assurance staff reported they had found severe underwriting errors, including evidence of predatory lending, legal and state viola- tions, and credit issues, in  of the loans they audited in November and December . In , Chief Operating Officer and later CEO Brad Morrice recommended these results be removed from the statistical tools used to track loan performance, and in , the department was dissolved and its personnel terminated. The same year, the Internal Audit department identified numerous deficiencies in loan files; out of nine reviews it conducted in , it gave the company’s loan production depart- ment “unsatisfactory” ratings seven times. Patrick Flanagan, president of New Cen- tury’s mortgage-originating subsidiary, cut the department’s budget, saying in a memo that the “group was out of control and tries to dictate business practices in- stead of audit.”  This happened as the company struggled with increasing requests that it buy back soured loans from investors. By December , almost  of its loans were going into default within the first three months after origination. “New Century had a brazen obsession with increasing loan originations, without due regard to the risks associated with that business strategy,” New Century’s bankruptcy examiner reported.  In September —seven months before the housing market peaked—thou- sands of originators, securitizers, and investors met at the ABS East  conference in Boca Raton, Florida, to play golf, do deals, and talk about the market. The asset- backed security business was still good, but even the most optimistic could read the signs. Panelists had three concerns: Were housing prices overheated, or just driven by “fundamentals” such as increased demand? Would rising interest rates halt the market? And was the CDO, because of its ratings-driven investors, distorting the mortgage market?  CHRG-110hhrg41184--203 Mr. Bernanke," That is an interesting approach. I think you would have to make sure that you were controlling for other factors, like regional and other differences, that might also be affecting the rates. Mr. Miller of North Carolina. Okay. I also asked the Congressional Research Service to look at--before 1978 the law, bankruptcy law is treated, secured or mortgages on investment property and mortgages on homes exactly the same. Neither one could be modified in bankruptcy. After that, at least in some parts of the country, they could not--it remained the same for home mortgages, and it became--it could be modified as to investment properties. I asked them to look at terms of availability of credit before and after 1978 for investment property versus home mortgages. And the conclusion was that if anything credit became more available for investment properties after 1978. There was an increase in mortgage lending, above that for home lending and the terms and credit, the terms and availability, the term seemed to be about the same. But it concluded that it was probably not the result of changes in the law, it was that there were so many forces in effect that it was almost impossible to identify any change. Does that sound correct? " CHRG-111hhrg48674--315 Mr. Castle," Thank you, Mr. Chairman. Chairman Bernanke, first of all, I am delighted you are here. I am delighted we are having this hearing. I had written to the chairman of the committee some time ago asking for it, and I think all of us looked forward to it, and I think it is very valuable. You made a statement earlier--and you have made it before, I have seen it before at least; and that is that only half of loans at normal times are from banks. Can you briefly summarize where the other--what the percentages might be on the other half, where they might come from? And let me tell you why I am asking the question. We are concerned about not just the liquidity and the capitalization, all of which you are concerned about; it is part of your job. But we are also concerned about what is happening in terms of lending practices and the economy in general; and I am just concerned about what the other lending outlets might be, if you know that. " CHRG-111hhrg55809--256 Mr. Green," Exactly. The market, stock prices are, generally speaking, procyclical, but unemployment is, generally speaking, countercyclical. So I want to talk for just a quick moment about countercyclicality. When a policy is countercyclical, it will cool down an economy that is in an upswing, and it will stimulate an economy this is in a downturn. If this is the case, when we require banks to increase that capital ratio in a recession, while it may be a good thing to do, it can also prove to be procyclical in that it can offset some of the lending that might take place. Would you just kindly give a quick comment on this, the capital requirement, because, if you recall, we started out with a TARP fund that became a capital purchase program that dealt with capital requirements, and that may have had some impact on the lending side of banking, if you would, please? " CHRG-111shrg57319--162 Mr. Vanasek," Historically, Washington Mutual, in comparison to other banks that I worked for, was administratively weak, and it did not carry the same priority, in other organizations that I worked for. Randy and I both work for Norwest, any suspicion of fraud would have resulted in immediate terminations. Senator Kaufman. Yes, they are administratively weak. Do you think based on the presentation up here of how emphasis was made on subprime loans, how they are more profitable, do you really think that if, in fact, the company had been losing money because of administration that it would have been just as weak administratively? Do you think if they were reporting the fact that we were, not doing enough loans, do you think that would have been administered poorly? I mean, it is one thing to say it is administered poorly, it is another when it is an incredible advantage to you, to your compensation program, to everything you are doing, to continue to administer poorly. How much of that do you think---- " CHRG-111hhrg48873--205 Mr. Bernanke," We provide information regularly by law. I think section 129 reports. We have given all of our 13(3) lending, which provides in detail the arrangements we will have, and we will be happy to provide you more information if you would like to have it. Ms. Velazquez. Thank you. " CHRG-111hhrg55811--119 Mr. Sherman," Section 1204 is the mechanism by which the Executive Branch can lend unlimited amounts of money or make unlimited investments in any systemically important--which really means top 20--financial institution. " FOMC20080310confcall--40 38,MS. PIANALTO., Yes. I just wanted to clarify that we are being asked to authorize the acceptance of different collateral. Who determines the size of the lending program on an ongoing basis? Is that determined by the Desk? CHRG-110hhrg46595--288 Mrs. Biggert," According to the Wall Street Journal in an article published Wednesday--I believe Wednesday afternoon--they said that, ``The auto firms don't appear to have collateral that would meet the Fed's lending criteria.'' Is this true? " CHRG-109hhrg31539--247 Mr. Bernanke," I would have to discuss it with other board members and the like, but I would certainly think about whether it makes sense in this context. Again, there are other ways to address the issue, through fair lending, for example, but I would certainly be willing to consider that issue. " CHRG-110hhrg34673--230 Mr. Perlmutter," My last question, I had a number of organizations, interest groups, approach me on the issue of banks getting into the real estate business as opposed to remaining in the lending business. Does the Fed have an opinion on that, or do you have an opinion on that? " CHRG-111shrg52966--65 Mr. Polakoff," Absolutely, Senator. We took public enforcement action against AIG regarding some of its inappropriate lending. Senator Reed. No, I am talking about the issue of risk assessment, risk management, the issues that have been the subject of this GAO report? " CHRG-111shrg56376--127 RESPONSES TO WRITTEN QUESTIONS OF SENATOR BUNNING FROM JOHN C. DUGANQ.1. What is the best way to decrease concentration in the banking industry? Is it size limitations, rolling back State preemption, higher capital requirements, or something else?A.1. The financial crisis has highlighted the importance of inter-linkages between the performance of systemically important banks, financial stability, and the real economy. It has also highlighted the risks of firms that are deemed ``too big to fail.'' There are a range of policy options that are under active consideration by U.S. and global supervisors to address these issues. Given the multifaceted nature of this problem, we believe that a combination of policy responses may be most appropriate. A crucial first step, we believe, is strengthening and raising the current capital standards for large banking organizations to ensure that these organizations maintain sufficient capital for the risks they take and pose to the financial system. Part of this effort is well underway through initiatives being taken by the Basel Committee on Bank Supervision (the ``Committee''). As announced in July, the Committee has adopted a final package of measures that will strengthen and increase the capital required for trading book and certain securitization structures. The results of a recent quantitative analysis conducted by the Committee to assess the impact of the trading book rule changes suggest that these changes will increase average trading book capital requirements by two to three times their current levels, although the Committee noted significant dispersion around this average. The Committee has underway several other key initiatives that we believe are also critical to reduce the risks posed by large, internationally active banks. These include: Strengthening the quality, international consistency, and transparency of a bank's capital base; Developing a uniform Pillar -1 based leverage ratio, which, among other requirements, would apply a 100 percent credit conversion factor to certain off- balance sheet credit exposures; Introducing a minimum global standard for funding liquidity that includes a stressed liquidity coverage ratio requirement, underpinned by a longer-term structural liquidity ratio; and Developing a framework for countercyclical capital buffers above the minimum requirement. The framework will include capital conservation measures such as constraints on capital distributions. The Basel Committee will review an appropriate set of indicators, such as earnings and credit-based variables, as a way to condition the build up and release of capital buffers. In addition, the Committee will promote more forward-looking provisions based on expected losses.The OCC has been actively involved in, and strongly supports, these initiatives. In addition to these actions, there are other policy initiatives under consideration, including the development of incremental capital surcharges that would increase with the size and/or risk of the institution, and measures to reduce the systemic impact of failure, such as reduced interconnectedness and resolution planning. As noted in my testimony, the OCC also endorses domestic proposals to establish a Financial Stability Oversight Council that would identify and monitor systemic risk, gather and share systemically significant information, and make recommendations to individual regulators. This council would consist of the Secretary of the Treasury and all of the Federal financial regulators, and would be supported by a permanent staff. We also endorse enhanced authority to resolve systemically significant financial firms. We believe that a multipronged approach, as outlined above; is far more appropriate than relying on a single measure, such as asset size, to address the risks posed by large institutions. We also believe that to ensure the competitiveness of U.S. financial institutions in today's global economy, many of these policy initiatives need to be coordinated with, and implemented by, supervisors across the globe. Finally, we strongly disagree with any suggestion that Federal preemption was a root cause of the financial crisis or that rolling back preemption would be a solution. In this regard, we would highlight that the systemic risk posed by companies such as AIG, Lehman Brothers, and Bear Stearns were outside of the OCC's regulatory authority and thus not affected by the OCC's application of Federal preemption decisions.Q.2. Treasury has proposed making the new banking regulator a bureau of the Treasury Department. Putting aside whether we should merge the current regulators, does placing the new regulator in Treasury rather than as a separate agency provide enough independence from political influence?A.2. It is critical that the new agency be independent from the Treasury Department and the Administration to the same extent that the OCC and OTS are currently independent. For example, current law provides the OCC with important independence from political interference in decision making in matters before the Comptroller, including enforcement proceedings; provides for funding independent of political control; enables the OCC to propose and promulgate regulations without approval by the Treasury; and permits the agency to testify before Congress without the need for the Administration's clearance of the agency's statements. It is crucial that these firewalls be maintained in a form that is at least as robust as current law provides with respect to the OCC and the OTS, to enable the new regulator to maintain comparable independence from political influence. In addition, consideration should be given to providing the new regulator the same independence from OMB review and clearance of its regulations as is currently provided for the FDIC and the Federal Reserve Board. This would further protect the new agency's rulemaking process from political interference.Q.3. Given the damage caused by widespread use of subprime and nontraditional mortgages--particularly low documentation mortgages--it seems that products that are harmful to the consumer are also harmful to the banks that sell them. If bank regulators do their job and stop banks from selling products that are dangerous to the banks themselves, other than to set standards for currently unregulated firms, why do we need a separate consumer protection agency?A.3. In the ongoing debate about reforming the structure of financial services regulation to address the problems highlighted by the financial crisis, relatively little attention has been paid to the initial problem that sparked the crisis: the exceptionally weak, and ultimately disastrous, mortgage underwriting practices accepted by lenders and investors. The worst of these practices included: The failure to verify borrower representations about income and financial assets (the low documentation loans mentioned in this question); The failure to require meaningful borrower equity in the form of real down payments; The acceptance of very high debt-to-income ratios; The qualification of borrowers based on their ability to afford artificially low initial monthly payments rather than the much higher monthly payments that would come later; and The reliance on future house price appreciation as the primary source of repayment, either through refinancing or sale.The consequences of these practices were disastrous not just for borrowers and financial institutions in the United States, but also for investors all over the world due to the transmission mechanism of securitization. To prevent this from happening again, while still providing adequate mortgage credit to borrowers, regulators need to establish, with additional legislative authorization as necessary, at least three minimum underwriting standards for all home mortgages: First, underwriters should verify income and assets. Second, borrowers should be required to make meaningful down payments. Third, a borrower should not be eligible for a mortgage where monthly payments increase over time unless the borrower can afford the later, high payments.It is critical that these requirements, and any new mortgage regulation that is adopted, apply to all credit providers to prevent the kind of competitive inequity and pressure on regulated lenders that eroded safe and sound lending practices in the past. Prudential bank supervisors, including the OCC, are best positioned to develop such new underwriting standards and would enforce them vigorously with respect to the banks they supervise. A separate regulatory mechanism would be required to ensure that such standards are implemented by nonbanks. While the proposed new Consumer Financial Protection Agency would have consumer protection regulatory authority with respect to nonbanks, they would not have--and they should not have--safety and soundness regulatory authority over underwriting standards.Q.4. Since the two most recent banking meltdowns were caused by mortgage lending, do you think it is wise to have a charter focused on mortgage lending? In other words, why should we have a thrift charter?A.4. When there are systemwide problems with residential mortgages, institutions that concentrate their activities in those instruments will sustain more losses and pose more risk to the deposit insurance fund than more diversified institutions. On the other hand, there are many thrifts that maintained conservative underwriting standards and have weathered the current crisis. The Treasury proposal would eliminate the Federal thrift charter--but not the State thrift charter--with all Federal thrifts required to convert to a national bank, State bank, or State thrift, over the course of a reasonable transition period. (State thrifts would then be treated as State ``banks'' under Federal law.) An alternative approach would be to preserve the Federal thrift charter, with Federal thrift regulation being conducted by a division of the merged agency. With the same deposit insurance fund, same prudential regulator, same holding company regulator, and a narrower charter (a national bank has all the powers of a Federal thrift plus many others), it is unclear whether institutions will choose to retain their thrift charters over the long term.Q.5. Should banking regulators continue to be funded by fees on the regulated firms, or is there a better way?A.5. Funding bank regulation and supervision through fees imposed on the regulated firms is preferable to the alternative of providing funding through the appropriations process because it ensures the independence from political control that is essential to bank supervision. For this reason, fee-based funding is the norm in banking regulation. In the case of the OCC and OTS, Congress has determined that assessments and fees on national banks and thrifts, respectively, will fund supervisory activities, rather than appropriations from the United States Treasury. Since enactment of the National Bank Act in 1864, the OCC has been funded by various types of fees imposed on national banks, and over the more than 145 years that the OCC has regulated national banks, this funding mechanism has never caused the OCC to weaken or change its regulation or supervision of national banks, including with respect to national banks' compliance with consumer protection laws. Neither the Federal Reserve Board nor the FDIC receives appropriations. State banking regulators typically also are funded by assessments on the entities they charter and supervise.Q.6. Why should we have a different regulator for holding companies than for the banks themselves?A.6. Combining the responsibilities for prudential bank supervision and holding company supervision in the same regulator would be a workable approach in the case of those holding companies whose business is comprised solely or overwhelmingly of one or more subsidiary banks. Elimination of a separate holding company regulator in these situations would remove duplication, promote simplicity and accountability, and reduce unnecessary compliance burden for institutions as well. Such a consolidated approach would be more challenging where the holding company has substantial nonbanking activities in other subsidiaries, such as complex capital markets activities, securities, and insurance. The focus of a dedicated, strong prudential banking supervisor could be significantly diluted by extending its focus to substantial nonbanking activities. The Federal Reserve has unique resources and expertise to bring to bear on supervision of these sorts of activities conducted by bank affiliates in a large, complex holding company. Therefore, a preferable approach would be to preserve such a role for the Federal Reserve Board, but to clearly delineate the respective roles of the Board and the prudential bank supervisors with respect to the holding company's activities.Q.7. Assuming we keep thrifts and thrift holding companies, should thrift holding companies be regulated by the same regulator as bank holding companies?A.7. Yes. Thrift holding companies, unlike bank holding companies, currently are not subject to consolidated regulation; for example, no consolidated capital requirements apply at the holding company level. This difference between bank and thrift holding company regulation created arbitrage opportunities for companies that were able to take on greater risk under a less rigorous regulatory regime. Yet, as we have seen--AIG is the obvious example--large nonbank firms can present similar risks to the system as large banks. This regulatory gap should be closed, and these firms should be subject to the same type of oversight as bank holding companies. The Treasury Proposal would make these types of firms subject to the Bank Holding Company Act and supervision by the Federal Reserve Board. We support this approach, including a reasonable approach to grandfathering the activities of some thrift holding companies that may not conform to the activities limitations of the Bank Holding Company Act.Q.8. The proposed risk council is separate from the normal safety and soundness regulator of banks and other firms. The idea is that the council will set the rules that the other regulators will enforce. That sounds a lot like the current system we have today, where different regulators read and enforce the same rules different ways. Under such a council, how would you make sure the rules were being enforced the same across the board?A.8. The Treasury proposal establishes the Financial Services Oversight Council to identify potential threats to the stability of the U.S. financial system; to make recommendations to enhance the stability of the U.S. financial markets; and to provide a forum for discussion and analysis of emerging issues. Based on its monitoring of the U.S. financial services marketplace, the Council would also play an advisory role, making recommendations to, and consulting with, the Board of Governors of the Federal Reserve System. As I understand the Treasury proposal, however, the Council's role is only advisory; it will not be setting any rules. Therefore, we do not anticipate any conflicting enforcement issues to arise from the Council's role.Q.9. Mr. Dugan, in Mr. Bowman's statement he says Countrywide converted to a thrift from a national bank after it had written most of the worst loans during the housing bubble. That means Countrywide's problems were created under your watch, not his. How do you defend that charge and why should we believe your agency will be able to spot bad lending practices in the future?A.9. In evaluating the Countrywide situation, it is important to know all the facts. Both Countrywide Bank, N.A., and its finance company affiliate, Countrywide Home Loans, engaged in mortgage lending activities. While the national bank was subject to the supervision of the OCC, Countrywide Home Loans, as a bank holding company subsidiary, was subject to regulation by the Federal Reserve and the States in which it did business. Mortgage banking loan production occurred predominately at Countrywide Home Loans, \1\ the holding company's finance subsidiary, which was not subject to OCC oversight. Indeed, all subprime lending, as defined by the borrower's FICO score, was conducted at Countrywide Home Loans and not subject to OCC oversight. The OCC simply did not allow Countrywide Bank, N.A., to engage in such subprime lending.--------------------------------------------------------------------------- \1\ Countrywide Financial Corporation 10-Q (Mar. 31, 2008).--------------------------------------------------------------------------- When Countrywide Financial Corporation, the holding company, began to transition more of the mortgage lending business from Countrywide Home Loans to the national bank, the OCC started to raise a variety of supervisory concerns about the bank's lending risk and control practices. Shortly thereafter, on December 6, 2006, Countrywide Bank applied to convert to a Federal savings bank charter. Countrywide Bank became a Federal savings bank on March 12, 2007. Going forward, Countrywide Bank, FSB, was regulated by OTS, and Countrywide Home Loans was regulated by the OTS and the States in which it did business. Countrywide Financial Corporation continued to transition its mortgage loan production to the Countrywide Bank, FSB. By the end of the first quarter of 2008, over 96 percent of mortgage loan production of Countrywide Financial Corporation occurred at Countrywide Bank, FSB. \2\--------------------------------------------------------------------------- \2\ Countrywide Financial Corporation 10-Q (Mar. 31, 2008).--------------------------------------------------------------------------- Bank of America completed its acquisition of Countrywide Financial Corporation on June 30, 2008. Countrywide Bank, N.A., was not the source of toxic subprime loans. The OCC raised concerns when Countrywide began transitioning more of its mortgage lending operations to its national bank charter. It was at that point that Countrywide flipped its national bank charter to a Federal thrift charter. The facts do not imply lax supervision by the OCC, but rather quite the opposite. The OCC continues to identify and warn about potentially risky lending practices. On other occasions, the OCC has taken enforcement actions and issued guidance to curtail abuses with subprime credit cards and payday loans. Likewise, the Federal banking agencies issued guidance to address emerging compliance risks with nontraditional mortgages, such as payment option ARMs, and the OCC took strong measures to ensure that that guidance was effectively implemented by national banks throughout the country.Q.10. All of the largest financial institutions have international ties, and money can flow across borders easily. AIG is probably the best known example of how problems can cross borders. How do we deal with the risks created in our country by actions somewhere else, as well as the impact of actions in the U.S. on foreign firms?A.10. As noted in our response to Question 1, the global nature of today's financial institutions increasingly requires that supervisory policies and actions be coordinated and implemented on a global basis. The OCC is an active participant in various international supervisory groups whose goal is to coordinate supervisory policy responses, to share information, and to coordinate supervisory activities at individual institutions whose activities span national borders. These groups include the Basel Committee on Bank Supervision (BCBS), the Joint Forum, the Senior Supervisors Group (SSG), and the Financial Stability Board. In addition to coordinating capital and other supervisory standards, these groups promote information sharing across regulators. For example, the SSG recently released a report that evaluates how weaknesses in risk management and internal controls contributed to industry distress during the financial crisis. The observations and conclusions in the report reflect the results of two initiatives undertaken by the SSG. These initiatives involved a series of interviews with firms about funding and liquidity challenges and a self-assessment exercise in which firms were asked to benchmark their risk management practices against recommendations and observations taken from industry and supervisory studies published in 2008. One of the challenges that arise in resolving a cross-border bank crisis is that crisis resolution frameworks are largely designed to deal with domestic failures and to minimize the losses incurred by domestic stakeholders. As such, the current frameworks are not well suited to dealing with serious cross-border problems. In addition to the fact that legal systems and the fiscal responsibility are national matters, a basic reason for the predominance of the territorial approach in resolving banking crises and insolvencies is the absence of a multinational framework for sharing the fiscal burdens for such crises or insolvencies. To help address these issues, the BCBS has established a Cross-border Bank Resolution Group to compare the national policies, legal frameworks and the allocation of responsibilities for the resolution of banks with significant cross-border operations. On September 17, 2009, the BCBS issued for comment a report prepared by this work group that sets out 10 recommendations that reflect the lessons from the recent financial crisis and are designed to improve the resolution of a failing financial institution that has cross-border activities. The report's recommendations fall into three categories including: The strengthening of national resolution powers and their cross-border implementation; Ex ante action and institution-specific contingency planning, which involves the institutions themselves as well as critical home and host jurisdictions; and, Reducing contagion and limiting the impact on the market of the failure of a financial firm by actions such as further strengthening of netting arrangements.We believe adoption of these recommendations will enhance supervisors' ability to deal with many of the issues posed by resolving a cross-border bank. ------ CHRG-111shrg53085--16 STATEMENT OF SENATOR CHARLES E. SCHUMER Senator Schumer. I would ask that my entire statement be put in the record. I just want to make three quick points in reference to some of the testimonies. First, in reference to Mr. Mica's testimony, I think it is really important we look for more places for small businesses to get loans. Banks are not doing it right now. And one of the things I will be asking you to comment upon is legislation that we are putting in. I think it was in 1996 we said that credit unions could only do 12 percent of their lending to small business. I have scores, maybe hundreds, probably thousands of businesses in my area that cannot get loans or are actually having lines of credit pulled from them by banking institutions. I have credit unions that would like to lend to these businesses and prevent them--they are profitable, ongoing businesses--from going under, and the credit unions cannot lend because of the cap. I think we ought to lift it, and I will be putting in legislation on that. In reference to Mr. Whalen, having a unitary regulator makes a great deal of sense. Right now, banks can choose their regulators, oftentimes. You know, that is sort of like picking the umpire, and then having the umpire get paid more the more he is picked. We know what would happen. Senator Bunning knows best of all. The strike zone would expand. The calls would be different. And it would not work. And, finally, Ms. Hillebrand, I just wanted to point out Senator Durbin and I have introduced legislation to have a Financial Product Safety Commission. I think that is really important. That avoids the cracks in regulation that Mr. Whalen has talked about because if the product is regulated, not who issues it, you are not going to have mortgage brokers getting around the banks, which is what happened before. So I think that is important to do, and with that I would just ask that my entire statement be entered into the record. " CHRG-111hhrg56847--37 Chairman Spratt," Before going to Ms. Schwartz, we have been informed by the Chairman's staff that you have a plane to catch at 12:30. So I am going to ride the 5-minute space pretty tightly. Ms. Schwartz. Ms. Schwartz. Thank you very much. Thank you, Mr. Chairman, for your--I do want to follow up on, I think, some of the questions that have been asked and you have elaborated, and particularly Mr. Ryan's last set of questions about business growth, small business growth. We do see, many of us, as the answer, both in the short-term and the long-term, as growing jobs in the private sector. And particularly we have focused on the job growth in a small business. And we have taken a number of actions that we feel are making a difference. If you want to comment on some of them. And I wanted to ask you specifically about lending, for you to elaborate a bit more on small business lending. We have done investment tax credits, biotherapeutics, we may do them for biofuels as a way to incentivize small businesses that don't have assets to be able to take regular tax credits, can do investment tax credits. We have extended bonus depreciation for small businesses, making capital investments. We have increased the cashflow for small business by providing a 5-year operating loss carryback. We have actually cut capital gains taxes for investments for small business, stocks would be extended, small business expensing. We have actually created tax credits for small businesses to provide health benefits. And the President has a new initiative on exports, which you referenced very briefly on the importance--I will say it is the importance of expanding our export opportunities, particularly for small business. We tend not to think about the opportunities for small businesses to increase their outreach to the markets in the world and to be able to sell their products around the world. And there is an initiative the President has directly endorsed to double that export number. It is actually really quite small, unlike many other countries. We are looking in the future in two areas to expand these investment tax credits as one way to help innovative new businesses, small businesses that have a hard time accessing capital. And I wanted to know what you think of that. Because many of us do believe that the new technology businesses, some of them in the energy sector, some of them in the health sector, but more broadly are really a great growth area for the United States. We have always been on the cutting edge of innovation and technology. And so I would ask you to comment on the actions we have taken, whether you think we should be continuing those, how much they have made a difference and will make a difference in expanding growth, small business growth in particular and we hope jobs. And secondly to expand on small business lending. We all hear it. We continue to hear it. Our concern, as you pointed out, was making sure whether banks, which is where small businesses go for this lending, are acting too conservatively. They get mixed messages a bit from the regulators to say--and we agree that they have to make sure they have enough capital themselves. But they have got to get some dollars out the door. We are looking this week at small business lending legislation that would actually encourage banks through some Federal dollars to get those dollars out the door to small businesses. And again I would highlight the interests we have in growth areas. Manufacturing, but particularly innovative entrepreneurs who are out there, want to take these steps and have a hard time accessing small business lending. Do you want to comment? I know you try not to comment on legislation, but the access to capital, what the Federal Government can do to encourage banks to do this. And again, more that we might be doing or that you might be able to do to encourage small business growth as one of the ways out of this difficult economy that I believe we have stabilized but really has a long way to go to create those jobs that we all want to see happen. " fcic_final_report_full--236 CDO S : “CLIMBING THE WALL OF SUBPRIME WORRY ” In March , Moody’s reported that CDOs with high concentrations of subprime mortgage–backed securities could incur “severe” downgrades.  In an internal email sent five days after the report, Group Managing Director of U.S. Derivatives Yuri Yoshizawa explained to Moody’s Chairman McDaniel and to Executive Vice Presi- dent Noel Kirnon that one managing director at Credit Suisse First Boston “sees banks like Merrill, Citi, and UBS still furiously doing transactions to clear out their warehouses. . . . He believes that they are creating and pricing the CDOs in order to remove the assets from the warehouses, but that they are holding on to the CDOs . . . in hopes that they will be able to sell them later.”  Several months later, in a review of the CDO market titled “Climbing the Wall of Subprime Worry,” Moody’s noted, “Some of the first quarter’s activity [in ] was the result of some arrangers fever- ishly working to clear inventory and reduce their balance sheet exposure to the sub- prime class.”  Even though Moody’s was aware that the investment banks were dumping collateral out of the warehouses and into CDOs—possibly regardless of quality—the firm continued to rate new CDOs using existing assumptions. Former Moody’s executive Richard Michalek testified to the FCIC, “It was a case of, with respect to why didn’t we stop and change our methodology, there is a very conservative culture at Moody’s, at least while I was there, that suggested that the only thing worse than quickly getting a new methodology in place is quickly getting the wrong methodology in place and having to unwind that and to fail to consider the unintended consequences.”  In July, McDaniel gave a presentation to the board on the company’s  strate- gic plan. His slides had such bleak titles as “Spotlight on Mortgages: Quality Contin- ues to Erode,” “House Prices Are Falling  .  .  . ,” “Mortgage Payment Resets Are Mounting,” and “. MM Mortgage Defaults Forecast –.”  Despite all the evi- dence that the quality of the underlying mortgages was declining, Moody’s did not make any significant adjustments to its CDO ratings assumptions until late Septem- ber.  Out of  billion in CDOs that Moody’s rated after its mass downgrade of sub- prime mortgage–backed securities on July , ,  were rated Aaa.  Moody’s had hoped that rating downgrades could be staved off by mortgage mod- ifications—if their monthly payments became more affordable, borrowers might stay current. However, in mid-September, Eric Kolchinsky, a team managing director for CDOs, learned that a survey of servicers indicated that very few troubled mortgages were being modified.  Worried that continuing to rate CDOs without adjusting for known deterioration in the underlying securities could expose Moody’s to liability, Kolchinsky advised Yoshizawa that the company should stop rating CDOs until the securities downgrades were completed. Kolchinsky told the FCIC that Yoshizawa “admonished” him for making the suggestion.  CHRG-111hhrg46820--117 Mr. Schrader," Question for Ms. Dorfman. I am trying to follow up on Bart's comments. In my State oftentimes there is a lot of lip service paid to limited minorities and small businesses and their access to some of the larger construction grants and/or opportunities like the stimulus. And they never really happen. Is there a better way that you or the Women's Chamber has come upon that we should be using to deliver funds to make sure that there is adequate representation by women and minority small business? Ms. Dorfman. Thank you. What we have found is that women have really relied heavily on SBA lending because they often aren't able to access traditional loans, and so putting the money into the SBA lending programs and making sure that they do have access to those programs would be the first, I think, way to get into the money into their hands. " CHRG-111hhrg52261--109 Mr. Hampel," Thank you. Chairwoman Velazquez, Ranking Member Graves, and other members of the committee, thank you very much for the opportunity to testify at today's hearing on behalf of the Credit Union National Association, which represents over 90 percent of our Nation's 8,000 State and Federal credit unions, the State leagues, and their 92 million members. I am Bill Hampel, the Chief Economist. Credit unions did not contribute to the recent financial debacle, and their current regulatory regime, coupled with their cooperative structure, militates against credit unions ever contributing to a financial crisis. As Congress considers regulatory restructuring, it is important that you not throw out the baby with the bathwater. Regulatory restructuring should not just mean more regulation. There needs to be recognition that in certain areas, such as credit unions, regulation and enforcement is sound and regulated entities are performing well. Credit unions have several concerns in the regulatory restructuring debate. These include the preservation of the independent regulator, the development of the CFPA, and the restoration of credit unions' ability to serve their business-owning members. First, it is critical that Congress retain an independent credit union regulator. Because of credit unions' unique mission, governance, and ownership structure, they tend to operate in a low-risk, member-friendly manner. Applying a bank-like regulatory system to this model would threaten the benefits that credit unions provide their members. There is some logic for consolidating bank regulators where competition can lead to lax regulation and supervision, but that condition does not exist for credit unions which have only one Federal regulator, the National Credit Union Administration. The general health of the credit union system proves that our system works well. Considering the CFPA, consumers of financial products, especially those provided by currently unregulated entities, do need greater protection. CUNA agrees that a CFPA could be an effective way to achieve that protection, provided that the agency does not impose redundant or unnecessary regulatory burdens on credit unions. In order for a CFPA to work, consumer protection regulation must be consolidated and streamlined to lower costs and improve consumer understanding. CUNA strongly feels that the CFPA should have full authority to write the rules for consumer protection, but for currently regulated entities, such as credit unions, the examination and enforcement of those regulations should be performed by the prudential regulator that understands their unique nature. Under this approach, the CFPA would have backup examination authority. CUNA urges Congress to take the difficult step of preempting State consumer protection laws if establishing a CFPA. We are confident that by creating a powerful Federal agency with the responsibility to regulate consumer protection law, with rigorous congressional oversight, more than adequate consumer protection will be achieved. And if the CFPA is sufficiently empowered to ensure nationwide consumer protection, why should any additional State rules be necessary? Conversely, if the proposed CFPA is not expected to be up to the task, why even bother establishing such an agency in the first place? Finally, because they are already significantly regulated at the State level, we don't believe that certain types of credit life and credit disability insurance should be under the CFPA. As Congress considers regulatory restructuring legislation, CUNA strongly urges Congress to restore credit unions' ability to properly serve the lending needs of their business-owning members. There is no economic or safety and soundness rationale to cap credit union business lending at 12.25 percent of assets. Before 1998, credit unions faced no statutory limit on their business lending. The only reason this restriction exists is because the banking lobby was able to leverage the provision when credit unions sought legislation to permit them to continue serving their members. The credit union business lending cap is overly restrictive and undermines America's small businesses. It severely limits the ability of credit unions to provide loans to small businesses at a time when these borrowers are finding it increasingly difficult to obtain credit from other types of financial institutions, as was described by Mr. Hirschmann from the U.S. Chamber in the previous panel. It also discourages credit unions that would like to enter the business lending market from doing so. We are under no illusion that credit unions can be the complete solution to the credit crunch that small businesses face, but we are convinced that credit unions should be allowed to play a bigger part in the solution. Eliminating or expanding the business lending cap would allow more credit unions to generate the portfolios needed to comply with NCUA's regulatory requirements and would expand business loans to many credit union members, thus helping local communities and the economy. Credit unions would do this lending prudently; the loss rate on business loans at credit unions is substantially below that of commercial banks. A growing list of small business and public policy groups agree that now is the time to eliminate the statutory credit union business cap for credit unions. And in July, Representatives Kanjorski and Royce introduced H.R. 3380, the Promoting Lending to America's Small Business Act, which would increase the credit union business lending cap to 25 percent of total assets and change the size of a loan to be considered a business loan. We estimate that credit unions could safely and soundly lend an additional $10 billion in small loans in the first year after enactment of such a bill. Madam Chairwoman, thank you very much for convening this hearing, and I look forward to answering the committee's questions. " CHRG-111hhrg56776--204 Mr. Bernanke," This has been one of our top priorities. It's very, very important. What you need to do here is get an appropriate balance, on the one hand, between making sure the banks are safe and sound, making good loans. On the other hand, making sure that credit-worthy borrowers can get credit, and that the economy can grow. So we need to find the appropriate balance there, and we have done that in a number of ways. We have taken the lead on issuing guidance to our examiners and to the banks on small business lending, on commercial real estate lending, where the emphasis is on finding that appropriate balance. And it's giving lots of examples to the banks and the examiners, where you can look at the example and it gives you some insight into what criteria to apply when you're looking at a loan. And, in particular, one point that we have made repeatedly is that just because the asset value underlying a loan, the collateral of the loan has gone down, doesn't mean that it's a bad loan. Because as long as the borrower can make the payments, that still can be a good loan, and we shouldn't penalize the banks for making those loans. So, we have issued those guidances, and we have done an enormous amount of training with our examiners to make sure they understand it. We have been gathering information and feedback from the field, including asking for more data and more information, but at each of the reserve banks around the country, having meetings that bring in small businesses, banks, and community leaders, to try and get into the details of what's going on. We have also tried to support the small business lending market with our TALF program, which has helped bring money from the securities markets into the small business lending arena. So it is a very important priority for us. We were asked before about the interaction between being responsible for the macro-economy and being a supervisor. Well, here is one case where knowing what's going on in the banking system is extremely important for understanding what's going on in the economy broadly. And we take that very seriously. So, I realize it's still an issue. It's going to be a concern, because certainly standards have tightened up. Certainly some people who were credit-eligible before are no longer eligible, because their financial conditions are worse. But we really think it's very important that credit-worthy borrowers be able to get credit, and we are working really hard on that. " FOMC20070807meeting--17 15,MR. DUDLEY.,"1 Thank you. As you all know, there has been considerable financial market turbulence since the last meeting: Problems in subprime mortgage credit have persisted and intensified; credit-rating agencies have begun to downgrade asset-backed securities and CDOs (collateralized debt obligations) that reference subprime debt; the problems in subprime have spread into the alt-A mortgage space and into parts of the prime mortgage market; corporate credit has been infected, with high-yield bond and loan spreads moving out sharply; and stock prices have faltered. Although markets generally have been functioning well in terms of liquidity and the ability to transact, there have been some important exceptions. The nonconforming residential mortgage market and the structured-finance product markets—especially the CDO and CLO (collateralized loan obligation) markets—have been significantly impaired, and there are concerns about the ability of some asset-backed commercial paper programs to continue to source funding via that market. As a consequence, market expectations with respect to monetary policy have shifted sharply, with market expectations consistent with considerable monetary policy easing over the next year. Market participants are worried about the effect of tightening credit standards on housing and about the deterioration in the market function in structured finance, which could broaden and be self-reinforcing, ultimately damaging the macroeconomy. I am going to be referring to this handout as we go through these comments. In tracing the source of the turmoil that we have experienced recently, we find that the deterioration of the subprime mortgage sector continues to play an important role in several ways. First, the deterioration in underlying credit quality continues unabated. As shown in exhibit 1, delinquencies of more than sixty days for recent ABX index vintages have continued to move higher, and the pace of deterioration—measured by the steepness of the curves—has, if anything, worsened. Note that the newest vintage—07-2, so the second half of 2007—does not show any benefit from improved underwriting standards. That stems mainly from the fact that the pipeline to build these securities is relatively long—with the average loan referenced by this index more than six months old at this point. It also may reflect the fact that this newest vintage gets—in contrast to earlier vintages—less benefit from earlier home- price appreciation. As a consequence of this poor credit performance, ABX spreads have continued to widen sharply. This is shown in exhibit 2, which shows the performance for ABX BBB- tranches across vintages, and exhibit 3, which shows the performance for the various tranches of the 07-1 vintage. The deterioration in the 1 Materials used by Mr. Dudley are appended to this transcript (appendix 1). higher-rated tranches has been much more severe than earlier in the year. In part, this greater deterioration reflects the fact that loss estimates have been trending higher, putting the higher-rated tranches more in harm’s way. It also reflects efforts to hedge subprime risk by going short these indexes by people who can’t liquidate securities easily. Translating these ABX spreads back into price, July was a very rough month for ABX. Price declines of 20 points or more occurred in the ABX BBB- tranches of some more-recent vintages. Second, the disturbing delinquency trajectories shown in exhibit 1 have caused the rating agencies to downgrade a significant number of residential asset-backed securities and CDOs that have exposure to the subprime sector. However, most of the downgrades apply to vintages before 06-2. For more- recent vintages, the loss experience is worse but still hard to estimate. This means that many more downgrades lie ahead. Third, some of the credit-rating agencies have made changes to their structured-finance rating models. That, combined with huge marked-to-market losses even in highly rated subprime tranches, has led to a fundamental reevaluation of what a credit rating means and how much comfort an investor should take from a high credit rating on an opaque structured-finance CDO or CLO product. The problems in subprime have spread into other mortgage markets, including alt-A, certain types of prime residential mortgage products, and commercial mortgage-backed securities (CMBS). Countrywide, for example, announced a deterioration in its second-lien prime mortgage book. Meanwhile, American Home Mortgage, which had operated primarily in the alt-A and nontraditional prime mortgage space as both a large monoline mortgage issuer and a REIT investor, was forced to shut down its operations last week and filed for bankruptcy yesterday. Market liquidity for nonconforming residential mortgage products is poor, and this has contributed to a further tightening in underwriting standards. For example, a number of mortgage originators indicated that they will no longer offer 2/28 and 3/27 adjustable-rate mortgage products, and some have indicated that they will not buy any alt-A mortgages originated by brokers. At the same time that we have seen turmoil in the subprime market, it has spread into the corporate sector as well. Credit spreads in the corporate sector have also widened sharply. For example, in July, high-yield corporate bond spreads widened about 150 basis points (see exhibit 4). Similarly, the spreads on key hedging indexes that reference credit default swaps on corporates have also gone up sharply. For example, in July the spreads on three of these major indexes rose nearly 200 basis points. This is illustrated in exhibit 5. The ITRAXX crossover index references fifty European nonfinancial names with ratings below BBB- or at BBB- and on negative watch. The high-yield CDX index references credit default swaps on 100 high-yield U.S. names. The LCDX index references credit default swaps on 100 U.S. leveraged loans. In contrast to the residential mortgage sector, corporate credit fundamentals still look good. In particular, as shown in exhibit 6, corporate default rates for both investment-grade and below-investment-grade borrowers have been at very low levels. Of course, as we saw in the subprime market, readily available credit can depress default ratios. One should expect that the tightening of credit standards in the corporate sector would generate some rise in default rates independent of other developments. Nevertheless, other measures also underscore the positive fundamentals of the corporate sector—in contrast to the poor fundamentals in residential mortgages. For example, global growth has been unusually strong with little volatility, and corporate profit margins are unusually wide, both in the United States and elsewhere. Moreover, the slowdown in profit growth expected for the United States has been milder than anticipated. This can be seen in the rise in the median equity analysts’ bottom-up earnings forecasts for the S&P 500 companies for 2007, which is shown in exhibit 7. It was falling through about April. Since then, expectations for this year have actually increased, and they have been increasing recently, even over the past month. So how does one explain the contagion to corporate credit from the subprime market given the disparity in fundamentals between these two sectors? Although the answer is complex, one factor stands out: There has been a loss of confidence among investors in their ability to assess the value of and risks associated with structured products, which has led to a sharp drop in demand for such products. The loss of confidence stems from many sources, including the opacity of such products; the infrequency of trades, which makes it more difficult to judge appropriate valuation; the difficulty in forecasting losses and the correlation of losses in the underlying collateral; the sensitivity of returns to the loss rate and the degree of correlation; and the problem that the credit rating focuses mainly on one risk—that of loss from default. The CLO and CDO markets have facilitated the transformation of low-rated paper—for which there is a limited investor appetite—into a high proportion of high- grade-rated debt. For example, in a typical CLO structure, the underlying loan quality averages a rating of about B. Yet through the magic of structured finance and the corporate rating agencies, the resulting CLO tranches are rated predominately investment grade. Exhibit 8 shows the structure for a representative CLO: More than two-thirds is AAA-rated debt, and 87 percent is investment grade. The loss of confidence among investors in the ability to assess the value and risks associated with this structured product has led to a sharp drop in CDO and CLO issuance. As shown in exhibit 9, CLO and CDO issuance plummeted in July. This is very important because the CLO and CDO markets represent the bulk of the demand for non- investment-grade debt. With this demand falling away at a time when the forward supply of high-yield corporate loans and debt exceeds $300 billion by some measures, a huge mismatch between demand and supply has developed. The underlying problem is that the depth of the market for non-investment-grade rated loans and debt—excluding CDO and CLO demand—is far shallower than the market for investment-grade products. Where do we go from here? Presumably buyers and sellers in the corporate sector are in the process of finding appropriate market-clearing prices. But it may take time for the market to settle down, especially given the August doldrums that are upon us. Moreover, we still may have further scope for market dislocations. After all, some single-strategy hedge funds that emphasize corporate credit may have been caught out by the sharp widening in spreads that has occurred over the past few weeks. When such results become known, investor redemptions could follow— leading to forced selling to generate the cash to fund these redemptions. In addition, the asset-backed commercial paper market is very skittish in two areas—structured investment vehicles and extendable commercial paper programs. Yesterday at least two commercial paper programs were subject to extension. It is not clear whether or to what degree these extensions will further unsettle the commercial paper market, but that is clearly a risk. The effective shutdown of the CDO and CLO markets has, in turn, raised questions about the sustainability of the strong bid by private equity firms to conduct leveraged buyouts. This uncertainty has undoubtedly been a factor behind the recent weakness of the U.S. stock market. The importance of the buyout bid can be seen in the relative underperformance of the Russell 2000 index compared with the S&P 500 index during the past few weeks (see exhibit 10). The problems in corporate credit and the virtual shutdown of the CLO and CDO distribution mechanism have caused investors to reevaluate both the business opportunities and the risks associated with large investment and commercial banks. Investment bank and commercial bank shares have underperformed the broader stock market indexes. In addition, as shown in exhibit 11, the CDS spreads for the major investment and commercial banks have widened considerably over the past month. The CDS spreads for financial guarantors have widened as well, even though the exposures of these firms appear to be concentrated in the most senior portions of the subprime and structured-finance debt structures. Perception of the strength of the financial guarantors could prove important given the key role that they play in some markets, such as the municipal debt sector, that lie far afield from either the subprime mortgage market or the corporate debt markets. Only in the past few weeks have the problems in the subprime and corporate debt markets led to broader risk-reduction activities. These risk-reduction efforts are similar to the adjustments that we saw in late February and early March. A matrix that shows the correlation of returns across different asset classes over the past few weeks (see exhibit 12) looks very similar to the correlation matrix that we saw following the late February risk-reduction period (see exhibit 13). It looks very different from the very calm period we had from late March through the first part of July, which is shown in exhibit 14. But the adjustments are not uniform across markets. In some ways, the risk reduction that we are seeing this time is a little more U.S. specific, a little more corporate credit specific, and a little more mortgage specific. For example, as shown in exhibit 15, implied volatility in interest rate swaps—the SMOVE index—and in equities—the VIX index—has climbed well above the late February peak. In contrast, the foreign exchange markets have experienced a less-pronounced rise in volatility. In the United States, the turmoil in financial markets has been accompanied by a shift in monetary policy expectations. Exhibit 16 illustrates the Eurodollar futures strip. As can be seen, the futures curve has shifted down about 40 basis points since the last FOMC meeting. We are back where we were before the May FOMC meeting. Currently, market prices imply a bit more than 50 basis points of easing by year-end 2008. The shift in expectations appears to reflect, in part, a revival of the “downside risks to growth” idea rather than that the Federal Reserve will absolutely cut interest rates. This can be seen in several ways. The shift in market expectations implicit in Eurodollar futures yields has not been accompanied by a substantial change in dealer forecasts. As shown in exhibits 17 and 18, which show the federal funds rate projections of the primary dealers before the June and the current FOMC meetings, the average dealer forecast and the range of dealer forecasts have not changed much over the past six weeks. Instead, a gap has opened up between the average dealer forecasts, represented in the exhibits by the green circles, and the forecasts implicit in market yields, represented by the horizontal black lines. The most recent dealer survey does not capture the minor forecast changes that occurred late last week. For example, two dealers with tightening forecasts pushed back the timing of the first tightening, and one dealer with an easing forecast moved it closer and increased the magnitude (not shown in exhibits 17 or 18). The dealers’ forecasts are modal forecasts. In contrast, the expectation embodied in market yields represents the mean of the distribution of expected outcomes. Presumably, it includes some possibility that the current market turbulence could lead to a weaker growth outcome and a reduction in the FOMC’s federal funds rate target. Options on Eurodollar futures contracts 300 days forward show a sharp downward skew in the distribution of rates (see exhibit 19). Although the mode is at 5.25 percent, the same as it was before the June meeting, the probability distribution has shifted down drastically below that 5.25 percent mode. So it may not be correct to say that market participants now expect much more monetary policy easing. Instead, a more proper characterization might be that the perceptions of downside risks have reemerged, and this characterization is reflected in the downward skew below what is still a 5.25 percent modal forecast for the Eurodollar rate. There were no foreign operations during this period. I request a vote to ratify the operations conducted by the System Open Market Account since the June FOMC meeting. Of course, I am very happy to take questions." fcic_final_report_full--226 THE BUST CONTENTS Delinquencies: “The turn of the housing market” .............................................  Rating downgrades: “Never before” ...................................................................  CDOs: “Climbing the wall of subprime worry” .................................................  Legal remedies: “On the basis of the information” .............................................  Losses: “Who owns residential credit risk?” ......................................................  What happens when a bubble bursts? In early , it became obvious that home prices were falling in regions that had once boomed, that mortgage originators were floundering, and that more and more families, especially those with subprime and Alt-A loans, would be unable to make their mortgage payments. What was not immediately clear was how the housing crisis would affect the fi- nancial system that had helped inflate the bubble. Were all those mortgage-backed securities and collateralized debt obligations ticking time bombs on the balance sheets of the world’s largest financial institutions? “The concerns were just that if people . . . couldn’t value the assets, then that created . . . questions about the solvency of the firms,” William C. Dudley, now president of the Federal Reserve Bank of New York, told the FCIC.  In theory, securitization, over-the-counter derivatives and the many byways of the shadow banking system were supposed to distribute risk efficiently among investors. The theory would prove to be wrong. Much of the risk from mortgage-backed securi- ties had actually been taken by a small group of systemically important companies with outsized holdings of, or exposure to, the super-senior and triple-A tranches of CDOs. These companies would ultimately bear great losses, even though those in- vestments were supposed to be super-safe. As  went on, increasing mortgage delinquencies and defaults compelled the ratings agencies to downgrade first mortgage-backed securities, then CDOs. Alarmed investors sent prices plummeting. Hedge funds faced with margin calls from their repo lenders were forced to sell at distressed prices; many would shut down. Banks wrote down the value of their holdings by tens of billions of dollars.  CHRG-111shrg54675--83 PREPARED STATEMENT OF FRANK MICHAEL President and Chief Executive Officer, Allied Credit Union, Stockton, California, On Behalf of the Credit Union National Association July 8, 2009 Chairman Johnson, Ranking Member Crapo, and Members of the Financial Institutions Subcommittee, thank you very much for the opportunity to testify at today's hearing on ``The Effects of the Economic Crisis on Community Banks and Credit Unions in Rural Communities'' on behalf of the Credit Union National Association (CUNA). CUNA is the Nation's largest credit union advocacy organization, representing over 90 percent of our Nation's approximately 8,000 State and Federal credit unions, their State credit union leagues, and their 92 million members. My name is Frank Michael, and I am President and CEO of Allied Credit Union in Stockton, California. Allied Credit Union is a small institution with $20 million in assets and approximately 2,600 member-owners. Originally my credit union's field of membership was limited to Greyhound bus drivers but it has grown to include employees served by a variety of labor union locals, those who live, work, worship, or attend school in the incorporated and unincorporated areas of Stockton, California, and employees of a number of companies outside of Stockton proper. I also serve as Chair of CUNA's Small Credit Union Committee--which is charged with monitoring issues affecting small credit unions that operate in both urban and rural settings. I am honored to be here to speak to you about the present state of small credit unions in rural communities, the obstacles these institutions are encountering, and the effects of recent legislation on these institutions.Credit Unions Stand Apart From Other Financial Institutions I would like to emphasize that while I am here to represent the views of ``small'' credit unions, credit unions are generally very small by banking industry standards: The average credit union has roughly $110 million in total assets whereas the average banking institution is 15 times larger with $1.7 billion in total assets. \1\ (The median size credit union has just $15 million in total assets and the median size bank is about 10 times larger with $146 million in total assets).--------------------------------------------------------------------------- \1\ Financial data is as of March 2009. Credit union data is from the NCUA, bank data is from the FDIC.--------------------------------------------------------------------------- It is also important to stress that credit unions--rural, urban, large, and small--did not contribute to the subprime meltdown or the subsequent credit market crisis. Credit unions are careful lenders. And, as not-for-profit membership cooperatives the overriding operating objective at credit unions is to maximize member service. Incentives at credit unions are aligned in a way that ensures little or no harm is done to the member-owners. As we have seen, the incentives outside of the credit union sector are aligned in a way that can (and often does) cause harm to consumers. In the case of toxic mortgages such as subprime mortgages, entities operating outside of the cooperative sector focused on maximizing loan originations (specifically fee income from those originations) even though many of the loans originated were not in the borrower's best interest. Further, credit unions hold most of their loans in portfolio. In recent years, 70 percent of credit union mortgage originations have been held in portfolio--only 30 percent have been sold into the secondary market. In the broader credit union loan portfolio the percentage held is even higher. The maintenance of this ownership interest means that credit unions care deeply about what ultimately happens to the loans they originate--they care if the loans are paid back. The subprime crisis, in contrast, has been closely linked to lenders who adopted the originate-to-sell model. These lenders cared little about repayments because the quality of the loans they sold became someone else's problem. In the end these structural and operational differences translated into high asset quality at credit unions. \2\ Annualized first quarter 2009 net charge-offs at credit unions were equal to 1.11 percent of average loans outstanding. In the same period, banking industry net charge-offs were 1.94 percent.--------------------------------------------------------------------------- \2\ High credit union asset quality is doubly impressive given the exemplary record of credit union success in serving those of modest means. For example, credit union mortgage loan delinquency and chargeoff rates are very low compared to other lenders. At the same time Home Mortgage Disclosure Act (HMDA) statistics consistently show that lower income and minority borrowers in the market for mortgages are substantially more likely to be approved for a loan at a credit union. HMDA data also shows that compared to other lenders, a greater percentage of total credit union home loans are granted to low/moderate income consumers.--------------------------------------------------------------------------- Delinquency rates--a forward-looking indicator of credit quality also highlights the credit union difference. As of March 2009, 60+ day dollar delinquency rates on credit union loans were 1.44 percent. In contrast the banking industry's 90+ day dollar delinquency rate was 3.88 percent--over two-and-one-half times higher than the credit union norm despite an additional 30 days of collection efforts. High asset quality helped to keep credit union capital ratios near record levels. At the end of March 2009 the aggregate credit union net worth ratio was 10 percent--substantially higher than the 7 percent regulatory standard that institutions need to be considered ``well capitalized.'' Strong asset quality and high capital kept most credit unions ``in the game'' while the other lenders pulled back and significantly tightened loan underwriting standards. Overall, loan growth rates at credit unions have remained comparatively high. In the year ending March 2009, credit union loans grew by 6 percent--a rate of increase that is well above the 2 percent to 3 percent growth credit unions usually see in consumer-led recessions and a stark contrast to the 3 percent decline in bank loans over the same timeframe. Real estate loans at credit unions grew by nearly 9 percent in the year ending March 2009, while banking industry real estate loans declined by approximately 2 percent. Business loans at credit unions grew by nearly 16 percent in the year ending March 2009, whereas commercial loans at banking institutions declined by 3 percent. Importantly, credit union pricing continues to reflect a strong, long-standing consumer-friendly orientation. According to Datatrac, a national financial institution market research company, credit union average loan rates have remained far lower than those in the banking arena and credit union average yields on savings accounts have remained far higher than those in the banking arena. The pricing advantage to credit union members is evident on nearly every account that Datatrac measures. In the aggregate, CUNA economists estimate that the credit union pricing advantage saved credit union members $9.25 billion in 2008 alone. \3\ This makes a significant difference to tens of millions of financially stressed consumers throughout the Nation.--------------------------------------------------------------------------- \3\ This estimate does not include the procompetitive effects credit union pricing has on banking institutions. Several recent studies indicate that the credit union presence causes other institutions to price in a more consumer-friendly fashion, saving consumers several billions of dollars annually. See Feinberg (2004) and Tokel (2005).--------------------------------------------------------------------------- While credit unions have generally fared well, they are not immune from the effects of the financial crisis. Of course, the ``too-big-to-fail'' issue roils many small credit unions, including those operating in rural areas. In addition, there are some natural person credit unions, especially in States such as California, Florida, Arizona, Nevada, and Michigan that are experiencing serious financial stresses, including net worth strains, primarily as a result of the collateral effects of their local economic environments. Within the credit union system, the corporate credit union network has been particularly hard hit as credit market dislocations saddled several of these institutions with accounting losses on mortgage-backed and asset-backed securities. There are currently 28 corporate credit unions, which are owned by their natural person credit union members. Corporate credit unions are wholesale financial institutions that provide settlement, payment, liquidity, and investment services to their members. The powers of corporate credit unions differ from natural person credit unions. For example, the mortgage backed and asset backed securities that are permissible investments for corporate credit unions and not generally permissible for natural person credit unions. For the most part, the problematic securities were tripled-A rated at the time the corporate credit unions purchased them. However, as a result of the impact of the economy on the securities, and the mortgages and other assets underlying the securities, the National Credit Union Administration (NCUA) has projected substantial credit losses relating to these securities. The recently enacted, ``Helping Families Save Their Homes Act of 2009'' gave NCUA additional tools with which to assist credit unions in dealing with costs related to Corporate Credit Union stabilization actions. We applaud the Banking Committee's leadership on that issue, and thank Congress for acting expeditiously to address these concerns. These stabilization efforts permit credit unions to continue to provide high levels of membership service while reducing the immediate financial impact on credit unions and ensuring the maintenance of a safe and strong Nation Credit Union Share Insurance Fund.Rural Credit Unions Are Playing a Vital Role in the Economic Recovery Rural credit unions are unique in many respects. \4\ There are nearly 1,500 U.S. credit unions with a total of $60 billion in assets headquartered in rural areas. These institutions represent 19 percent of total credit unions and 7 percent of total U.S. credit union assets.--------------------------------------------------------------------------- \4\ For purposes of this analysis ``rural'' areas are defined as non-MSA counties, consistent with OMB definitions. This definition includes 64 percent of U.S. counties and 16 percent of the total U.S. population. Of course, many credit unions that are headquartered in urban areas have branches in rural areas. These institutions are not included in our analysis because financial results are not available at the branch level.--------------------------------------------------------------------------- Rural credit unions tend to be small--even by credit union standards. On average, rural credit unions have just $39 million in total assets (making them about one-third the size of the average U.S. credit union and one-fortieth the size of the average U.S. banking institution.) In addition, nearly one-quarter (23 percent) of rural credit unions operate with one or fewer full-time equivalent employee. Over half (54 percent) of rural credit unions are staffed by five or fewer full-time equivalent employees. These differences mean that even in good times, rural credit unions tend to face challenges in a way that larger credit unions do not. Pressures on the leaders of these small credit unions are great because they must be intimately involved in all aspects of credit union operations. Their small size, without the benefits of economies of scale, magnifies the challenges they face. Competitive pressures from large multistate banks and nontraditional financial services providers each increasingly provide substantial challenges. Greater regulatory burdens, growing member sophistication, loss of sponsors, and difficulties in obtaining training and education also loom large for most of the Nation's small credit unions. A bad economy can make things even worse. Small credit unions have very close relationships with their members. And member needs increase dramatically during recessions: They experience more personal financial difficulty; job losses mount; retirement funds dwindle; debt loads balloon; divorce rates rise. Small institutions come under tremendous pressure as they attempt to advise, consult with, and lend to these members. Despite these substantial hurdles rural credit unions are posting comparatively strong results: Their loan and savings growth rates are nearly identical to the national credit union norms. Their delinquency rates are nearly identical to the national average and their net chargeoff rates are about one-half the national credit union norm. They posted earnings declines, but also reflected stronger earnings results and report higher net worth ratios than the national credit union averages.Rural Credit Unions Face Growing Concerns Although small, rural credit unions are relatively healthy and continue to play a vital role in the Nation's economic recovery, that role is being threatened. There are several concerns raised by small credit unions--and rural credit unions in particular--that deserve mention.Regulatory Burden and Reregulation. The credit union movement is losing small institutions at a furious pace--about one per day. Many of these are rural credit unions. The rate of decline does not seem to be slowing and most observers expect the pace to accelerate. The declines do NOT reflect failures but arise from voluntary mergers of small institutions into larger institutions. If you ask small institutions, they will tell you that one of the larger contributors to this consolidation is the smothering effect of the current regulatory environment. Small credit union operators believe that the regulatory scrutiny they face is inconsistent with both their exemplary behavior in the marketplace and with the nearly imperceptible financial exposure they represent. A large community of small credit unions, free of unnecessary regulatory burden, benefits the credit union movement, the public at large and especially our rural communities. As the Subcommittee considers regulatory restructuring proposals, we strongly urge you to continue to keep these concerns in the forefront of your decision making. Moreover, we implore you to look for opportunities to provide exemptions from the most costly and time-consuming initiatives to cooperatives and other small institutions. Both the volume of rules and regulations as well as the rate of change in those rules and regulations are overwhelming--especially so at small institutions with limited staff resources. Additionally, rural credit unions, like all credit unions, play ``by the rules.'' Yet, they correctly worry that they will be forced to pay for the sins of others and that they will be saddled with heavy additional burdens as efforts to reregulate intensify. Nevertheless, while others in the financial services community call for the Administration to back down on plans to create a separate Consumer Financial Protection Agency (CFPA), CUNA President and CEO Dan Mica met with Treasury Secretary Geithner last week to discuss the administration's financial regulatory overhaul legislation. In that meeting, Mr. Mica signaled our willingness to work with the administration and Congress, to maintain a seat at the table and to continue the conversation to obtain workable solutions. Credit union member-ownership translates to a strong proconsumer stance but that stance must be delicately balanced with the need keep our member-owned institutions an effective alternative in the marketplace. Of course, any new legislation and regulation comes with possibility of unintended consequences, and credit unions are particularly sensitive to the unintended consequences of otherwise well-intentioned legislation, especially given an issue that has arisen with respect to the Credit Card Accountability Responsibility and Disclosure Act (CARD Act).Credit Card Accountability, Responsibility and Disclosure Act CUNA supports the intent of the CARD Act to eliminate predatory credit card practices. Although it will require some adjustments in credit card programs in the next 6 weeks to provide a change-in-terms notice 45 days in advance and to require periodic statements to be mailed at least 21 days in advance before a late charge can be assessed, CUNA supports these provisions and credit unions are diligently working with their data processors to effectuate these changes by the August 20, 2009, effective date. However, Section 106 of the CARD Act also requires, effective August 20, 2009, that the periodic statements for all open-end loans--not just credit card accounts--be provided at least 21 days before a late charge can be assessed. This means that a creditor must provide periodic statements at least 21 days in advance of the payment due date in order to charge a late fee. Open-end loans include not only credit cards, but also lines of credit tied to share/checking accounts, signature loans, home equity lines of credit, and other types of loans where open-end disclosures are permitted under Regulation Z, the implementing regulations for the Truth in Lending Act. We believe extending the requirements of this provision beyond credit cards was unintended, and ask Congress to encourage the Federal Reserve Board to postpone the effective date of this provision. If this provision is not postponed and considered further, the implementation of this provision will impose a tremendous hardship on credit unions. Simply put, we do not think credit unions can dismantle and restructure open-end lending programs they have used for decades in order to meet the August 20th deadline. By way of background, this provision appeared for the first time in the Senate manager's amendment to H.R. 627. The House-passed bill only applied the 21-day requirement to credit cards and was to be effective in 2010. During the Senate's consideration of this issue, the 21-day requirement was described as applying only to credit cards. \5\ In the weeks since enactment, many began to notice that the provision was not limited to credit card accounts and wondered if it was a drafting error. The confusion over this provision continues, as evidenced by the fact that as recently as June 25, the Office of Thrift Supervision released a summary of the CARD Act which states that the 21-day rule only applies to credit cards. \6\--------------------------------------------------------------------------- \5\ Remarks of Senator Dodd during consideration of S. Amdt. 1058 to H.R. 627. Congressional Record. May 11, 2009, S5314. \6\ http://files.ots.gslsolutions.com/25308.pdf.--------------------------------------------------------------------------- There is a great deal of uncertainty about this particular provision, which makes it quite understandable that creditors may not even know about the ramifications of this new provision and the changes they need to have in place in 6 weeks. This provision creates unique issues for credit unions because of their membership structure; as you know, credit unions serve people within their fields of membership who choose to become members. Because of this membership relationship, most credit unions provide monthly membership statements which combine information on a member's savings, checking and loan accounts other than for credit cards. For almost 40 years--since the implementation of Regulation Z--credit unions have been authorized to use multifeatured open-end lending programs that allow credit unions to combine an array of loan products and provide open-end disclosures for compliance purposes. Today, almost half of the Nation's credit unions--about 3,500 credit unions--use these types of open-end programs, which can include as open-end lending products loans secured by automobiles, boats, etc. CUNA is still trying to determine the full impact of the new law if credit unions will have to provide a 21-day period before the payment due date of all open-end loan products. Here are some preliminary compliance problems we have identified: 1. Credit unions will need to consider discontinuing the use of consolidated statements, something they cannot possibly do in the next 6 weeks, because different loans on the statements often have different due dates. 2. In order to comply with the 21-day mailing period, credit union members will no longer be able to select what day of the month they want designate as their due date for their automobile payments, a practice often allowed by credit unions, and no longer may be able to have biweekly payments to match repayments with biweekly pay checks, which helps members to budget. 3. Credit unions may have to discontinue many existing automated payment plans that will fail to comply with the 21-day requirement and work with members to individually work out new plans in order to comply with the law. 4. The 21-day requirement as it applies to home equity lines of credit (HELOCs) may raise contractual problems that cannot be easily resolved. These complicated changes simply cannot be executed within the next 6 weeks, and CUNA requests that Congress urge Federal Reserve Board to limit the August 20 effective date to the two credit card provisions in Section 106, at least for credit unions.Credit Union Lending to Small Businesses As noted above, credit unions have been able to ``stay in the game'' while other lenders have pulled back. The credit crisis that many small businesses face is exacerbated by the fact that credit unions are subject to a statutory cap on the amount of business lending they can do. This cap--which is effectively 12.25 percent of a credit union's total assets--was imposed in 1998, after 90 years of credit unions offering these types of loans to their members will no significant safety and soundness issues. CUNA believes that the greater the number of available sources of credit to small business, the more likely a small business can secure funding and contribute to the Nation's economic livelihood. Currently, 26 percent of all rural credit unions offer member business loans to their members. These loans represent over 9 percent of total loans in rural credit union portfolios. In contrast member business loans account for less than 6 percent of total loans in the movement as a whole. Total member business loans at rural credit unions grew by over 20 percent in the year ending March 2009, with agricultural MBLs increasing by over 12 percent and Non-Ag MBLs increasing 26 percent in the 12 month period. This is strong evidence that rural credit unions remain ``in the game'' during these trying times. But more could be done. And more should be done. A chorus of small business owners complains that they can't get access to credit. Federal Reserve surveys show that the Nation's large banks tightened underwriting standards for the better part of the past year. In 2005, an SBA research publication noted that large bank consolidation is making it more difficult for small businesses to obtain loans. \7\ Given the fact that the average size of a credit union member business loan is approximately $216,000 this is a market that credit unions are well suited to serve. And this is a market that credit unions are eager to serve.--------------------------------------------------------------------------- \7\ Small Business Administration. The Effects of Mergers and Acquisitions on Small Business Lending by Large Banks. March 2005.--------------------------------------------------------------------------- Chairman Johnson, you undoubtedly hear a lot of rhetoric surrounding credit union member business lending. However, please allow me to paint a more complete picture of the member business loan (MBL) activity of credit unions. Member business loans that credit unions provide their members are relatively small loans. Nationally, credit union business lending represents just over one percent (1.06 percent) of the depository institution business lending market; credit unions have about $33 billion in outstanding business loans, compared to $3.1 trillion for banking institutions. \8\ In general, credit unions are not financing skyscrapers or sports arenas; credit unions are making loans to credit union members who own and operate small businesses.--------------------------------------------------------------------------- \8\ All financial data is March 2009. Credit union data is from NCUA; Bank data is from FDIC.--------------------------------------------------------------------------- Despite the financial crisis, the chief obstacle for credit union business lending is not the availability of capital--credit unions are, in general, well capitalized. Rather, the chief obstacle for credit unions is the arbitrary statutory limits imposed by Congress in 1998. Under current law, credit unions are restricted from member business lending in excess of 12.25 percent of their total assets. This arbitrary cap has no basis in either actual credit union business lending or safety and soundness considerations. Indeed, a subsequent report by the U.S. Treasury Department found that business lending credit unions were more regulated than other financial institutions, and that delinquencies and charge-offs for credit union business loans were ``much lower'' than that for either banks or thrift institutions. \9\--------------------------------------------------------------------------- \9\ United States Department of Treasury, ``Credit Union Member Business Lending.'' January 2001.--------------------------------------------------------------------------- The statutory cap on credit union member business lending restricts the ability of credit unions offering MBLs from helping their members even more, and discourages other credit unions from engaging in business lending. The cap is a real barrier to some credit unions establishing an MBL program at all because it is costly to create an MBL program and it is easy to reach the cap in fairly short order--this is especially true for small rural institutions. The cap effectively limits entry into the business lending arena on the part of small- and medium-sized credit unions because the startup costs and requirements, including the need to hire and retain staff with business lending experience, exceed the ability of many credit unions with small portfolios to cover these costs. For example, the average rural credit union that does not now engage in business lending has $17 million in average assets. At the institution level, that translates to roughly $2 million in MBL authority which, in turn translates to an average of only nine loans. The cap is overly restrictive and undermines public policy to support America's small businesses. It severely restricts the ability of credit unions to provide loans to small businesses at a time when small businesses are finding it increasingly difficult to obtain credit from other types of financial institutions, especially larger banks. Today, only one in four credit unions have MBL programs and aggregate credit union member business loans represent only a fraction of the commercial loan market. Eliminating or expanding the limit on credit union member business lending would allow more credit unions to generate the level of income needed to support compliance with NCUA's regulatory requirements and would expand business lending access to many credit union members, thus helping local communities and the economy. While we support strong regulatory oversight of how credit unions make member business loans, there is no safety and soundness rationale for the current law which restricts the amount of credit union business lending. There is, however, a significant economic reason to permit credit unions to lend without statutory restriction, as they were able to do prior to 1998: America's small businesses need the access to credit. As the financial crisis has worsened, it has become more difficult for small businesses to get loans from banks, or maintain the lines of credit they have had with their bank for many years. A growing list of small business and public policy groups agree that now is the time to eliminate the statutory credit union business lending cap, including the Americans for Tax Reform, the Competitive Enterprise Institute, the Ford Motor Minority Dealer Association, the League of United Latin American Citizens, the Manufactured Housing Institute, the National Association for the Self Employed, the National Association of Mortgage Brokers, the National Cooperative Business Association, the National Cooperative Grocers Association, the National Farmers Union, the National Small Business Association, the NCB Capital Impact, and the National Association of Professional Insurance Agents. We hope that Congress will eliminate the statutory business lending cap entirely, and provide NCUA with authority to permit a CU to engage in business lending above 20 percent of assets if safety and soundness considerations are met. We estimate that if the cap on credit union business lending were removed, credit unions could--safely and soundly--provide as much as $10 billion in new loans for small businesses within the first year. This is economic stimulus that would not cost the taxpayers a dime, and would not increase the size of government.Conclusion In closing, Chairman Johnson, Ranking Member Crapo, and all the Members of this Subcommittee, we appreciate your review of these issues today. Every day, credit unions reinforce their commitment to workers, small business owners, and a host of others in rural communities seeking to better their quality of life by providing loans on terms they can afford and savings rates that are favorable. We look forward to working with you to ensure the credit union system continues to be an important bulwark for the 92 million individuals and small businesses that look to their credit union for financial strength and support. ______ CHRG-111hhrg52261--129 Mr. Roberts," I think that is really a very good question. In my testimony, I spoke about the fact that in 2008, my bank paid $75,000 in FDIC insurance. In 2009, that number could be anywhere between $550,000 and $700,000. When you start looking at those numbers, what in turn you see is, that means profitability. Money that is going to go into the capital of our organization is going to be reduced by $475,000 to about $600,000. In turn, what that relates to is capital to support loans, loans that might be available, supported by that capital, could be anywhere from $5 million to $7 million less. That is certainly going to impact our ability to lend to small businesses as well as customers as a whole. As those capital requirements get to be tighter, it certainly does provide an additional safety net, but one has to keep in mind that it is also going to restrict lending. " CHRG-111hhrg48674--139 Mr. Henry," Thank you, Mr. Chairman. And thank you, Chairman Bernanke, again, for testifying. This is very helpful and constructive, not just for us on the committee, but for the American people, to know the actions you are taking, and we appreciate it. Secretary Geithner's proposal this morning or outline or vague outline or bullet points, whatever he offered, it mentions the extension of the term asset-backed securities lending facility to other types of assets. One area in particular that some of us have concerns about are commercial-backed mortgage securities. That market has dried up in assets. There was $270 billion lent in 2007; $12 billion in 2008; and a number of loans are coming due in 2009. And so we have seen a vague reference to this. If, in fact, the lending will be extended or the TALF program will include CMBS, when do you see that being up and running and functional? " CHRG-111hhrg52261--150 Mr. Westmoreland," There is somewhere down the line with the credit default swap and all of these derivatives and stuff that, to me, somebody that was--these companies are regulated. The SEC or somebody should have caught this, and I don't know if it was underregulation or the lack of enforcement in people wanting to expose some of these programs that were out there. But the problem that we are having--and I am in Georgia, and we have had more failed banks that anywhere else, and what is happening is--Mr. Roberts, you spoke of this--the regulators are coming in and changing the way some of these banks, that had a good business going on, are able to lend money, how much cash reserves they have got to have versus how much money they are able to lend; reduction in real estate portfolios that are performing assets, but they are wanting them reappraised, more cash put in the deal. And it is really a snowball effect. And Madam Chair, I will yield. I know I have taken more time than the light. But--I would like to have at least one more round of questioning, if that is possible, but I yield back to you. " fcic_final_report_full--188 As late as July , Citigroup and others were still increasing their leveraged loan business.  Citigroup CEO Charles Prince then said of the business, “When the mu- sic stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.” Prince later explained to the FCIC, “At that point in time, because interest rates had been so low for so long, the private equity firms were driving very hard bargains with the banks. And at that point in time the banks individually had no credibility to stop participating in this lending business. It was not credible for one institution to unilaterally back away from this leveraged lending business. It was in that context that I suggested that all of us, we were all regulated entities, that the regulators had an interest in tightening up lending standards in the leveraged lending area.”  The CLO market would seize up in the summer of  during the financial cri- sis, just as the much-larger mortgage-related CDO market seized. At the time this would be roughly  billion in outstanding commitments for new loans; as de- mand in the secondary market dried up, these loans ended up on the banks’ balance sheets.  Commercial real estate—multifamily apartment buildings, office buildings, ho- tels, retail establishments, and industrial properties—went through a bubble similar to that in the housing market. Investment banks created commercial mortgage– backed securities and even CDOs out of commercial real estate loans, just as they did with residential mortgages. And, just as houses appreciated from  on, so too did commercial real estate values. Office prices rose by nearly  between  and  in the central business districts of the  markets for which data are available. The increase was  in Phoenix,  in Tampa,  in Manhattan, and  in Los Angeles.  Issuance of commercial mortgage–backed securities rose from  billion in  to  billion in , reaching  billion in . When securitization markets contracted, issuance fell to  billion in  and  billion in . When about one-fourth of commercial real estate mortgages were securitized in , securitizers issued  billion of commercial mortgage CDOs, a number that again dropped pre- cipitously in .  CHRG-111shrg57319--535 Mr. Rotella," Senator, as I said in my opening statement, shortly after arriving at Washington Mutual and having been an observer from JP Morgan Chase, I was aware of the fact that the company had an extreme concentration in real estate loans as a thrift. It had a concentration in Florida and in California, 60 percent of its mortgage assets. As I said earlier, it was going through explosive growth, particularly in higher-risk lending, and the operating infrastructure was quite weak. That combined with the view that the housing market was softening led a group of us to begin a process of diversifying the company and de-emphasizing the mortgage business, which over time we hoped would lead us to a company that was concentrated less in real estate and had other asset classes. Senator Coburn. So in your testimony, on the one hand you say that you were simply carrying out the chairman and CEO's strategies as far as the high-risk category; but on the other hand, you are saying it was your decision to decrease the high-risk lending. Which is it? " CHRG-110hhrg46596--129 Mr. Castle," And let me just restate, of course, that I am just talking about those loans which are being made pursuant to these emergency circumstances as opposed to their normal bank lending, which I think takes on a different tone all together. " CHRG-110hhrg46591--216 Mr. Bachus," Well, now, are you aware that I proposed capital injections with covered bonds or lending or, you know, backup private equity? But we did get a 5 percent rate of return that goes to 9 percent. " FOMC20080310confcall--42 40,MR. ALVAREZ.," The resolution that the FOMC will be asked to vote on today will have an outside limit of $200 billion as the total size of the term securities lending facility. If it were to go above that, it would have to come back to the FOMC. " FOMC20081029meeting--70 68,MR. LOCKHART.," So in the case of a foreign bank--they lend to a foreign bank in their country, in Mexico in this case--defaulting, whose problem is it? Is it the home country supervisor's problem, or is it Mexico's problem vis-�-vis us? " CHRG-110hhrg46593--81 Mr. Bernanke," Where do you get the $1 trillion from? There has been $250 billion by the Treasury, and the Fed hasn't spent any money. We only lend money. Ms. Velazquez. Okay. So, of the money that has been lent, how many foreclosures have been prevented, individuals? " CHRG-110hhrg46593--5 Mrs. Maloney," Thank you, Mr. Chairman. I welcome our distinguished guests and thank you for your leadership. I particularly would like to commend Chairman Bair for her leadership in foreclosure prevention and particularly for developing a new loan modification guarantee program to refinance on a large scale, which would help us to save millions of people and help them to stay in their homes. And I would like to be associated with the comments of both the ranking member and the chairman that our intention was to use some of the TARP money to invest in our economy and to get it moving in the right direction. Certainly stabilizing housing, as Chairman Bernanke has said repeatedly, that we must fix the housing crisis before we can get the economy back on track. So whatever the model, I firmly support using TARP money to stabilize housing and our economy. Secondly, my constituents are telling me that many of them still cannot get access to credit. Given that bank lending is still basically shut down, we need to be asking whether and when we should expect at least some fraction of TARP funds injected into banks to be lent. After all, one of the primary purposes of the TARP program was to get credit moving. I have nonbank lenders who are my constituents who lend money to small businesses and want access to the TARP to increase that activity. Today's Wall Street Journal talks about insurance companies that are buying up banks just to get access to the TARP money. And we then read many articles that banks are using TARP money for buying other banks. So we are basically funding mergers and acquisitions, not lending. My basic question is, why shouldn't we be giving TARP money out based on the activity it funds? Why don't we fund organizations that will lend it, whether it is a bank, an insurance company, so that we will be getting the credit out into the communities which was the purpose of the TARP program? Again, every article talks about how it is being used for capital formation, mergers, acquisitions, other activities, buying up swaps, buying other things instead of getting the credit out into the communities. So there are many questions before us today, but those are two of my prime focuses, that we should be helping people stay in their homes, and we should be working harder to get credit out into the communities. Thank you. " CHRG-111hhrg67816--150 Mr. Green," Our office has been hearing from constituents concerned that the free credit reports do not list all the information that credit lending entities have access to. Do you know if there is a case and, if so, do you believe consumers should have access to all this information? It seems that consumers should have access to all the credit information available to them. Have you heard of that or has that been an issue with the FTC? " CHRG-110hhrg46591--113 Mr. Ackerman," Thank you, Mr. Chairman. Damon Runyon, less famous for being born in Manhattan, Kansas, than writing about Manhattan, New York, didn't write about or create characters on either Main Street or Wall Street, but more on 42nd Street for plays like Guys and Dolls. He created characters that included street hustlers, gamblers, and book makers. If he could create a character here who was looking at this subprime mess that we are in, he would probably create one who wanted to ask a question that went something like: How can you make book on a horse that ain't never run before? And I guess I would ask that question, because there is no other character here. " FinancialCrisisReport--480 In addition, during the first quarter of 2007, the Mortgage Department drastically slowed its RMBS origination business and its purchase of whole loans and RMBS securities. 2027 Those actions meant that Goldman was not only reducing its inventory, but also reducing its intake of what had previously been a constant inflow of billions of dollars in whole loans and RMBS securities purchased as part of its securitization business. In addition to selling whole loans and RMBS securities, the Mortgage Department wrote down the value of its remaining subprime mortgage portfolio. On February 8, 2007, for example, Mr. Gasvoda recommended that certain whole loan pools and RMBS securities be marked down by $22 million. 2028 On February 9, 2007, Mr. Sparks reported a $30 million writedown on non performing loans. 2029 Mr. Ruzika responded: “Ok, you’ve been communicating the write down was coming. Let’s go through the residual risk and make sure we get to the correct number for the quarter.” 2030 Residual risk referred to the non rated equity tranches that underwriters like Goldman often retained from the RMBS securitizations they originated; those tranches were also written 2025 2/9/2007 email exchange between Kevin Gasvoda and sales syndicate, “GS Syndicate RM BS Axes (INTERNAL), ” GS MBS-E-010370495, Hearing Exhibit 4/27-73. 2026 2/23/2007 “Significant Cash Inventory Change (Q1 ’07 vs. Q4 ’06),” datasheet prepared by Goldman, GS MBS- E-010037311, Hearing Exhibit 4/27-12. 2027 See, e.g., 3/8/2007 email from Daniel Sparks, “Mortgage risk,” GS MBS-E-002206279, Hearing Exhibit 4/27- 75 ( “[f]or residential loans, we have not bought much lately ”); 3/26/2007 Goldman presentation to Board of Directors, “Subprime Mortgage Business, ” GS MBS-E-005565527, Hearing Exhibit 4/27-22 (reporting that Mortgage Department is using “conservative bids ” on loans); 3/14/2007 Goldman Presentation to SEC, “Subprime Mortgage Business 14-Mar-2007, ” at 7, GS MBS-E-010022328; 3/2/2007 email to Craig Broderick, “Audit Committee Package_Feb 21_Draft_Mortgage_Page.ppt,” GS M BS-E-009986805, Hearing Exhibit 4/27-63 (we are “lowballing ” bids on loans). 2028 2/8/2007 email from Kevin Gasvoda to Daniel Sparks, “Post, ” GS MBS-E-002201668, Hearing Exhibit 4/27-7 ( “monthly performance analysis completed this morning on what can be securitized vs will be foreclosed tells us we should mark down around $22mm ”). See also 2/2/2007 email from Daniel Sparks, “Second lien deal performance and write-down, ” GS MBS-E-002201050, Hearing Exhibit 4/27-92 ( “Gasvoda alerted me last night that we will take a write-down to some retained positions next week as the loan performance data from a few second lien sub-prime deals just came in (comes in monthly) and it is horrible. ”); 2/8/2007 email from Kevin Gasvoda to Tom Montag, “Mortgage risk – credit residential, ” at 2, GS MBS-E-010372233, Hearing Exhibit 4/27-74. Mr. Gasvoda summarized the other write-downs as follows: “ – 2nd lien residual – took $20-25mm write-downs over last 3 months (could lose $5-15 mm more) – 2nd lien retained bonds –took $18mm write-down this week (could lose $5-15 more) – Subperforming loan book – taking $28mm write-down this week (could lose $20-40mm more) W hat do all these areas have in common? – most HPA [housing price appreciation] sensitive sectors. They ’ve crumbled under HPA slowdown as these are the most levered borrowers. W hat have we done to mitigate? – we stopped buying subprime 2nd liens in the summer of ‘06 and have focused on alt-a and prime. ” 2029 2030 2/9/2007 email from Daniel Sparks, “Scratch & dent loan write down $30mm, ” GS MBS-E-009760380. Id. down in value. Those writedowns not only implemented Goldman’s policy of using current market values for its assets, but also effectively reduced the size of Goldman’s “long” position in subprime mortgage related assets. As Mr. Ruzika wrote to Mr. Cohn: “working with Dan to uncover exactly what else needs to be written down so that we can pnl [profit and loss] it this quarter and be clean going into next quarter.” 2031 FinancialCrisisInquiry--27 CHAIRMAN ANGELIDES: But Mr. Blankfein, you are actually creating these securities. And let me just tell you, as someone who’s been in business for half my career, the notion that I would make a transaction with you and then the person with whom I made that transaction would then bet that that transaction would blow up is inimical to me. And I guess the question is you weren’t purely a broker. You were actually taking subprime product, packaging it up, and selling it under your label. Correct? BLANKFEIN: Let me be clear. We were not a broker at all. CHAIRMAN ANGELIDES: Correct. BLANKFEIN : Not at all. CHAIRMAN ANGELIDES: Yes. You were a principal. BLANKFEIN: We are a principal. CHAIRMAN ANGELIDES: OK. BLANKFEIN: The act—it wasn’t as if we were creating product, that product existed necessarily, and we were shorting it. The act of selling it reduced our risk. CHRG-111hhrg48868--123 Mr. Ackerman," They went to AIG because these guys rated AIG triple A, and so everybody assumes that their subsidiary is triple A, which you haven't rated. It's like if I have an 800 credit score, are you going to lend my kid money because you think he has an 800 credit score? " CHRG-109hhrg28024--141 Chairman Oxley," The gentle lady from California, Ms. Lee. Ms. Lee. Thank you, Mr. Chairman. Welcome, Mr. Chairman. Congratulations to you. Let me say a couple of things. First, I'm glad to hear you say that you recognize that a rise in inequality is a concern and a problem, but you also indicated that part of this had to do with the fact that lower wage workers haven't received a higher level of income, those at least who have no more education than a high school education. I think I heard you correctly, you don't support an increase in the minimum wage. You indicated your policies would be very consistent to Chairman Greenspan. I believe that's probably about where he was. I'm quite frankly very disappointed. I know you do support the tax cuts and making those tax cuts permanent, and it seems to me if you are really concerned about this rise in inequality, somehow you as our new Federal Reserve Chair would say something about increasing the minimum wage for very low wage workers. Secondly, part of this rise in inequality has to do with discrimination in mortgage lending. If you look at the home ownership rates, you have approximately 70 percent nationwide with regard to the Caucasian population, yet you have 46 percent African American, 46/47 percent Latino. There is a huge disparity there. With Mr. Greenspan, we were trying to talk with him about how to make sure that financial institutions provided more mortgage lending to African Americans and Latino's. Right now, conventional loans, I believe probably most banks provide maybe one to two percent of their conventional loans to African Americans. That is just down right shameful. Yet, on the other hand again, going back to Mr. Greenspan and if you are going to be consistent with much of his policies and his work, I have to raise these issues with you. CRA, for example. Many of these banks that receive an A or B on their CRA ratings probably lend one to three percent of their mortgages to African Americans and Latino's. I don't know for the life of me how they can get an outstanding and satisfactory CRA rating, when again, they are not in good faith lending to minority communities. Finally, just with regard to prime loans and sub-prime loans, the data that came out in October of last year, we have a report, and Mr. Chairman, I'd like to put this in the record. " FinancialCrisisReport--91 OTS examination noted that 20,000 brokers and lenders had submitted loans to WaMu for approval during the year, a volume that was “challenging to manage.” 285 A 2005 internal WaMu investigation of two high volume loan centers in Southern California that accepted loans from brokers found that “78% of the funded retail broker loans reviewed were found to contain fraud.” 286 A 2006 internal WaMu inquiry into why loans purchased through its subprime conduit were experiencing high delinquency rates found the bank had securitized broker loans that were delinquent, not underwritten to standards, and suffering from “lower credit quality.” 287 OTS examinations in 2006 and 2007 also identified deficiencies in WaMu’s oversight efforts. 288 For example, a 2007 OTS memorandum found that, in 2007, Washington Mutual had only 14 full-time employees overseeing more than 34,000 third party brokers submitting loans to the bank for approval, 289 which meant that each WaMu employee oversaw more than 2,400 brokers. The OTS examination not only questioned the staffing level, but also criticized the scorecard WaMu used to rate the mortgage brokers, which did not include the rates at which significant lending or documentation deficiencies were attributed to the broker, the rate at which the broker’s loans were denied or produced unsaleable loans, or any indication of whether the broker was included on industry watch lists for prior or suspected misconduct. In 2006, federal regulators issued Interagency Guidance on Nontraditional Mortgage Product Risks (NTM Guidance) providing standards on how banks “can offer nontraditional mortgage products in a safe and sound manner.” 290 It focused, in part, on the need for banks to “have strong systems and controls in place for establishing and maintaining relationships” with third party lenders and brokers submitting high risk loans for approval. It instructed banks to monitor the quality of the submitted loans to detect problems such as “early payment defaults, incomplete documentation, and fraud.” If problems arose, the NTM Guidance directed banks to “take immediate action”: 283 Id. 284 Id. at 24. 285 Id. 286 11/16/2005 “Retail Fraud Risk Overview,” prepared by WaMu Credit Risk Management, at JPM_WM02481938, Hearing Exhibit 4/13-22b. 287 12/12/2006 WaMu Market Risk Committee Minutes, JPM_WM02095545, Hearing Exhibit 4/13-28. 288 4/2010 IG Report, at 24-25, Hearing Exhibit 4/16-82. 289 6/7/2007 OTS Asset Quality Memo 11, “Broker Credit Administration,” Hedger_Ann-00027930_001, Hearing Exhibit 4/16-10. 290 10/4/2006 “Interagency Guidance on Nontraditional Mortgage Product Risks,” (NTM Guidance), 71 Fed. Reg. 192 at 58609. “Oversight of third party brokers and correspondents who originate nontraditional mortgage loans should involve monitoring the quality of originations so that they reflect the institution’s lending standards and compliance with applicable laws and regulations. … If appraisal, loan documentation, credit problems or consumer complaints are discovered, the institution should take immediate action.” 291 CHRG-110shrg50416--24 Mr. Montgomery," Chairman Dodd, Senator Shelby, members of the Committee, thank you for the opportunity to address you this morning on the role of the Department of Housing and Urban Development and, more particularly, the Federal Housing Administration, in addressing the mortgage crisis. I would like to focus my brief remarks this morning on the recently launched Hope for Homeowners program, as well as a counter cyclical role that FHA plays in the market, starting with the latter. It was just 2 years ago that FHA was viewed as all but irrelevant. Subprime and Alt-A loans were the products of choice and we at FHA were left standing on the sidelines, hoping that the first time home buyers, who would have been better served by FHA, would find the means to survive the risky and costly products they chose instead. As you well know, we voiced our concerns throughout this period, publicly asserting that families who could not qualify for prime rate mortgage products should access market rate financing through the FHA rather than paying more in their interest rates. As you know, unfortunately, the crisis overtook the market and FHA became important once again as a result of the overall tightening and private conforming and the evaporation of non-prime products. As a result of this contraction, in just the last 2 years FHA's market share has grown from 2 percent to 17 percent of the mortgage market. That is overall mortgage market. Specific to new construction, our market is now 25 percent. Let me put this increase in perspective with real numbers. In fiscal year 2007, we endorsed about 425,000 single family loans, including purchase loans, by the way, and refis. In fiscal year 2008, we endorsed more than 1.2 million, including 632,000 purchase loans. If you think about it, in the middle of this turmoil, we did 632,000 purchase loans last fiscal year. In other words, our overall business has more than doubled this year. And we project that next year that number will be about 1.4 million. In fact, we have pumped close to $200 billion of much needed liquidity into the mortgage market during that time. Let me just also say that our application rate is on a trajectory of 3 million applications a year, and these are levels that we have not seen in more than 10 years. A lot of this business has been coming in through the FHASecure product, which many of you are familiar with. I remember testifying before this Committee about a year ago that I thought we might reach 240,000 borrowers in fiscal year 2008. I was off with that estimate. Since we announced the FHASecure product a little more than a year ago close to 400,000 families have refinanced out of a burdensome mortgage into a safe, affordable FHA product. We think that number will push close to 500,000 by the end of the calendar year. Let me just talk briefly about what we have done to help our FHA-insured borrowers who are experiencing troubles. In fiscal year 2008, FHA servicers completed more than 100,000 loss mitigation actions. Of these, 96,500 are currently retaining homeownership. This is an 11.5 percent increase in homeownership retention over 2007. And overall the expected retention rate of these borrowers is 87 percent. In fact, our loss mitigation efforts by HUD have helped more than 300,000 families over the last 3 years. I am happy to say that we also now have the Hope for Homeowners refinance rescue product available. The Oversight for H4H, as we call it, composed of the agencies represented here today, accomplished the goal of getting this program up and running by October the 1st, only 60 days after passage of the law. As a result of this tremendous team effort, we now have the additional rescue program available to the lending community and to borrowers alike. I'm sure you are wondering when we will see the first loan insured, the first family saved, and another tool to help us see the beginning of the end of this crisis. Let me say that I know that all of us up here today testifying before you feel the same sense of urgency. But it will take time for the lending community to get the program up and running. The unique statutory requirements make the program very different from any other FHA product and require lenders to take additional time and care to set up the program and the operations in a way that supports the program fully. We have devoted a lot of resources over the last 2 weeks, reaching out and educating the lending community and counselors about this program. This is what we have heard from them: while they are all very interested in offering the product, they need to be vigilant and want to be vigilant about the implementation process. Lenders and counselors alike need to train staff. They need to change protocols, modify systems, and take other steps to ensure that their companies are complying with the terms of the new program. In addition, lenders must modify their internal IT systems and protocols to ensure that they support the product fully before they move to full implementation. This kind of activity is time consuming and we should all embrace the efforts by the lending community to handle this program in a way that ensures its success. I feel very confident that FHA will continue to play a critical role in helping families in need of refinance loans to save their homes, and also families who need safe market rate financing to purchase a home. I thank you for the opportunity to testify here today. " FOMC20071031meeting--98 96,MR. ROSENGREN.," I had a follow-up question on nonresidential structures. You talked about drilling and mining, and I was wondering about the other parts of commercial real estate. Was anything in there? I don’t know if you had a chance to look at it, but the reason I ask is that, if you thought financing was starting to become a problem and you do have very weak nonresidential investment going forward, you would expect to start seeing it there. So I’m wondering if anything was in that breakout. I have a second question, which is that you didn’t mention durable goods. But if I thought that credit problems, particularly subprime and other things, were starting to create issues, I would expect to start seeing more imprints in the data for some of the durable goods. So was seeing durable goods a little stronger in the consumption figures a surprise at all?" CHRG-111shrg57322--753 Mr. Viniar," I think Goldman Sachs is a major player in the world financial markets. The financial markets, I believe, got over-levered. I think lending standards declined. Senator Ensign. Do you feel that Goldman Sachs has any responsibility, not blame---- " CHRG-111hhrg48867--101 Mr. Wallison," It offers the opportunity to create an unlimited number of future Fannies and Freddies. The essence of Fannie Mae and Freddie Mac, the reason they became so powerful, so large, and ultimately were able to take so much in the way of risk, is that they were seen by the markets as backed by the government. And no matter what the government said about whether it was backing them, the markets were quite clear about this: The government was going to back them if they failed. Now, that is the kind of situation that we are creating when we are talking about systemically significant companies, because if we create such companies, if we have a regulator that is blessing them as systemically significant, we are saying they are too big to fail. If they fail, there will be some terrible systemic result. And therefore, the market will look at that and say, well, we are going to be taking much less risk if we lend to company ``A'' that is systemically significant rather than lending to company ``B'' that is not. " CHRG-111hhrg51591--75 Mr. Harrington," I would like to see a really detailed analysis of the securities lending issue and exactly what happened, why it happened, what the nature of the breakdown was, to what extent New York's Insurance Department and various other State regulators may have been asleep at the switch. Securities lending had gone on for so long and had been a major part of so many operations, I think it was regarded as routine business with no mischief involved. Clearly, it now appears there might have been some real mischief. So there could seriously have been some State regulatory failure there. I would want to really look into the specifics of the securities lending. But I have to go back and say everybody failed here. The OTS failed. Foreign bank regulators failed. They were letting foreign banks load up on AIG paper, CDS paper. Presumably, if they were doing their job, they would have said, how can we have so much of our banking system dependent on the promise of a single United States institution? Bank regulators failed. I don't know about the Comptroller, but the Fed in many respects must have failed to allow so many banks to contract with AIG given that it was running amok, so to speak, on these dimensions. So the Fed was partially to blame. The FDIC seems to have been to blame. The SEC, you can lay a lot of blame at their feet. And then also the Federal Reserve in general. I mean, I won't go--we don't want to go to low interest rates and what that did to the incentives in the entire system. But my point would just be you may well be correct that there is blame to go around. " FOMC20070810confcall--33 31,MR. LACKER.," Just in response to you, Richard, I agree with Tim that the last thing we want to do is to be sending a message behind the scenes as we did in ’87, encouraging anybody to lend to anybody they wouldn’t otherwise be interested in lending to under their current operating risk-management standards. What I like about the statement that the Chairman read to us is the focus on keeping the federal funds rate near its target. I think that’s what we should remain focused on. Credit spreads are beyond our ability to peg or influence, and I don’t think we should go down the road of trying to do so. I agree with President Geithner that the statement takes its power from that. It’s important for us in our deliberations to remain clinical about this and very specific in our diagnosis of symptoms and what’s going on. I think markets are working fine. The quantities just happen to be zero right now in some of them, [laughter] and things are going to hell in a handbasket." fcic_final_report_full--459 The GSE Act was a radical departure from the original conception of the GSEs as managers of a secondary market in prime mortgages. Fannie Mae was established as a government agency in the New Deal era to buy mortgages from banks and other loan originators, providing them with new funds with which to make additional mortgages. In 1968, it was authorized to sell shares to the public and became a government-sponsored enterprise (GSE) 9 —a shareholder-owned company with a government mission to maintain a liquid secondary market in mortgages. Freddie Mac was chartered by Congress as another GSE in 1970. Fannie and Freddie carried out this mission effectively until the early 1990s, and in the process established conservative lending standards for the mortgages they were willing to purchase, including such elements as downpayments of 10 to 20 percent, and minimum credit standards for borrowers. The GSE Act, however, created a new “mission” for Fannie Mae and Freddie Mac—a responsibility to support affordable housing—and authorized HUD to establish and administer what was in effect a mortgage quota system in which a certain percentage of all Fannie and Freddie mortgage purchases had to be loans to low-and- moderate income (LMI) borrowers—defined as persons with income at or below the median income in a particular area or to borrowers living in certain low income communities. The AH goals put Fannie and Freddie into direct competition with the FHA, which was then and is today an agency within HUD that functions as the federal government’s principal subprime lender. 7 Low income is usually defined as 80 percent of area median income (AMI) and moderate income as 100 percent of AMI. 8 Report of the Committee on Banking Housing and Urban Affairs, United States Senate to accompany S. 2733. Report 102-282, May 15, 1992, pp. 34-5. 9 Fannie and Freddie were considered to be government sponsored enterprises because they had been chartered by Congress and were given various privileges (such as exemption from the Securities Act of 1933 and the Securities Exchange Act of 1934) and a line of credit at the Treasury that signaled a special degree of government support. As a result, the capital markets (which continued to call them “Agencies”) assumed that in the event of financial diffi culties the government would stand behind them. This implied government backing gave them access to funding that was lower cost than any AAA borrower and often only a few basis points over the applicable Treasury rate. CHRG-110shrg50416--91 Mr. Kashkari," Senator, we share your perspective, and we want these banks to lend, and I do not think we havereticence to it. I think we will look at this with our regulatory colleagues. Ultimately, the regulatory---- Senator Menendez. Why not set a standard, then? Why not set a set of standards by which people could judge by? " fcic_final_report_full--125 In the end, companies in subprime and Alt-A mortgages had, in essence, placed all their chips on black: they were betting that home prices would never stop rising. This was the only scenario that would keep the mortgage machine humming. The ev- idence is present in our case study mortgage-backed security, CMLTI -NC, whose loans have many of the characteristics just described. The , loans bundled in this deal were adjustable-rate and fixed-rate residen- tial mortgages originated by New Century. They had an average principal balance of ,—just under the median home price of , in .  The vast major- ity had a -year maturity, and more than  were originated in May, June, and July , just after national home prices had peaked. More than  were reportedly for primary residences, with  for home purchases and  for cash-out refinancings. The loans were from all  states and the District of Columbia, but more than a fifth came from California and more than a tenth from Florida.  About  of the loans were ARMs, and most of these were /s or /s. In a twist, many of these hybrid ARMs had other “affordability features” as well. For ex- ample, more than  of the ARMs were interest-only—during the first two or three years, not only would borrowers pay a lower fixed rate, they would not have to pay any principal. In addition, more than  of the ARMs were “/ hybrid balloon” loans, in which the principal would amortize over  years—lowering the monthly payments even further, but as a result leaving the borrower with a final principal pay- ment at the end of the -year term. The great majority of the pool was secured by first mortgages; of these,  had a piggyback mortgage on the same property. As a result, more than one-third of the mortgages in this deal had a combined loan-to-value ratio between  and . Raising the risk a bit more,  of the mortgages were no-doc loans. The rest were “full-doc,” although their documentation was fuller in some cases than in others.  In sum, the loans bundled in this deal mirrored the market: complex products with high LTVs and little documentation. And even as many warned of this toxic mix, the reg- ulators were not on the same page. FEDERAL REGULATORS: “IMMUNITY FROM MANY STATE LAWS IS A SIGNIFICANT BENEFIT ” For years, some states had tried to regulate the mortgage business, especially to clamp down on the predatory mortgages proliferating in the subprime market. The national thrifts and banks and their federal regulators—the Office of Thrift Supervision (OTS) and the Office of the Comptroller of the Currency (OCC), respectively—resisted the states’ efforts to regulate those national banks and thrifts. The companies claimed that without one uniform set of rules, they could not easily do business across the country, and the regulators agreed. In August , as the market for riskier subprime and Alt- A loans grew, and as lenders piled on more risk with smaller down payments, reduced documentation requirements, interest-only loans, and payment-option loans, the OCC fired a salvo. The OCC proposed strong preemption rules for national banks, nearly identical to earlier OTS rules that empowered nationally chartered thrifts to disregard state consumer laws.  FOMC20081029meeting--261 259,MR. FISHER.," Mr. Chairman, if I could just add one other thing. We are hearing more and more about people switching to LIBOR, trying to shift their lending contracts to LIBOR rather aggressively, obviously, because they are higher rates. But I'm wondering if you're picking that up as well. " CHRG-111hhrg53241--46 The Chairman," So, apparently, there was not even any interest in doing it. And the question is, in general, is it your impression that consumer issues like this--Truth in Lending, the Homeowners Equity Protection Act, other areas that the Fed had--did they get equal attention at the Federal Reserve with other regulatory duties? " CHRG-110hhrg44900--4 The Chairman," Okay, so there is an overflow room for people who can't find seats. We have gotten the agreement of the Chairman and the Secretary, preliminary to any opening statements, to stay until 1 p.m. We will probably have some votes, so we will maximize our time. Let me remind the members that Chairman Bernanke will be before this committee next week for the Humphrey-Hawkins hearing on the economy. Members are obviously free to raise anything they want today, but it is my hope that we would focus on these very important questions of financial regulation. I know there are members who want to review what happened with Bear Stearns and then what we do going forward, but I personally believe the best use of the committee's time today would be to focus on those structural questions and regulatory questions. We will have the Chairman before us for 3 more hours next week to talk about the economy and Humphrey-Hawkins; and, again, I would urge members to do that. All members are free, as we know, to bring up whatever they want, but that would be our hope, because I did note that some of the members of the committee had asked previously for a hearing to look into what happened with Bear Stearns. And I said at the time that I thought that was very important. I believed it was best to do that in this broader context. Members want to get a new context because the experience regarding Bear Stearns is clearly the context in which much of this hearing is and much of what we will be talking about is what happens if that should occur. So those are the parameters. Given the importance of this, and given the interest of members in speaking, we are going to hold pretty firmly to the 5-minute rule. And, obviously, we are not going to completely finish in 5 minutes, but no question can be asked after the 5 minutes have expired. We will allow the answers to conclude. But I am going to have to restrain myself and others from asking any questions after the 5 minutes. Under the rules that apply when we have cabinet and cabinet-level officials, there are two opening statements on each side, the chairs and ranking members of the appropriate subcommittees. In this case, it seems clear to me that it is the Financial Institutions Subcommittee that is the developing subcommittee so that is how we will proceed. The official part of the hearing will now begin and I will recognize myself for a fairly strict 5 minutes. When I was about to become chairman of this committee in 2006, I was told by a wide range of people that our agenda should be that of further deregulating. I was told that the excess regulation in America from Sarbanes-Oxley and other acts was putting American investment companies and financial institutions at a competitive disadvantage and that people much prefer the softer touch of the financial services authority to the harshness of the American regulatory structure. Things have changed. Where there was a strong argument as recently as November of 2006 that we had been over-regulating the financial system, I believe the evidence is now clear that we are in one of the most serious economic troubles that we have seen recently, in part because of an inadequacy of regulation. Clearly, that has been the case with regard to subprime mortgages, but what has been striking is not simply that we had the problems with subprime mortgages, but that those problems infected so much of the financial system, including, I must say, many in Europe. One of the things though that I do take away from that set of conversations, and then it's a fairly clear one is that what we do, and I believe there is a consensus now among people in the Administration, among many of us in Congress, and among people in the financial industry, that an increase in regulation is required. It must be done sensibly. It must be market sensitive. But I believe we have seen a significant shift from the notion that the most important issue was to deregulate further to one recognizing the need for more sensible regulation, but more regulation. It is clear that this needs to be done in the context of international cooperation, and I am encouraged to believe, and the first trip this committee took when I became chairman was to Belgium and London to meet with people from the European Union and Great Britain in terms of their financial regulation. This needs to be done with international cooperation and I think the prospects of that are very good. I think there was a broad international recognition that some form of increased regulation was necessary. And the form we are talking about is regulation of risk-taking outside the very narrowly defined commercial banking. Innovation is very important, and an innovation that has brought a great deal of benefit during the last few decades is securitization. Securitization replaces the lender-borrower relationship and the discipline that you have in the lender-borrower relationship. A very large part of our problem is that we have not yet found sufficient replacement for the discipline of a lender not lending to a borrower unless the lender is sure that the borrower will be able to repay. Something that simple causes problems in subprime, and it has caused problems elsewhere. We have had too many loans made without sufficient attention to whether or not the loans could be repaid. And, what we now have is a contagion, because people who bought loans in various forms that they shouldn't have bought are now resistant to buying things that they should buy. That is why I believe regulation properly done, regulation of risk that is too unconstrained today, because the various risk management techniques that were supposed to replace the lender-borrower relationship have not been successful. Diversification and quantitative models and the rating agencies, we have not yet replaced them. Some form of regulatory authority is necessary. If properly done, a market sensitive regulatory authority not only prevents some of the problems, but is pro-market, because we have investors now who are unwilling to invest even in things they should. Many of our nonprofit institutions and our State and local governments have been the victims of this. So our job, I believe--and I congratulate the officials of this Administration for having done a good job in the current legal context of dealing with these problems--is to look at what happened, to look at what is now going on, and to decide what should be done to provide a better statutory framework for the increase in regulation that I believe people agree should happen. The gentleman from Alabama. " FinancialCrisisInquiry--177 And so, Mr. Zandi, if you would commence your testimony. Thank you very much. ZANDI: Well, thank you, Mr. Chairman and other distinguished members of the commission. I—I want to thank you for the opportunity to testify today. The views I express are my own and not those of the Moody’s Corporation. The purpose of my testimony is to assess the economic impact of the financial crisis that began nearly three years ago. While the financial crisis has abated and the financial system has stabilized, the system remains troubled. Failures at depository institutions continue at an alarming rate and likely will continue for several years more to come. The securitization markets also remain dysfunctional as investors anticipate more loan losses and are uncertain about various legal and accounting rule changes and regulatory reform. Without support from the Federal Reserve’s TALF program, private bond issuance and securities backing of consumer and business loans would be completely dormant. Households and businesses are struggling with the resulting severe credit crunch. The extraordinary tightening of underwriting standards by nearly all creditors is clear in the lending statistics. Here’s a very astounding statistic. The number of bank credit cards outstanding has fallen by nearly 100 million cards in just over the past year and-a-half, a 20 percent decline. Total household debt, including credit cards, auto loans and mortgage debt has declined a stunning $600 billion, or 5 percent. And outstanding C&I loans, commercial investor loans, have declined by some 20 percent since peaking in late 2008. Some of this reflects the desire of households and businesses to reduce their debt loads. But it also stems from lenders’ inability and unwillingness to lend. Small banks are vital to consumer and small- business lending. And without the ability to sell the loans they originate to investors in the securities market, banks and other lenders don’t have the capital sufficient to significantly expand their lending. The economic recovery will struggle to gain traction until credit flows more freely, which won’t occur until bank failures abate and there’s a well functioning securities market. FOMC20070509meeting--82 80,MR. KOHN.," So here is my reasoning. I thought that the average includes lots of episodes of more or less steady growth in steady state and then other episodes of cyclical adjustments. In my mind, we were in the middle of a kind of mini-cycle, which was an adjustment from greater-than-sustainable growth to growth that we hope is sustainable. We’ve seen that the adjustment had already created some inventory overhangs and some changes in capital spending plans. So I thought that, because we’re not at a steady state, things might be a little more uncertain than usual. But I compensated for that by narrowing my confidence bands in ’08 and ’09 [laughter] when I think we’ll be close to a kind of a steady state. On the skews part, like President Geithner, I had downside skews on output. It wasn’t so much housing because I think that, with the adjustment to demand or activity that’s in the staff forecast and my own adjustment to prices, the risks around that are approximately balanced. Nor was it a spreading of problems in the subprime market to other credit markets; I think we’ve seen enough since the subprime problems started to be pretty sure that the risk is no more than the normal kind. Rather, the risk I saw was from concerns about the financial position and the psychology of the household sector and the interaction of those with housing. So it was a spillover in some sense from housing to consumption. The financial obligations ratio is very high. Households, as President Geithner noted, are highly leveraged. One of the surprises to me in the development of subprime markets was apparently how many borrowers and lenders were counting on the future appreciation in houses just to support the debt service, to say nothing of the consumption that must be going on at the same time. I suspect that this is more widespread than just the subprime market. How many households were expecting price appreciation to continue more as it did before rather than to slow down or even for prices to decline (as I think they will), it’s hard to say. But I suspect there are a lot of these households, and I think we could get some feedback there. The staff has the saving rate actually declining in the second and third quarters, and there might be some technical reasons for that. Even to get modest consumption growth, we see a very gradual uptrend in the saving rate over time. That might be the most likely outcome, but it did suggest to me that there is at least some fatter tail on the possibility that households, seeing what’s happening in the housing market and to their financial obligations, will draw back more quickly from spending. When President Geithner and I were in Basel, the most popular question to us was whether capital spending would really pick up again. A number of central bankers doubted that that could happen as long as consumption wasn’t growing more rapidly. But I’m comfortable with the capital spending pattern so long as the consumption pattern looks something like the pattern in the Greenbook and like the one that I have as my most likely outcome. More generally, as you pointed out at one point last fall, Mr. Chairman, I think we’re in a very unusual situation of below-potential growth for an extended period—a situation that is pretty much unprecedented without breaking out one way or another. Some nonlinearity is going to come up and bite us here, and, as I see it, the nonlinearity is most likely in the household sector. Now, if income proceeds along the expected path, it seems to me that there are upside risks to inflation moving down to 2 percent and staying there in our forecast. I think that overall we’re facing a more difficult inflation environment than we have for the past ten years or so: the high level of resource utilization; rising import prices from the decline in the dollar and the high level of demand relative to potential supply globally, including in the emerging-market economies—one thing we heard in Basel was that increasing numbers of these economies are having trouble sterilizing their reserve accumulation and are running into inflation pressures from that happening—higher prices for energy, food, and other commodities; higher headline inflation; and possibly even slower trend productivity growth. I didn’t see a downside skew to any of these things. But, as I thought about the whole picture with all these things seeming to tilt a bit on one side and their interaction, it seemed to me that there was some upside risk to the possibility that inflation expectations would rise rather than stay where they are as assumed in my most likely outcome. Now, for policy purposes, I would weight the upside risk to inflation more than the downside risk to growth, but we’ll get to that later in the day. Thank you, Mr. Chairman." CHRG-111hhrg55814--295 Mr. Manzullo," That is my question--the only people around here who do not seem to be getting any recognition or any respect are the people who have been doing their jobs back home in the State insurance authorities, and then all of a sudden people say, let's bring it together. The third question is open to everybody, actually to the Governor. The Feds already had the authority, it has had it for years, to set underwriting standards for mortgages. I am talking subprimes. And do ridiculous things, such as requiring written proof of a person's earnings. And yet the Fed never put those regulations into effect until October 1st of this year. So why should the Fed be given more authority under a brand new organization set up when it had that authority in the first place and simply failed to act? And the failure did not occur during Mr. Bernanke's term. By the time he got in, it was too late. " CHRG-111hhrg53244--360 Mr. Grayson," Well, actually, according to the chart on page 28, virtually the entire amount that is reflected in your current balance sheet went out starting in the last quarter of 2007. And before that, going back to the beginning of this chart, the amount of lending was zero to foreigners. Is that-- " CHRG-111hhrg53245--181 Mr. Royce," Thank you, Mr. Chairman. I would ask a question of Mr. Mahoney and Mr. Zandi for their opinion on this. For many years I was concerned about the perceived government-backing of Fannie Mae and Freddie Mac and about the ability of these firms to borrow at interest rates that were a lot lower. They were near governmental rates. And most private companies of course because of perceived investment risk associated with Fannie and Freddie being so much lower, most of their competitors were at a disadvantage. At the same time, they were allowed to involve themselves in arbitrage. I think the leverage was 100 to one. I think that one of the main problems that we had was legitimizing the idea that subprime loans were safe. And I think the fact that the Government-Sponsored Enterprises went out and purchased for their portfolios a half trillion of these, directed by the government to do so, by the way; and one of the comments made by one of the GSE officials was that we sought to indicate to the market the safety of mortgage-backed securities that were subprime. And I do think that that entire process, and the way in which they became a duopoly, forced their competitors out, became too big to fail, there is a probably a lesson we should learn out of that. And I think it would be very dangerous for Congress to move to set up a regulatory structure that separates these institutions that are deemed systemically significant from the other institutions, whether you do that de facto or de juri, whether you name them or you do not name them. The result I suspect is likely to be the same. There will be the perception that these particular institutions are going to be covered. So how will the market perceive these companies, and are you concerned that counterparties will then perceive their investment risk in these institutions would be a lot lower and therefore it starts the process of being able to overleverage. It starts the process certainly of having a lower cost of capital, which will force your competitors out of the market. What will this mean for institutions competing against these now government-backed companies that in essence become too big to fail and Government-Sponsored Enterprises in a way. That would be the result I fear out of it? " CHRG-111hhrg48874--185 Mr. Foster," Do you think if there was explicit collateral support, that might encourage some slice of lending? Governor? Ms. Duke. Congressman, you're right, and particularly a lot of small businesses that use their home equity to finance their businesses are being squeezed by that. I think some of the progress that we have made in talking about loan modifications and talking about refinance that are now allowing, in the GSE loans, refinances to take place, even when the loan to value might be up to 105 percent. I think that could have some help. On the commercial property side, there is a program under SBA, and I'm not quite sure what the funding necessary is. But SBA does have a program where the bank lends 50 percent of the value and then the SBA loan covers 40 percent and the businessman has 10 percent. That sometimes helps businesses who otherwise wouldn't have largedown payments or equity positions in their buildings. " CHRG-111hhrg54868--73 The Chairman," I will take the last 20 seconds to say, I would note, Mr. Dugan, you mentioned the failure to do the subprime regulation in the nonbanks. The authority to do that was lodged in one those safety and soundness regulators whose autonomy you are protecting, the Federal Reserve. Your proposal would keep that in the Federal Reserve, your position. Because the Federal Reserve has made your consumer protections, and you have said leave them with the safety and soundness regulator. The fact is, as Mr. Miller also pointed out, you said, well, we couldn't do that; the Federal Reserve gave them the permission to do it. So the consequence of what you are saying, don't give any enforcement powers to this, the Federal Reserve refused to use the enforcement powers, and you are for the status quo with the Federal Reserve. " CHRG-111hhrg55811--318 Mr. Sherman," I know. Yes. And I should make a further comment based on the ranking member's comments. His comments seem to be on the order of, well, the old system was working just fine except for subprime. I would point out it was working fine because it had an implicit Federal guarantee and the market was shocked when Lehman Brothers was outside of what people thought was that umbrella. So it is hard to say the old system was working fine when it only worked with an implicit Federal guarantee that I think most of our colleagues on the other side of the aisle voted against. Mr. Hill, can Morgan Stanley do just fine without a code section that allows the Administration to bail you out without consulting Congress in the future? " fcic_final_report_full--123 HOEPA (Home Ownership and Equity Protection Act) hearings in San Francisco. At the hearing, consumers testified to being sold option ARM loans in their primary non-English language, only to be pressured to sign English-only documents with sig- nificantly worse terms. Some consumers testified to being unable to make even their initial payments because they had been lied to so completely by their brokers.”  Mona Tawatao, a regional counsel with Legal Services of Northern California, de- scribed the borrowers she was assisting as “people who got steered or defrauded into entering option ARMs with teaser rates or pick-a-pay loans forcing them to pay into—pay loans that they could never pay off. Prevalent among these clients are seniors, people of color, people with disabilities, and limited English speakers and seniors who are African American and Latino.”  Underwriting standards: “We’re going to have to hold our nose” Another shift would have serious consequences. For decades, the down payment for a prime mortgage had been  (in other words, the loan-to-value ratio (LTV) had been ). As prices continued to rise, finding the cash to put  down became harder, and from  on, lenders began accepting smaller down payments. There had always been a place for borrowers with down payments below . Typically, lenders required such borrower to purchase private mortgage insurance for a monthly fee. If a mortgage ended in foreclosure, the mortgage insurance company would make the lender whole. Worried about defaults, the GSEs would not buy or guarantee mortgages with down payments below  unless the borrower bought the insurance. Unluckily for many homeowners, for the housing industry, and for the financial system, lenders devised a way to get rid of these monthly fees that had added to the cost of homeownership: lower down payments that did not require insurance. Lenders had latitude in setting down payments. In , Congress ordered federal regulators to prescribe standards for real estate lending that would apply to banks and thrifts. The goal was to “curtail abusive real estate lending practices in order to reduce risk to the deposit insurance funds and enhance the safety and soundness of insured depository institutions.”  Congress had debated including explicit LTV stan- dards, but chose not to, leaving that to the regulators. In the end, regulators declined to introduce standards for LTV ratios or for documentation for home mortgages.  The agencies explained: “A significant number of commenters expressed concern that rigid application of a regulation implementing LTV ratios would constrict credit, impose additional lending costs, reduce lending flexibility, impede economic growth, and cause other undesirable consequences.”  In , regulators revisited the issue, as high LTV lending was increasing. They tightened reporting requirements and limited a bank’s total holdings of loans with LTVs above  that lacked mortgage insurance or some other protection; they also reminded the banks and thrifts that they should establish internal guidelines to man- age the risk of these loans.  High LTV lending soon became even more common, thanks to the so-called piggyback mortgage. The lender offered a first mortgage for perhaps  of the home’s value and a second mortgage for another  or even . Borrowers liked these because their monthly payments were often cheaper than a traditional mort- gage plus the required mortgage insurance, and the interest payments were tax de- ductible. Lenders liked them because the smaller first mortgage—even without mortgage insurance—could potentially be sold to the GSEs. CHRG-111shrg57320--206 Mr. Dochow," You fill out your paperwork, you put down what your income is---- Senator Kaufman. Right. Mr. Dochow [continuing]. And the bank pulls your FICO scores, your credit reports, the loan gets approved or disapproved. Those programs lend themselves more to that type of underwriting. Senator Kaufman. Right. " CHRG-110shrg50416--65 Mr. Kashkari," Again, we do expect, but we are hesitant to put a specific dollar figure because these financial institutions--again, as you know, Senator, we are talking about very large financial institutions and very small. One size fits all is---- Senator Schumer. What are you going to do for banks that do not increase their lending at all that take this capital? " CHRG-111hhrg48674--132 Mr. Meeks," Let me then move to another area that I think is of critical importance as we move forward. I have also been looking at a number of individuals who talk about the lack of availability of warehouse lending credit facilities. We had a hearing back, I guess it was a couple of weeks ago, and we heard testimony that 85 to 90 percent of the warehouse lending capacity is gone from the market, and some of the remaining warehouse providers may not stay in business. I know that lowering the overall rate is one thing. But if there is no money available by the warehouse lenders, then there is nothing to do at closing, and so people will not be able to take advantage. You know, we want to get folks to refinance or to be able to mitigate the mortgage they are in, but there needs to be some additional money therein. So, first, I want to make sure you are aware of this problem, and, second, what impact will it have in the marketplace if we stimulate demand for mortgages without ensuring adequate funding capacity at closing tables across the country for the warehouse credit facilities? " CHRG-110hhrg46593--197 OPERATING OFFICER, BANK OF THE WEST, ON BEHALF OF THE INDEPENDENT COMMUNITY BANKERS OF AMERICA (ICBA) Ms. Blankenship. Thank you, Acting Chairman Kanjorski, and members of the committee. Thank you for allowing the Independent Community Bankers of America to testify today. I am Cynthia Blankenship. I am chief operating officer and vice chairman of Bank of the West in Grapevine, Texas, and chairman of the Independent Community Bankers of America. We want to express our appreciation to Chairman Frank, Representative Kanjorski, Representative Bachus, and many others on the committee for their support of important community bank provisions in the Emergency Economic Stabilization Act. ICBA commends the extraordinary efforts of Congress, Treasury, the Federal Reserve, and the FDIC to address the current economic crisis. Given the speed and the enormity of the undertaking, it is understandable that significant issues have come up regarding the Troubled Asset Relief Program's Capital Purchase Program. The terms released by Treasury several weeks ago were unworkable for privately-held banks, Subchapter S banks and mutual institutions because of legal constraints and organizational structures peculiar to each of the types of these institutions. ICBA and others have provided Treasury concrete suggestions to overcome the obstacles. We have had a constructive dialogue with Treasury on these issues, and last night, Treasury released a term sheet for a privately held C corporation bank. But a term sheet is still urgently needed for the more than 3,000 Subchapter S and mutual banks. This represents one-third of most of the community banks, privately-held banks, in the United States that still have no access to the TARP. While Treasury is working in good faith to produce term sheets, ICBA members are growing increasingly concerned about the rate the funds are flowing out of the program. At this point, only $60 billion is left uncommitted from the $250 billion Capital Purchase Program. And, yet, more than 6,000 privately-held Subchapter S and mutual institutions have not had the opportunity to apply. There are more than 8,000 community banks nationwide, and they are well-positioned to extend lending in their communities should they choose to use the Capital Purchase Program. Including them will stimulate lending in those communities. ICBA applauds FDIC's actions to unlock the market through the Temporary Liquidity Guarantee Program. The guarantee provides deposit insurance in transaction accounts and will enhance depositor confidence in community banks and free up capital to large deposits. The guaranteed program for our senior unsecured debt, however, provides few benefits for community banks, as they do not issue much in the way of senior unsecured debt, other than Federal funds purchased. The current processing for the program makes it unattractive for Federal funds to purchase transactions. Overnight Federal funds pose little risk of default. And at current prices for Federal funds, the 75 basis point fee exceeds the interest rate. We have suggested that the FDIC adopt risk-based pricing for the guarantee so that it will be more attractive for overnight transactions and consider allowing banks to separately opt out of the guarantee for overnight Federal funds. If the guarantee fee does not cover the cost of the program, only banks and thrifts will be subject to a special assessment fee to make up that deficit; yet holding companies with significant nonbank subsidiaries can participate in the program. Some mechanism is needed to ensure these holding companies pay their fair share. Community banks played no role in causing the current economic crisis, the foreclosure crisis, and by and large they did not engage in subprime lending practices. And they did not become entangled with toxic investment products. As a result, community banks are not experiencing unusual levels of mortgage defaults. When defaults do arise, community banks understand that foreclosure is the least attractive alternative and do everything they can to avoid it. Our involvement in servicing loans and finding solutions for consumers extends beyond our own customers, and we offer refinancing to many troubled borrowers and loans from other institutions. Mr. Chairman and members of the committee, ICBA stands ready to work with you to maximize participation in the programs authorized under the EESA and to promote the free flow of capital so essential to our economy. I appreciate the opportunity to testify today. [The prepared statement of Ms. Blankenship can be found on page 145 of the appendix.] " CHRG-111hhrg48873--182 Mr. Bernanke," I don't know where $10 trillion comes from. The Congress has the right to authorize funds, which is what they did in the TARP Program. And in the 1930's, they gave the Federal Reserve the power for emergency lending as a means for addressing financial crises, which is what we have done. " CHRG-111hhrg56766--263 Mr. Bernanke," All the things we have talked about from the monetary policy side, lending, from whatever actions Congress wants to take on the employment side, I think those are the issues that will create stabilization in the labor market, and that in turn is one of the keys to consumer confidence. " CHRG-111hhrg56241--201 Mr. Grayson," Well, let's say it was only 10 to one. Isn't it true that every dollar that is paid on executive compensation means $10 less in loan ability for these institutions, the ability to lend out money to the rest of America? Professor? " CHRG-111shrg57320--214 Mr. Dochow," Actually, I think it raises a different issue---- Senator Kaufman. OK. Mr. Dochow [continuing]. In addition to the potential fraud. It raises the issue of income and incentives. And what I mean by that is stated income programs generally gave the lending institutions a higher margin. Senator Kaufman. Right. " CHRG-111shrg55117--62 Mr. Bernanke," I would have to get back to you with the exact numbers, but we have seen improvements on the interest rates and spreads in the secondary markets, which suggest some increased availability of funds and lower rates. And although it is not a Federal Reserve initiative, I would just take note of the Treasury's initiatives under the TALF to put money into SBA lending and to support that area. But I absolutely agree with you, this is one of the toughest areas because traditionally, in a downturn, small business is the first to get cutoff. Senator Schumer. Right. And what about lifting the credit unions' cap on small business lending? It was put in as part of a political compromise years ago, maybe decades ago. I do not think there is any reason not to lift it. If this is another place where small business could get loans, and credit unions are often tied into their communities and want to help, what do you think of that idea? I think it is now 12.5 percent. Some of us have proposed legislation to lift it. " CHRG-110hhrg45625--56 The Chairman," Thank you. First, a request for working together. As we look at every method unfolded, there is a danger that community banks will be victimized when they are among the least guilty of any of the misdeeds. These are the people who didn't make bad subprime loans. As you know--we have talked about this--held preferred stock in Fannie Mae and Freddie Mac and they are at risk of losing that or not at risk of losing that. I would hope--off the subject here--and we have been talking to the people in the tax committees--that we could get an agreement to give them--all those who held preferred stock appropriate tax relief. I think that would be fair. The government caused a loss to them and I think that we ought to at least allow for some pretty quick deduction. Mr. Chairman? " FinancialCrisisReport--378 Goldman Sachs was established in 1869 as an investment bank. 1513 Originally a private partnership, in 1999, it became a publicly traded corporation. In 2008, it converted to a bank holding company. Its headquarters are located in New York City, and the firm manages about $870 billion in assets. 1514 Goldman employs about 14,000 employees in the United States and 32,500 worldwide. In 2007, it reported net revenues of $11.6 billion, of which $3.7 billion was generated by the Structured Products Group in the Mortgage Department, primarily as a result of its subprime investment activities. 1515 Unlike other Wall Street banks, Goldman has no retail banking operations. It does not accept deposits from, nor lend to, retail customers, nor does its broker-dealer provide advice to or execute trades on behalf of retail customers. Goldman provides services only to so-called “sophisticated” institutional investors, generally large corporations, financial services firms, pension funds, hedge funds, and a few very wealthy individuals. 1516 For most of its history, Goldman operated exclusively as an investment bank, providing investment advice to corporate clients, arranging and executing mergers and acquisitions, and arranging financing for customers through stock and bond offerings. After the 1999 repeal of the Glass-Steagall Act, which had restricted the activities that could be engaged in by investment banks, Goldman expanded its operations. 1517 Over the last ten years, traditional investment banking activities have become a small percentage of Goldman’s business. Goldman has instead become primarily a Wall Street trading house, providing broker-dealer services to institutional customers, acting as a prime broker to hedge funds, 1518 structuring and financing deals for customers from its own capital, and conducting proprietary trading activities for its own benefit. In the years leading up to the financial crisis, Goldman became an active investor and participant in the deals and transactions that it was handling for clients as well as selling to investors. 1519 1513 The background information about Goldman in this section was taken from several sources. See “Profile, Goldman Sachs, ” Reuters.com ; “Profile, The Goldman Sachs Group, Inc.,” Hoovers.com ; 4/19/2010, “A Brief History of Goldman Sachs – Timeline, ” W all Street Journal ; 1/2010, “The Bank Job, ” Vanity Fair (written with cooperation of Goldman Sachs). 1514 During 2006 and 2007, Goldman ’s headquarters were at 85 Broad Street in Manhattan. In 2010, the firm moved its headquarters to 200 W est Street in Manhattan. See “Morgan Stanley May Lease Old Goldman Sachs Building, ” Bloomberg (10/18/2010). 1515 See Goldman Sachs Form 10-K for the fiscal year ending Nov. 30, 2007, filed with the SEC on 1/28/2008, at 64; 11/30/2007 “SPG Trading Mortgages W eekly Metrics 30-November-2007,” GS MBS-E-015646485. 1516 1517 1518 See supra note 1513. Id. “Prime brokers ” are generally large broker-dealers that provide a special set of services to special clients, including securities lending, leveraged trade execution, and cash management. See definition of “prime brokerage ” at Investopedia.com. 1519 See supra note 1513. FinancialCrisisReport--85 In February 2007, WaMu senior managers discussed “how best to dispose” of $433 million in Long Beach performing second lien loans, due to “disarray” in the securitization market. 249 David Beck, head of WaMu’s Wall Street operation, wrote that securitizing the loans was “not a viable exit strategy” and noted: “Investors are suffering greater than expected losses from subprime in general as well as subprime 2nd lien transactions. As you know, they are challenging our underwriting representations and warrants. Long Beach was able to securitize 2nd liens once in 2006 in May. We sold the BBB- bonds to investors at Libor +260. To date, that transaction has already experienced 7% foreclosures.” 250 WaMu CEO Killinger complained privately to President Steve Rotella: “Is this basically saying that we are going to lose 15 [percent] on over $400 million of this product or 60 million. That is a pretty bad hit that reflects poorly on credit and others responsibility for buying this stuff. Is this showing up in hits to compensation or personnel changes.” 251 WaMu President Rotella responded: “This is second lien product originated 7-10 months ago from Long Beach. … In 2006 Beck’s team started sprinkling seconds in deals as they could. And, we now have the % down to the low single digits, so that we can sell all into our deals (assuming the market doesn’t get even worse).” He continued: “In terms of folks losing their jobs, the people largely responsible for bringing us this stuff are gone, the senior management of LB.” 252 Also in February 2007, early payment defaults again ticked up. A review of the first quarter of 2007 found: “First payment defaults (FPDs) rose to 1.96% in March but are projected to fall back to 1.87% in April based on payments received through May 5th.” 253 It also reported that the findings from a “deep dive into February FPDs revealed” that many of the problems could have been eliminated had existing guidelines been followed: “The root cause of over 70% of FPDs involved operational issues such as missed fraud flags, underwriting errors, and condition clearing errors. This finding indicates there may be opportunities to improve performance without further restricting underwriting guidelines.” 254 249 2/2007 email chain among WaMu personnel, JPM_WM00673101-03, Hearing Exhibit 4/13-17. 250 Id. at JPM_WM00673103. 251 Id. at JPM_WM00673101. 252 Id. 253 “Quarterly Credit Risk Review SubPrime,” prepared by WaMu Home Loans Risk Management (1st Quarter, 2007), Hearing Exhibit 4/13-18. 254 Id. FinancialCrisisReport--122 In that particular securitization, Goldman Sachs served as the lead underwriter, WCC served as the securities dealer, Deutsche Bank served as the trustee of the trust set up to hold the securities, and Long Beach served as the mortgage servicer. Another document, prepared by Goldman Sachs, shows the variety of relationships that WaMu engaged in as part of its securitization efforts. 438 That document, which consists of a list of various loan pools and related matters, shows that WaMu worked with Goldman Sachs to make whole loan sales; securitize loans insured by the Federal Home Administration or Veterans Administration; and securitize prime, subprime, Alt A, second lien, and scratch and dent nonperforming loans. It also shows that Goldman Sachs asked WaMu and Long Beach to repurchase more than $19.7 million in loans it had purchased from the bank. 439 Goldman Sachs handled a number of securitizations for Long Beach. At one point in 2006, Goldman Sachs made a pitch to also handle loans issued by WaMu. One Goldman Sachs broker explained to a colleague in an email: “They have possibly the largest subprime portfolio on the planet.” 440 (2) Deficient Securitization Practices Over the years, both Long Beach and Washington Mutual were repeatedly criticized by the bank’s internal auditors and reviewers, as well as its regulators, OTS and the FDIC, for deficient lending and securitization practices. Their mortgage backed securities were among the worst performing in the marketplace due to poor quality loans that incurred early payment defaults, fraud, and high delinquency rates. Long Beach Securitizations. In April 2005, an internal email sent by an OTS regulator recounted eight years of abysmal performance by Long Beach securities, noting that loan delinquencies and losses occurred in pools containing both fixed rate and adjustable rate mortgages: “[Securitizations] prior to 2003 have horrible performance …. For FRM [fixed rate mortgage] losses, LBMC finished in the top 12 worst annual NCLs [net credit losses] in 1997 and 1999 thru 2003. LBMC nailed down the number 1 spot as top loser with an NCL of 14.1% in 2000 and placed 3 rd in 2001 with 10.5% .... For ARM losses, LBMC really outdid themselves with finishes as one of the top 4 worst performers for 1999 thru 2003. For specific ARM deals, LBMC made the top 10 worst deal list from 2000 thru 2002. LBMC had an extraordinary year in 2001 when their securitizations had 4 of the top 6 worst NCLs (range: 11.2% to 13.2%). 438 Undated “List of WaMu-Goldman Loans Sales and Securitizations,” Hearing Exhibit 4/13-47b. 439 Id. 440 3/24/2005 email from Kevin Gasvoda of Goldman Sachs to Christopher Gething, others, Hearing Exhibit 4/27- 167b. “Although underwriting changes were made from 2002 thru 2004, the older issues are still dragging down overall performance. Despite having only 8% of UPB [unpaid balances] in 1st lien FRM pools prior to 2002 and only 14.3% in 2002 jr. lien pools, LBMC still had third worst delinquencies and NCLs for most of [the] period graphed from 11/02 thru 2/05 and was 2nd worst in NCLs in 2005 out of 10 issuers graphed. … At 2/05, LBMC was #1 with a 12% delinquency rate. Industry was around 8.25%. At 3/05, LBMC had a historical NCL rate of 2% smoking their closest competitor by 70bp and tripling the industry average.” 441 CHRG-111hhrg54872--74 Mr. Shelton," No, not at all. The biggest problem right now is first the lack of access of capital in the communities you are talking about. Some of the biggest challenges we have are issues not clearly covered by this bill, are issues very much like payday lending, some of those concerns. Too often in the communities that we serve there are so few legitimate financial lending institutions available that they find themselves being victimized by 456 percent APR when they go to, for instance, a payday lending facility in the local community. So the idea is to make sure: one, there is capital available in those communities; two, it is done in a fair way; and three, there is oversight to make sure the same consumers you are talking about don't get taken advantage of in the process. What we saw happening as we saw the economic downturn is very well, even with the policies and oversight available to us now, there are many consumers who are actually led into products that they could not sustain. And we want to make sure there is oversight and transparency there as well. Brokers sat down with racial and ethnic minorities, sat down with the elderly and very well discussed products that they did not get full disclosure on how those products would actually function. As a result, tragedy occurred. There are many Americans who owned their own homes that went to refinance. For instance, elderly to buy new storm windows to address issues of climate change, or new roofs to address leakage of an aging house found themselves not only going into debt, but also going into debt at a rate they were not aware they would be going into because there was not full disclosure or full oversight. So we very well argue that we need the products, we need the oversight, and we need a clear agency whose primary function is to provide some protection of the consumers as we enter these very challenging products. " CHRG-111shrg50814--35 Chairman Dodd," Thank you, Senator, very much. Senator Bunning. Senator Bunning. Thank you, Mr. Chairman. Welcome, Chairman Bernanke. Outstanding Fed lending hit about $2.3 trillion in December. It has fallen to about $1.9 trillion, but you have pledged another $1 trillion in new lending. The total volume of loans made over the last months may be many times higher than that, but those of us outside the Fed do not have access to that information. Your testimony before this Committee on TARP was that we needed transparency so the American people could understand. One of the causes of the recession is the American people don't believe you or anybody sitting here is telling them the truth. That is one of the problems. But you have not been open about the Fed's balance sheet. I think the American people have a right to know where that money is going. When are you going to tell the public who is borrowing from the Fed and what they have pledged as collateral? When are we going to get the transparency from the Fed? " CHRG-110shrg50420--425 Mr. Fleming," Senator, there is a very great danger, I think, in preempting franchise laws at a State level. The first issue, I think, that would arise is that the lending institutions in the States depend on the franchise laws with respect to the risk that they are going to assume. So one of the unintended consequences of Federal preemption of State franchise laws, or another concern, of course, would be going into bankruptcy, would be that the lending institutions would further tighten credit. I also think, Senator, that there is a misunderstanding about whether or not franchise laws could prevent the Big Three, in this case, from doing the things that they are recommending to you today. I don't think that State franchise laws do that. I brought a copy, Senator, of a boilerplate franchise agreement, General Motors agreement. When I was Commissioner of Consumer Protection, one of my jobs was to make sure that contracts that renters sign, for example, the average consumer wasn't lopsided. This agreement is absolutely lopsided toward the manufacturer. They can basically do anything they want. Many of the franchise holders in Connecticut that are-- " CHRG-110hhrg38392--53 Mr. McHenry," Last month, the Federal Trade Commission had a very interesting new study on mortgage disclosures--you mentioned mortgage disclosures in your presentation--and it concluded in this study that current disclosures fail to convey key mortgage costs to many consumers, and in the study they found that about a third of consumers cannot identify their interest rate, whether it is prime, whether it is the prime and subprime marketplace; half could not correctly identify the loan amount; two-thirds could not recognize that they would be charged a prepayment penalty; and nearly nine-tenths could not identify the total amount of upfront charges. Do you believe that changes in mortgage disclosures can help the marketplace so that individuals can decide for themselves? If they have those clear and upfront pieces of information, can they better decide for themselves? " CHRG-111shrg57320--80 Mr. Thorson," And we commented in the report that in 2007, WaMu itself identified fraud losses of $51 million for subprime loans and $27 million for prime loans. That is a big number, and at some point, as you say, top management--I mean, you are talking about $78 million right there. Somebody is going to want to take a look at how that happened and what are we doing to stop it. Senator Kaufman. But even beyond that, I mean, don't you have kind of an obligation at some point, when you get numbers--I mean, that was in good times. God only knows when we went back and looked at what happened to mortgage-backed securities that ultimately went toxic, as the Chairman says. I mean, at some point you just say, yes, the bank is getting hurt and this and that, but there are some people involved and those who were committing fraud. " CHRG-110hhrg38392--3 Mr. Bachus," I thank the chairman, and Chairman Bernanke, thank you for your support and continued strong and wise stewardship of our Nation's monetary policy. As I said when you appeared before this committee in February, there is a difference of opinion on the strength of the economy. I would like to review some of the facts, which I think are hard to argue with. First of all, economic growth is robust, as illustrated by 132,000 new jobs created in June alone, and as you say in your testimony, 850,000 since the start of the year--over 8 million new jobs created since August of 2003. Unemployment remains low. Despite higher oil prices, and really it is something I am going to mention later in my remarks, oil has gone from $50 to $75 a barrel just from the middle of January. And despite the rise in energy cost, inflation is under control following the 2.4 percent in February 2, 2007, and 1.9 percent in May. While it has slowed recently, productivity has averaged 2.8 percent growth since 2001, well above the average productivity growth experienced in the 1970's, 1980's, or 1990's. Real wages have shown a healthy increase over the past year. And are supporting concerned strong consumer spending, even in the face of declines in real estate values in many areas of the country. The stock market continues to deliver superior returns to investors. This economic success story is a result of sound economic policies pursued, I believe, by this Republican Administration, by our Treasury Department, and by the Federal Reserve. They are also a testament to the hard work and innovation of American businesses and workers who comprise the American economy. Chairman Bernanke, I believe you deserve a great deal of credit for the performance of the economy as well. Instead of micromanaging monetary policy, you have held an absolutely steady hand for a year now balancing the tension between modest upside inflation risk and modestly slower growth. No one has summarized your tenure at the Fed better than The New York Times. In a June 25th story, less than a month ago, they said this, ``Could an ivy league academic like this ever have street credibility?'' The answer is clear: yes, yes, and yes again. The same article also observed that the economy today is pretty much exactly where Mr. Bernanke hoped it would be one year ago. Economic growth has slowed slightly, gradually reducing inflationary pressures. And while job creation has slowed, unemployment remains low at 4.5 percent. That is The New York Times. Before I conclude my remarks, Mr. Chairman, I would like to bring your attention to two topics of particular interest to members of this committee. First, as you know, Chairman Frank and I are both concerned over the recent turmoil in the subprime lending market. Just last week, Representatives Gillmor, Pryce, Miller, LaTourette, Capito, and I introduced legislation on this subject. Developing a consensus solution to this problem, while determining the Fed's proper role in regulating the mortgage industry, are priorities for Members on both sides of the aisle. The committee would benefit from your thoughts on the current state of the subprime mortgage market and its potential impact in the larger economy. And second, Mr. Chairman, the Fed, it has often been said, has a dual mandate, and that is price stability and full employment. While that mandate has certain factors that are more subject to management and control than others, there is one wild card, possibly two, when you talk about core inflation and then backing out energy and food. The wild card to me, and the disturbing factor in our economy, is energy cost over which the Federal Reserve has very little short term or long term influence. As I said earlier, the price of oil, if you go back to July of last year, $75, where it is today, but we have gone down to $50 a barrel and back up to $75. Some people say we will get relief because there may be an economic slowdown in China or India or Europe and that may bring us relief, but that would not be good for the economy. So we get in a situation where China is growing at 11 percent. Their energy demands are growing. And U.S. manufacturing, in fact, the largest contributor to job loss in this country over the last 10 years is the high cost of energy. And yet this Congress, for 10 years--for a year or two we have talked about the subprime situation. I would tell colleagues on both sides of the aisle, for 10 years, we have been talking about our dependency on foreign oil, we have been talking about the high cost of energy, we have talked about its devastating impact on employment and on manufacturing, but yet we have done nothing. China is building a new nuclear power plant every week. With every plant they bring online, they reduce the cost of energy and increase their competitiveness over us. Mr. Chairman, I believe that Congress' failure over many years to address this energy cost has created and will continue to create real problems for the Federal Reserve as you try to cope with both price stability and full employment, because I think the high cost of energy is a wild card over which you have no control. And it is my greatest concern, and I am sure it is a great concern to you moving forward. Let me conclude by saying that members--both Republican and Democrat--on this committee respect your experience, your judgment, and your obvious commitment to keeping America's economy strong and competitive. We appreciate you being here and look forward to your comments. " CHRG-111shrg50814--64 Mr. Bernanke," Providing sufficient capital to make sure that the banks in private hands can continue to provide the lending and liquidity needed for the economy to recover. If I might, Senator, if I may, the way this will be provided---- Senator Corker. Well, let me ask you this: What is the role of the common shareholders at that point? " CHRG-111shrg57319--485 Mr. Rotella," Senator, I believe given the expansion of stated income lending in the marketplace in general, it would be naive to think that there weren't some who didn't. Senator Kaufman. Do you have reason to believe that WaMu's internal controls are sufficient to deter fraud in these kind of products? " CHRG-111shrg57321--175 Mr. McDaniel," The credit protection levels were raised, and then the market shut down very quickly after that. Senator Kaufman. Ms. Corbet, when did you first pull your management team together and say, I don't think this is like what has happened in the past. We are producing products--way too many of our AAAs are defaulting. We should really change the way things are going. Ms. Corbet. Well, I think Standard and Poor's, concurrent with its own research and publications of some of the stresses that they were beginning to see in the marketplace back in 2005, they began to make, as earlier testified by the S&P folks, that they began to make changes in their criteria and their credit enhancement levels in 2005 and in 2006, as well. In fact, in 2006, the number of downgrades exceeded the number of upgrades for subprime residential mortgage-backed securities. So the actions were following the research and the findings that were being reported to the marketplace. In 2007, following again the two previous credit enhancement increases, again, the performance data was suggesting that it was even more serious than was previously contemplated, and so, therefore, in February 2007 S&P made another change and announcement of downgrades to--credit watch, excuse me, for subprime mortgages. In March, we reported also in a teleconference about what our outlook was in terms of expectations for the housing market and what the impact may be in terms of downgrades---- Senator Kaufman. And again, this reporting is great, but really, the key---- Ms. Corbet. Is actions, yes. Senator Kaufman. Yes. But, I mean, the key is how many AAAs are we sending out the door that in retrospect, when you look back on it 2 years later, are not AAA but they are junk? I mean, that is really the key. I think--and, Ms. Corbet, were you here for the first panel? Ms. Corbet. I was in and out, yes. Senator Kaufman. OK. That is not what they said in the first panel. They said a number of things, and what I would like to do is kind of go through them and see what you say. They said it was incentives. Ms. Corbet. Yes. Senator Kaufman. Mr. McDaniel, they said that there were incentives in the organization, in Moody's, to get more business out the door, to not worry so much about what the rating is going to be, just move it out there, quantity over quality, I think, is the term that one of the gentlemen used. Clearly, you haven't raised that as one of the problems. " CHRG-111shrg56262--16 Mr. Hoeffel," Thank you. I am testifying today on behalf of the Commercial Mortgage Securities Association. CMSA represents the collective voice of all market participants in the commercial real estate capital market finance industry, including lenders, issuers, investors, rating agencies, and servicers, among others. These participants come together to facilitate a transparent primary and secondary market for commercial mortgages. I am also an investor in CMBS, but I have more than two decades of experience as a commercial lender and a CMBS issuer. I would like to thank the Committee for the opportunity to share our views on securitization, which is crucial to borrower access to credit and our overall economy. This afternoon, I will focus specifically on securitized credit markets for commercial real estate, focusing on three issues: first, the enormous challenges facing the $3.5 trillion market for commercial real estate finance, of which about $850 billion is securitized; second, the unique structure of CMBS and the need to customized regulatory reforms accordingly to support recovery; and, finally, the need to restore the CMBS market to meet significant borrower demand. Today the commercial real estate market is facing a perfect storm based on three interconnected and pressing challenges. First, there is no liquidity or lending. In 2007, there were approximately $240 billion in CMBS loans made, approximately half of the total real estate lending market. CMBS issuance fell to only $12 billion in 2008, despite strong credit performance at the time and high borrower demand. It has now been well over a year since a new CMBS deal has been done. Second, there are significant loan maturities through 2010. In fact, hundreds of billions of dollars is coming due in the next 2 years. Capital refinance these loans is largely unavailable, and loan extensions are difficult to achieve. Third, the downturn in the U.S. economy persists. Commercial real estate is greatly impacted by the macroeconomic factors: high unemployment, low consumer confidence, poor business performance, and falling property values. This last point is especially important to highlight. Remember, commercial real estate did not cause the current liquidity crisis. It has been negatively affected by it now, 2 years into the crisis. Second, even within the commercial real estate finance industry, CMBS or securitization did not cause stress. In fact, nonsecuritized loans are now underperforming CMBS and are experiencing in some cases greater defaults. Ironically, securitization may be ultimately an exit strategy for these troubled loans. As financial policymakers, including the current and previous Administration, have rightfully pointed out, no recovery plan will be successful unless it helps restart the securitization markets. The IMF also asserts that securitization will assist withdrawal of Government interventions, employing private capital to fuel private lending. Today many recovery efforts in the commercial real estate market, such as TALF and PPIP, have been helpful. But they are in a nascent and delicate stage, as discussed in my written testimony. So it is important that regulatory reforms, including accounting changes, as George mentioned, must work to strengthen the securitized markets and to give private investors who bring their own capital to the table certainty you and confidence. Above all, in the commercial real estate context, there is a real concern that some of the reform proposals will be applied in a one-size-fits-all manner that could actually impede recovery. Specifically, there are a number of important distinctions between CMBS and other asset-based securities markets, and the upshot of these distinctions is that they help the CMBS market avoid problems of poor underwriting or inadequate transparency. These significant differences are in four major areas: First, the borrower. In CMBS, the borrower in most cases is a sophisticated business within income-producing property and contractual revenues from tenants as opposed to some situations in the subprime residential mortgage where a loan may have been underwritten for a borrower who could not document his income. Second, the structure of CMBS. There are only about 100 to 300 loans in a typical CMBS deal as opposed to thousands of loans in residential deals. This enables greater due diligence and analysis to be performed on CMBS pools by several different parties, including rating agencies and investors. Third, the existence of a third-party investor or B-piece buyer in the securitization process. Unlike other asset classes, CMBS has an investor who purchases a first loss position and conducts extensive due diligence as a result, which includes sit visits to every property. This investor also re-underwrites proposed loans in a potential pool, and they can negotiate to kick out any loans in which they do not wish to invest. Finally, greater transparency. CMBS market participants have significant access to loan, property, and bond level information at issuance and on an ongoing basis. In fact, the CMSA investor reporting package is used as a model for transparencies by other types of ABS markets. It is from this unique perspective that we approach regulatory reform proposals that will undoubtedly change the CMBS market. We do not necessarily oppose some of these proposals despite the fact that they will address practices that were typical in the subprime and residential securitization markets, not CMBS. Instead, we ask that policymakers ensure that such reforms are tailored to address the specific needs of each securitization asset class and to recognize the many safeguards that already exist in the CMBS market today. In this regard, two aspects of regulatory reform are of utmost interest to CMSA: a requirement that securitizers--that is, bond issuers and underwriters--retain at least 5 percent of the credit risk in any securitized loan pool; and a restriction of the ability of issuers to protect against or hedge this 5-percent retained risk. As is explained in more detail in my written testimony, the basic concern we have about both of these proposals is whether they will be applied in a one-size-fits-all manner. While we agree that it is important for the appropriate parties to keep skin in the game, CMBS deals are already structured to do this in a way that has worked well for the market and for the overall economy for years and can continue to serve the policy objective that is sought here. As discussed earlier, first loss buyers conduct their own extensive credit analysis on the loans, examining detailed information concerning every property before buying the highest-risk bonds in the CMBS securitization. If these reforms are not applied in a tailored fashion, the danger is that the reforms will end up hampering the ability of CMBS lenders to originate new loans, thereby limiting capital and the flow of credit at a time when our economy desperately needs it. Thank you. " FOMC20080130meeting--41 39,MR. LACKER.," Thanks. Going back to the LIBOR�OIS spread--that was what motivated this. It has fallen a lot. The bid-to-cover ratio is falling. If we try to lend $30 billion three more times, we could get to a point at which we satiate the market in term funds. " FinancialCrisisReport--408 Within about a month, in January 2007, the Mortgage Department had largely eliminated or offset its long subprime mortgage assets, but it didn’t stop there. In January and February, the Mortgage Department began building a multi-billion-dollar short position as part of a plan by the SPG Trading Desk to profit from the subprime RMBS and CDO securities starting to lose value. The plan was discussed with Mr. Sparks and Mr. Ruzika before it was set in motion. By the end of February 2007, the Department had swung from a $6 billion net long position to a $10 billion net short position, a $16 billion reversal in the span of two months. Selling Assets Outright. On December 14, 2006, the same day as the Viniar meeting, Kevin Gasvoda, head of the Residential Whole Loan Trading group, instructed his staff to begin selling the RMBS securities in Goldman’s inventory, focusing on RMBS securities issued from Goldman-originated securitizations. He urged them to “move stuff out” even at a loss: “[P]ls refocus on retained new issue bond positions and move them out. ... [W]e don’t want to be hamstrung based on old inventory. Refocus efforts and move stuff out even if you have to take a small loss.” 1651 In February 2007, to further encourage sales, Mr. Gasvoda issued a sales directive or “axe” to the Goldman sales force to sell the remaining RMBS securities from Goldman-originated RMBS securitizations. On February 9, 2007, the sales force reported a substantial number of sales, and Mr. Gasvoda replied: “Great job syndicate and sales, appreciate the focus.” 1652 In February 2007, Goldman CEO Lloyd Blankfein personally reviewed the Mortgage Department’s efforts to reduce its subprime RMBS whole loan, securities, and residual equity positions, asking Mr. Montag: “[W]hat is the short summary of our risk and the further writedowns that are likely[?]” 1653 After a short report from Mr. Montag, Mr. Blankfein replied: “[Y]ou refer to losses stemming from residual positions in old deals. Could/should we have cleaned up these books before and are we doing enough right now to sell off cats and dogs in other books throughout the division?” 1654 1651 1652 12/14/2007 email from Mr. Gasvoda, “Retained bonds, ” GS MBS-E-010935323, Hearing Exhibit 4/27-72. 2/9/2007 email exchange between Kevin Gasvoda and sales syndicate, “GS Syndicate RM BS Axes (INTERNAL), ” GS MBS-E-010370495, Hearing Exhibit 4/27-73. 1653 2/11/2007 email exchange between Lloyd Blankfein and Tom Montag, “Mortgage Risk – Credit residential,” GS MBS-E-009686838, Hearing Exhibit 4/27-130. 1654 Id. CHRG-111hhrg53248--68 Mr. Hensarling," I agree with you, Mr. Secretary. But the question is, besides subprime mortgages, was it viewed as a central cause, since you know the Fed has already issued their final home mortgage disclosure rules under Regulation Z. And so either, one, it is inadequate--I guess I am asking this question--why come up with an agency that has the power to ban or modify mortgages, ban or modify credit cards, ban or modify remittances? And I respectfully disagree with the chairman. I have read the language of his bill. I guess we can have two different lawyers look at it and decide what it means to have the ability to render unlawful unfair acts and practices that are subjectively decided on by this five-person unelected board. I mean, if credit cards and remittances were not a part of the central cause, why are they included in this legislation, and Fannie and Freddie aren't? " CHRG-111shrg62643--29 Mr. Bernanke," I think we do still have options, but they are not going to be the conventional options and so we need to look at them carefully and make sure we are comfortable with any step that we take. Senator Shelby. I want to get into the area of small business lending. Mr. Chairman, I hear reports of a credit crunch for small businesses and calls by other people to initiate more government programs to jump start lending in this area. I have two questions related to small business credit. First, is there some market failure or regulatory failure inhibiting the flow of small business credit which requires even more government intervention? Second, is there any slow down in small business credit because of weaker demand, because of a deterioration in financial conditions of small businesses and values of the collateral that they hold, or because of regulators somehow inhibiting or preventing good loans from being made? In other words, do we know the definitive reason for the slow down in credit flow to small businesses and what is your take? " CHRG-110hhrg46591--346 The Chairman," The gentlewoman from Illinois. Ms. Bean. Thank you, Mr. Chairman, and Ranking Member Bachus, for holding this important hearing today on something so many Americans are concerned about. They are rightfully concerned about their own and our Nation's economic futures and want to know that we are going to put in place the oversight and transparency to avoid this kind of situation ever happening again. I am proud to chair the new Democratic Working Group on Regulatory Modernization and we have put together a number of issues we are focusing on. And so, I wanted to give each of you maybe one question that addresses one of those each issues. To Mr. Washburn, regarding the mortgage reform bill that this committee passed last year, I believe it was in April, but unfortunately didn't get through the Senate and get to the President to become law, in that bill that we passed, we eliminated many of the risky lending practices that contributed to the subprime fallout that has so affected the rest of the capital market structure. We also put liability to the securitizers to address what Congressman LaTourette I think rightly attributed to, one of the problems was that the originators weren't ultimately going to be holding the bag for bad loans that they might write. And by putting liabilities to the securitizer we also then gave them a home waiver provision; that if they had best practices in place to make sure that the originators were adhering--the ability to pay models and old underwriting standards that used to work, they wouldn't have that liability. So my question to Mr. Washburn is, how do you feel about that bill, had it become law; and if it had a year ago, would we have avoided the number or the severity of some of the challenges that we are facing in this crisis? Before you go there, I want to lay out a couple of other questions and then we will come back. To Mr. Yingling, on mark to market, I think the chairman earlier talked about how the real issue--and you just spoke to it briefly--is that the capital calls more than necessarily how you measure, but the consequences of the accounting rules that affect it. My question is, the SEC has changed some of those rules recently, and how do you think that is affecting balance sheets currently with those changes that allow a little more flexibility? To Mr. Ryan, my question is regarding the uptick in the collateral rules. Earlier in the previous panel, we had some questions about the uptick rule and, if that was reinstated, would it avoid some of the naked short selling that has gone on and contributed to the downward spiral of many securities? But also the collateral role, not just as applied to those, but to the credit default swaps that don't require collateral to get involved in them and how that has allowed so many people to even create greater degrees of risk and leverage, what are your thoughts on that? And if we get to it with timing to Mr. Bartlett, you talked about a clearinghouse for derivatives and disclosure of risk and what your comments are on that. So I would like to go to Mr. Washburn first. " CHRG-111hhrg56766--126 The Chairman," Time has expired. We were going to have a hearing on March 2nd on that very subject. I had to postpone it because there was a major hearing on the fishing industry in my district and I had to fish or cut bait, so I'm going fishing, but also it turned out we had originally thought that would be a day in which there had been votes the day before. It is a day in which there are not votes until that evening and members expressed a lot of interest in it. We will, on the next available hearing day, have a full hearing on exactly that topic and so, Mr. Chairman, we will be looking for an elaboration of those views, but we had the hearing set for March 2nd on precisely the topic the gentleman asked, not just Fannie and Freddie Mac but its interaction with the FHA and Ginnie Mae and the Federal Home Loan Bank and all of the various strains of housing financing. So we'll get the rest of that answer within 10 days at the latest. The gentlewoman from New York, the Chair of the Small Business Committee, who will be co-presiding on Friday on a hearing on this recurring important topic of how do we get loans flowing to small businesses which she's been focused on, the gentlewoman from New York. Ms. Velazquez. Thank you, Mr. Chairman. Chairman Bernanke, you know, you quite well said that economic recovery is tied to jobs creation and we all know that job creators in our country are small businesses, and if you talk to any member in this panel sitting here, they will tell you that each one of us know some creditworthy borrowers who can't access lending and and we know that we have put together all these tools to incentivize lending and we see today's Wall Street Journal with that title about lending, the sharpest decline since 1942. And I know that your answer to me is going to be, well, that is not under my purview, but if we have tried all these tools and are not producing the success in terms of easing or getting credit flowing again for small businesses, even the loan guaranty by SBA, we have seen 50,000 less loans this year compared to last year and we increased the loan guaranty from 75 to 90, we reduced the fees paid by borrowers and lenders. So my question to you is, do you think that there is a time, given this economic crisis, for the Federal Government to play a more aggressive role in direct lending in a temporary basis? " CHRG-111hhrg54868--169 Mr. Royce," Thank you. Let me ask a quick question. This has to do with something that I remember the Federal Reserve bringing to us in, I think it was about 2004, where they laid out a concern they had with the Government-Sponsored Enterprises. And their worry was that, unless they could regulate for systemic risk and have the ability to reduce the portfolios some, they were worried that with a $1.5 trillion portfolio, and a mandate that we had built up over the years that half of it had to be subprime and Alt-A loans and so forth, that it was leveraged 100 to 1, and so they were saying, we could have a systemic risk problem if we don't have sufficient regulation to allow us to address this. Do you think that could have been a contributor to the problem in terms of what happened in the GSEs? If I could ask the panel? Ms. Bair. Yes, I think the GSEs did contribute to the problem. " fcic_final_report_full--15 We conclude that these two entities contributed to the crisis, but were not a pri- mary cause. Importantly, GSE mortgage securities essentially maintained their value throughout the crisis and did not contribute to the significant financial firm losses that were central to the financial crisis. The GSEs participated in the expansion of subprime and other risky mortgages, but they followed rather than led Wall Street and other lenders in the rush for fool’s gold. They purchased the highest rated non-GSE mortgage-backed securities and their participation in this market added helium to the housing balloon, but their pur- chases never represented a majority of the market. Those purchases represented . of non-GSE subprime mortgage-backed securities in , with the share rising to  in , and falling back to  by . They relaxed their underwriting stan- dards to purchase or guarantee riskier loans and related securities in order to meet stock market analysts’ and investors’ expectations for growth, to regain market share, and to ensure generous compensation for their executives and employees—justifying their activities on the broad and sustained public policy support for homeownership. The Commission also probed the performance of the loans purchased or guaran- teed by Fannie and Freddie. While they generated substantial losses, delinquency rates for GSE loans were substantially lower than loans securitized by other financial firms. For example, data compiled by the Commission for a subset of borrowers with similar credit scores—scores below —show that by the end of , GSE mort- gages were far less likely to be seriously delinquent than were non-GSE securitized mortgages: . versus .. We also studied at length how the Department of Housing and Urban Develop- ment’s (HUD’s) affordable housing goals for the GSEs affected their investment in risky mortgages. Based on the evidence and interviews with dozens of individuals in- volved in this subject area, we determined these goals only contributed marginally to Fannie’s and Freddie’s participation in those mortgages. CHRG-111hhrg58044--388 Mr. Pratt," Not really, because it is similar to asking us whether a creditor effectively uses a credit report for a lending decision. You have to have the creditor here in order to answer that question because they are the one that is going to be able to explain how they use the data, whether they include medical debts or do not include medical debts. I think that is very important. " FinancialCrisisReport--482 In early 2007, Goldman’s Mortgage Department initiated an intensive review of the loans in its inventory, warehouse accounts, and RMBS and CDO securitizations, to identify deficient loans and return them for refunds. On February 2, 2007, Mr. Sparks reported to senior Goldman executives Messrs. Viniar, Montag, and Ruzika that obtaining refunds from the loan originators would be “a battle”: “The team is working on putting loans in the deals back to the originators (New Century, WAMU, and Fremont – all real counterparties), as there seem to be issues potentially including some fraud at origination, but resolution will take months and be contentious. ... The put backs will be a battle.” 2038 2036 Goldman or a third party due diligence firm it hired typically examined a sample of the loans. Based on the number of problem loans found in the sample, Goldman or the due diligence firm extrapolated the total percentage of problem loans likely to be contained in the pool. This information was then factored into the price Goldman paid for the pool. Any specific loans identified in the sampling process as deficient were generally returned to the lender for repurchase, but it was rare for an investment bank to review 100% of a pool to identify all of the deficient loans and return them. Subcommittee interview of Clayton Holdings (11/9/2010). 2037 See, e.g., 1/8/2007 email from Daniel Sparks, “Color on the Sub Prime Market,” GS MBS-E-002195434 (after receiving a report on potential EPD problems, Mr. Sparks wrote: “I just can ’t see how any originator in the industry is worth a premium. I ’m also a bit scared of accredited and new century, and I ’m not sure about taking on a bunch of new exposures. ”); 2/8/2007 email from FICC analyst to Mr. Sparks, Mr. Gasvoda, and others, “2006 Subprime 2nds Deals Continue to Underperform,” GS MBS-E-003775340, Hearing Exhibit 4/27-167d ( “2006 vintage Subprime closed-end seconds (CES) issuance has continued to deteriorate. ... [N]on-GS Subprime CES deals are categorically experiencing similar negative behavior across shelves, originators, and servicers. ... Outlook: 2006 vintage ... could eventually reach 4-5+ times that of 2004/early 2005 vintages (more than double that of RA expected losses).”). 2038 2/2/2007 email from Daniel Sparks to Messrs. Montag, Ruzika, and Viniar, GS M BS-E-002201050, Hearing Exhibit 4/27-92. See also 2/2/2007 email from Michelle Gill, “W arehouse policy,” GS MBS-E-005556331 (discussing proposal to charge higher warehouse fees to mortgage originators with higher EPD and “drop-out ” rates, including Fremont and New Century). CHRG-111shrg51303--69 Mr. Dinallo," Senator, the only facts I could give you on this that might be helpful are twofold: The securities lending issue is over, and it cost about $17 billion. And the second fact is that, to the extent the American public are ever repaid on this, it will be from the proceeds of selling the insurance operating companies, and---- Senator Bunning. That is why the stock is at 50 cents? " CHRG-111hhrg56766--90 Mr. Bernanke," Well, there are two separate issues there. It's true that because the economy is weak that some borrowers are not in the market for credit and that's one of the reasons why bank lending is down. The other issue, though, which I think you began with is that in situations where there is a creditworthy borrower who would like credit, we want to make sure that they get credit and we have been very focused on that issue. " CHRG-111hhrg48873--94 Secretary Geithner," I think that is a very important thing. I mean, it is very important that the American people understand we are going to devote these resources to things that are going to get credit flowing again, get interest rates down, and improve the access for businesses and consumers to credit. That is the central obligation and purpose of this authority. And if you look at what we have done over the last several weeks, you can see we have moved quickly to put in place very substantial measures to address the housing crisis. You are seeing the actions of the Fed and the Treasury together bring down interest rates, allow Americans to refinance and take advantage of lower interest rates. You have seen us move to put in place very important new programs to help support small business lending, to get lending flowing again across the financial system as a whole. Those are very important things. But as part of that, we need better clarity on the rules of the game going forward. I completely agree. " CHRG-110hhrg46591--259 Mr. Washburn," Absolutely not. Community banks have been around forever, and we operate by a very simple business model. We lend money to people who pay us back. It is very simple. It has worked for years. We continue to want to do that going forward, so I do not see that changing whatever changes here. " FOMC20080724confcall--68 66,CHAIRMAN BERNANKE.," President Yellen, San Francisco did a really good job in a difficult situation. We were following that very carefully. Just a footnote, did the FDIC not give you some assurances as well--protections for lending--because they asked you explicitly to assist them in winding down the bank? " CHRG-111hhrg53248--142 Mr. Garrett," That certainly should trouble you because we have heard a lot of discussion on this panel with regard to something called predatory lending, and so many times they said that there should be other products that individuals should be entitled to but they are just not offered those, and all they are offered are these much higher rate products or just really ones that put them in a bad situation. " CHRG-111shrg56262--95 PREPARED STATEMENT OF ANDREW DAVIDSON President, Andrew Davidson and Company October 7, 2009 Mr. Chairman and Members of the Subcommittee, I appreciate the opportunity to testify before you today about securitization. My expertise is primarily in the securitization of residential mortgages and my comments will be primarily directed toward those markets. Securitization has been a force for both good and bad in our economy. A well functioning securitization market expands the availability of credit for economic activity and home ownership. It allows banks and other financial institutions to access capital and reduces risk. On the other hand a poorly functioning securitization market may lead to misallocation of capital and exacerbate risk. \1\--------------------------------------------------------------------------- \1\ Portions of this statement are derived from ``Securitization: After the Fall'', Anthony Sanders and Andrew Davidson, forthcoming.--------------------------------------------------------------------------- Before delving into a discussion of the current crisis, I would like to distinguish three types of capital markets activities that are often discussed together: Securitization, Structuring, and Derivatives. \2\--------------------------------------------------------------------------- \2\ See, Andrew Davidson, Anthony Sanders, Lan-Ling Wolff, and Anne Ching, ``Securitization'', 2003, for a detailed discussion of securitization and valuation of securitized products.--------------------------------------------------------------------------- Securitization is the process of converting individual loans into securities that can be freely transferred. Securitization serves to separate origination and investment functions. Without securitization investors would need to go through a very complex process of transferring the ownership of individual loans. The agency mortgage-backed securities (MBS) from Ginnie Mae, Fannie Mae, and Freddie Mac are one of the most successful financial innovations. However, as the last years have taught us, the so-called, ``originate to sell'' model, especially as reflected in private-label (nonagency) MBS, has serious shortcomings. Structuring is the process of segmenting the cash flows of one set of financial instruments into several bonds which are often called tranches. The collateralized mortgage obligation or CMO is a classic example of structuring. The CMO transforms mortgage cash flows into a variety of bonds that appeal to investors from short-term stable bonds, to long-term investments. Private label MBS use a second form of structuring to allocate credit risk. A typical structure uses subordination, or over-collateralization, to create bonds with different degrees of credit risk. The collateralized debt obligation or CDO is a third form of structuring. In this case, bonds, rather than loans, are the underlying collateral for the CDO bonds which are segmented by credit risk. Structuring allows for the expansion of the investor base for mortgage cash flows, by tailoring the bonds characteristics to investor requirements. Unfortunately, structuring has also been used to design bonds that obfuscate risk and return. Derivatives, or indexed contracts, are used to transfer risk from one party to another. Derivatives are a zero sum game in that one investor's gain is another's loss. While typically people think of swaps markets and futures markets when they mention derivatives, the TBA (to be announced) market for agency pass-through mortgages is a large successful derivative market. The TBA market allows for trading in pass-through MBS without the need to specify which pool of mortgages will be delivered. More recently a large market in mortgage credit risk has developed. The instruments in this market are credit default swaps (CDS) and ABX, an over-the-counter index based on subprime mortgage CDS. Derivatives allow for risk transfer and can be powerful vehicles for risk management. On the other hand, derivatives may lead to the creation of more risk in the economy as derivate volume may exceed the underlying asset by substantial orders of magnitude. For any of these products to be economically useful they should address one or more of the underlying investment risks of mortgages: funding, interest rate risk, prepayment risk, credit risk, and liquidity. More than anything else mortgages represent the funding of home purchases. The twelve trillion of mortgages represents funding for the residential real estate of the country. Interest rate risk arises due to the fixed coupon on mortgages. For adjustable rate mortgages it arises from the caps, floors and other coupon limitations present in residential mortgage products. Interest rate risk is compounded by prepayment risk. Prepayment risk reflects both a systematic component that arises from the option to refinance (creating the option features of MBS) as well as the additional uncertainty created by the difficulty in accurately forecasting the behavior of borrowers. Credit risk represents the possibility that borrowers will be unable or unwilling to make their contractual payments. Credit risk reflects the borrower's financial situation, the terms of the loan and the value of the home. Credit risk has systematic components related to the performance of the economy, idiosyncratic risks related to individual borrowers and operational risks related to underwriting and monitoring. Finally, liquidity represents the ability to transfer the funding obligation and/or the risks of the mortgages. In addition to the financial characteristics of these financial tools, they all have tax, regulatory and accounting features that affect their viability. In some cases tax, regulatory and accounting outcomes rather than financial benefit are the primary purpose of a transaction. In developing policy alternatives each of these activities: securitization, structuring and derivatives, pose distinct but interrelated challenges.Role of Securitization in the Current Financial Crisis The current economic crisis represents a combination of many factors and blame can be laid far and wide. Additional analysis may be required to truly assess the causes of the crisis. Nevertheless I believe that securitization contributed to the crisis in two important ways. It contributed to the excessive rise in home prices and it created instability once the crisis began. First, the process of securitization as implemented during the period leading up to the crisis allowed a decline in underwriting standards and excessive leverage in home ownership. The excess lending likely contributed to the rapid rise in home prices leading up to the crisis. In addition to the well documented growth in subprime and Alt-A lending, we find that the quality of loans declined during the period from 2003 to 2005, even after adjusting for loan to value ratios, FICO scores, documentation type, home prices and other factors reflected in data available to investors. The results of our analysis are shown in Figure 1. It shows that the rate of delinquency for loans originated in 2006 is more than 50 percent higher than loans originated in 2003. The implication is that the quality of underwriting declined significantly during this period, and this decline was not reflected in the data provided to investors. As such it could reflect fraud, misrepresentations and lower standard for verifying borrower and collateral data. The net impact of this is that borrowers were granted credit at greater leverage and at lower cost than in prior years.[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] In concrete terms, the securitization market during 2005 and 2006 was pricing mortgage loans to an expected lifetime loss of about 5 percent. Our view is that even if home prices had remained stable, these losses would have been 10 percent or more. Given the structure of many of these loans, with a 2-year initial coupon and an expected payoff by the borrower at reset, the rate on the loans should have been 200 or 300 basis points higher. That is, initial coupons should have been over 10 percent rather than near 8 percent. Our analysis further indicates that this lower cost of credit inflated home prices. The combination of relaxed underwriting standards and affordability products, such as option-arms, effectively lowered the required payment on mortgages. The lower payment served to increase the price of homes that borrowers could afford. Figure 2 shows the rapid rise in the perceived price that borrowers could afford in the Los Angeles area due to these reduced payment requirements. Actual home prices then followed this pattern. Generally we find that securitization of subprime loans and other affordability products such as option arms were more prevalent in the areas with high amounts of home price appreciation during 2003 to 2006. To be clear, not all of the affordability loans were driven by securitization, as many of the option arms remained on the balance sheet of lending institutions.[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] Figure 3 provides an indication of the magnitude of home price increases that may have resulted from these products on a national basis. Based on our home price model, we estimate that home prices may have risen by 15 percent at the national level due to lower effective interest rates. In the chart, the gap between the solid blue line and the dashed blue line reflects the impact of easy credit on home prices.[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] On the flip side, we believe that the shutting down of these markets and the reduced availability of mortgage credit contributed to the sharp decline in home prices we have seen since 2006 as shown in Figure 4. Without an increase in effective mortgage rates, home prices might have sustained their inflated values as shown by the dashed blue line. \3\--------------------------------------------------------------------------- \3\ See, http://www.ad-co.com/newsletters/2009/Jun2009/Valuation_Jun09.pdf for more details.[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] Thus the reduced focus on underwriting quality lead to an unsustainable level of excess leverage and reduced borrowing costs which helped to inflate home prices. When these ``affordability'' products were no longer sustainable in the market, they contributed to the deflation of the housing bubble. The way securitization was implemented during this period fostered high home prices through poor underwriting, and the end of that era may have led to the sharp decline in home prices and the sharp decline in home prices helped to spread the financial crisis beyond the subprime market. The second way that securitization contributed to the current economic crisis is through the obfuscation of risk. For many structures in the securitization market: especially collateralized debt obligations, structured investment vehicles and other resecuritizations, there is and was insufficient information for investors to formulate an independent judgment of the risks and value of the investment. As markets began to decline in late 2007, investors in all of these instruments and investors in the institutions that held or issued these instruments were unable to assess the level of risk they bore. This lack of information quickly became a lack of confidence and led to a massive deleveraging of our financial system. This deleveraging further depressed the value of these complex securities and led to real declines in economic value as the economy entered a severe recession. In addition, regulators lacked the ability to assess the level of risk in regulated entities, perhaps delaying corrective action or other steps that could have reduced risk levels earlier.Limitations of Securitization Revealed To understand how the current market structure could lead to undisciplined lending and obfuscation of risk it is useful to look at a simplified schematic of the market. \4\--------------------------------------------------------------------------- \4\ Adapted from ``Six Degrees of Separation'', August 2007, by Andrew Davidson http://www.securitization.net/pdf/content/ADC_SixDegrees_1Aug07.pdf.[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] In the simplest terms, what went wrong in the subprime mortgage in particular and the securitization market in general is that the people responsible for making loans had too little financial interest in the performance of those loans and the people with financial interest in the loans had too little involvement in the how the loans were made. The secondary market for nonagency mortgages, including subprime mortgages, has many participants and a great separation of the origination process from the investment process. Each participant has a specialized role. Specialization serves the market well, as it allows each function to be performed efficiently. Specialization, however also means that risk creation and risk taking are separated. In simplified form the process can be described as involving: A borrower--who wants a loan for home purchase or refinance A broker--who works with the borrower and lenders to arrange a loan A mortgage banker--who funds the loan and then sells the loan An aggregator--(often a broker-dealer) who buys loans and then packages the loans into a securitization, whose bonds are sold to investors. A CDO manager--who buys a portfolio of mortgage-backed securities and issues debt An investor--who buys the CDO debt Two additional participants are also involved: A servicer--who keeps the loan documents and collects the payments from the borrower A rating agency--that places a rating on the mortgage securities and on the CDO debt This chart is obviously a simplification of a more complex process. For example, CDOs were not the only purchasers of risk in the subprime market. They were however a dominant player, with some estimating that they bought about 70 percent of the lower rated classes of subprime mortgage securitizations. What is clear even from this simplified process is that contact between the provider of risk capital and the borrower was very attenuated. A central problem with the securitization market, especially for subprime loans was that no one was the gate keeper, shutting the door on uneconomic loans. The ultimate CDO bond investor placed his trust in the first loss investor, the rating agencies, and the CDO manager, and in each case that trust was misplaced. Ideally mortgage transactions are generally structured so that someone close to the origination process would take the first slice of credit risk and thus insure that loans were originated properly. In the subprime market, however it was possible to originate loans and sell them at such a high price, that even if the mortgage banker or aggregator retained a first loss piece (or residual) the transaction could be profitable even if the loans did not perform well. Furthermore, the terms of the residuals were set so that the owner of the residual might receive a substantial portion of their cash flows before the full extent of losses were known. Rating agencies set criteria to establish credit enhancement levels that ultimately led to ratings on bonds. The rating agencies generally rely on historical statistical analysis to set ratings. The rating agencies also depend on numeric descriptions of loans like loan-to-value ratios and debt-to-income ratios to make their determinations. Rating agencies usually do not review loans files or ``re-underwrite'' loans. Rating agencies also do not share in the economic costs of loan defaults. The rating agencies methodology allowed for the inclusion of loans of dubious quality into subprime and Alt-A mortgage pools, including low documentation loans for borrowers with poor payment histories, without the offsetting requirement of high down payments. To help assure investors of the reliability of information about the risks of purchased loans, the mortgage market has developed the practice of requiring ``representations and warranties'' on purchased loans. These reps and warrants as they are called, are designed to insure that the loans sold meet the guidelines of the purchasers. This is because mortgage market participants have long recognized that there is substantial risk in acquiring loans originated by someone else. An essential component in having valuable reps and warrants is that the provider of those promises has sufficient capital to back up their obligations to repurchase loans subsequently determined to be inconsistent with the reps and warrants. A financial guarantee from an insolvent provider has no value. Representations and warranties are the glue that holds the process together; if the glue is weak the system can collapse. The rating agencies also established criteria for Collateralized Debt Obligations that allowed CDO managers to produce very highly leveraged portfolios of subprime mortgage securities. The basic mechanism for this was a model that predicted the performance of subprime mortgage pools were not likely to be highly correlated. That is defaults in one pool were not likely to occur at the same time as defaults in another pool. This assumption was at best optimistic and most likely just wrong. In the CDO market the rating agencies have a unique position. In most of their other ratings business, a company or a transaction exists or is likely to occur and the rating agency reviews that company or transaction and establishes ratings. In the CDO market, the criteria of the rating agency determine whether or not the transaction will occur. A CDO is like a financial institution. It buys assets and issues debt. If the rating agency establishes criteria that allow the institution to borrow money at a low enough rate or at high enough leverage, then the CDO can purchase assets more competitively than other financial institutions. If the CDO has a higher cost of debt or lower leverage, then it will be at a disadvantage to other buyers and will not be brought into existence. If the CDO is created, the rating agency is compensated for its ratings. If the CDO is not created, there is no compensation. My view is that there are very few institutions that can remain objective given such a compensation scheme. CDO bond investors also relied upon the CDO manager to guide them in the dangerous waters of mortgage investing. Here again investors were not well served by the compensation scheme. In many cases CDO managers receive fees that are independent of the performance of the deals they manage. While CDO managers sometimes keep an equity interest in the transactions they manage, the deals are often structured in such a way that that the deal can return the initial equity investment even if some of the bonds have losses. Moreover, many of the CDOs were managed by start-up firms with little or no capital. Nevertheless, much of the responsibility should rest with the investors. CDO bond investors were not blind to the additional risks posed by CDO investing. CDOs generally provided higher yields than similarly rated bonds, and it is an extremely naive, and to my mind, rare, investor who thinks they get higher returns without incremental risk. It is not unusual, however, for investors not to realize the magnitude of additional risk they bear for a modest incremental return. Ultimately it is investors who will bear the losses, and investors must bear the bulk of the burden in evaluating their investments. There were clear warning signs for several years as to the problems and risk of investing in subprime mortgages. Nevertheless, investors continued to participate in this sector as the risks grew and reward decreased. As expressed herein, the primary problem facing securitization is a failure of industrial organization. The key risk allocators in the market, the CDO managers, were too far from the origination process and, at best, they believed the originators and the rating agencies were responsible for limiting risk. At the origination end, without the discipline of a skeptical buyer, abuses grew. The buyer was not sufficiently concerned with the process of loan origination and the broker was not subject to sufficient constraints.Current Conditions of the Mortgage-backed Securities Market More than 2 years after the announcement of the collapse of the Bear Stearns High Grade Structured Credit Enhanced Leverage Fund the mortgage market remains in a distressed state. Little of the mortgage market is functioning without the direct involvement of the U.S. Government, and access to financing for mortgage originators and investors is still limited. Fortunately there are the beginning signs of stabilization of home prices, but rising unemployment threatens the recovery. In the secondary market for mortgage-backed securities there has been considerable recovery in price in some sectors, but overall demand is being propped up by large purchases of MBS by the Federal Reserve Bank. In addition, we find that many of our clients are primarily focused on accounting and regulatory concerns related to legacy positions, and less effort is focused on the economic analysis of current and future opportunities. That situation may be changing as over the past few months we have seen some firms begin to focus on longer term goals.The Effectiveness of Government Action I have not performed an independent analysis of the effectiveness of Government actions, so by comments are limited to my impressions. Government involvement has been beneficial in a number of significant respects. Without Government involvement in Fannie Mae, Freddie Mac, and FHA lending programs, virtually all mortgage lending could have stalled. What lending would have existed would have been for only the absolute highest quality borrowers and at restrictive rates. In addition Government programs to provide liquidity have also been beneficial to the market as private lending was reduced to extremely low levels. Government and Federal Reserve purchases of MBS have kept mortgage rates low. This has probably helped to bolster home prices. On the other hand the start/stop nature of the buying programs under TARP and PPIP has probably been a net negative for the market. Market participants have held back on investments in anticipation of Government programs that either did not materialize or were substantially smaller in scope than expected. Furthermore Government efforts to influence loan modifications, while beneficial for some home owners, and possibly even investors, have created confusion and distrust. Investors are more reluctant to commit capital when the rules are uncertain. In my opinion there has been excessive focus on loan modifications as a solution to the current crisis. Loan modifications make sense for a certain portion of borrowers whose income has been temporarily disrupted or have sufficient income to support a modestly reduce loan amount and the willingness to make those payments. However for many borrowers, loan modifications cannot produce sustainable outcomes. In addition, loan modifications must deal with the complexities of multiple liens and complex ownership structures of mortgage loans. Short sales, short payoffs, and relocation assistance for borrowers are other alternatives that should be given greater weight in policy development. The extensive Government involvement in the mortgage market has likely produced significant positive benefits to the economy. However unwinding the Government role will be quite complex and could be disruptive to the recovery. Government programs need to be reduced and legislative and regulatory uncertainties need to be addressed to attract private capital back into these markets.Legislative and Regulatory Recommendations I believe that the problems in the securitization market were essentially due to a failure of industrial organization. Solutions should address these industrial organization failures. While some may seek to limit the risks in the economy, I believe a better solution is to make sure the risks are borne by parties who have the capacity to manage the risks or the capital to bear those risks. In practical terms, this means that ultimately bond investors, as the creators of leverage, must be responsible for limiting leverage to economically sustainable levels that do not create excessive risk to their stakeholders. Moreover, lenders should not allow equity investors to have tremendous upside with little exposure to downside risk. Equity investors who have sufficient capital at risk are more likely to act prudently. Consequently, all the information needed to assess and manage risks must be adequately disclosed and investors should have assurances that the information they rely upon is accurate and timely. Likewise when the Government acts as a guarantor, whether explicitly or implicitly, it must insure that it is not encouraging excessive risk taking and must have access to critical information on the risks borne by regulated entities. In this light, I would like to comment on the Administration proposals on Securitization in the white paper: ``Financial Regulatory Reform: A New Foundation.'' \5\ Recommendations 1 and 2 cover similar ground:--------------------------------------------------------------------------- \5\ http://www.financialstability.gov/docs/regs/FinalReport_web.pdf pp. 44-46. 1. Federal banking agencies should promulgate regulations that require originators or sponsors to retain an economic interest in a material portion of the credit risk of securitized credit --------------------------------------------------------------------------- exposures. The Federal banking agencies should promulgate regulations that require loan originators or sponsors to retain 5 percent of the credit risk of securitized exposures. 2. Regulators should promulgate additional regulations to align compensation of market participants with longer term performance of the underlying loans. Sponsors of securitizations should be required to provide assurances to investors, in the form of strong, standardized representations and warranties, regarding the risk associated with the origination and underwriting practices for the securitized loans underlying ABS. Clearly excessive leverage and lack of economic discipline was at the heart of the problems with securitization. As described above the market failed to adequately protect investors from weakened underwriting standards. Additional capital requirements certainly should be part of the solution. However, such requirements need to be constructed carefully. Too little capital and it will not have any effect; too much and it will inhibit lending and lead to higher mortgage costs. The current recommendation for retention of 5 percent of the credit risk does not seem to strike that balance appropriately. When a loan is originated there are several kinds of credit related risks that are created. In addition to systematic risks related to future events such as changes in home prices and idiosyncratic risks such as changes in the income of the borrower, there are also operational risks related to the quality of the underwriting and servicing. An example of an underwriting risk is whether or not the borrower's income and current value of their home were verified appropriately. Originators are well positioned to reduce the operational risks associated with underwriting and fight fraud, but they may be less well positioned to bear the long term systematic and idiosyncratic risks associated with mortgage lending. Investors are well positioned to bear systemic risks and diversify idiosyncratic risks, but are not able to assess the risks of poor underwriting and servicing. The securitization process should ensure that there is sufficient motivation and capital for originators to manage and bear the risks of underwriting and sufficient information made available to investors to assess the risks they take on. The current form of representations and warranties is flawed in that it does not provide a direct obligation from the originator to the investor. Instead representations and warranties pass through a chain of ownership and are often limited by ``knowledge'' and capital. In addition current remedies are tied to damages and in a rising home price market calculated damages may be limited. Thus a period of rising home prices can mask declining credit quality and rising violations of representations and warranties. Therefore, incentives and penalties should be established to limit unacceptable behavior such as fraud, misrepresentations, predatory lending. If the goal is to prevent fraud, abuse and misrepresentations rather than to limit risk transfer then there needs to be a better system to enforce the rights of borrowers and investors than simply requiring a originators to retain a set percentage of credit risk. I have proposed \6\ a ``securitization certificate'' which would travel with the loan and would be accompanied by appropriate assurances of financial responsibility. The certificate would replace representations and warranties, which travel through the chain of buyers and sellers and are often unenforced or weakened by the successive loan transfers. The certificate could also serve to protect borrowers from fraudulent origination practices in the place of assignee liability. Furthermore the certificate should be structured so that there are penalties for violations regardless of whether or not the investor or the borrower has experienced financial loss. The record of violations of these origination responsibilities should publically available.--------------------------------------------------------------------------- \6\ http://www.ad-co.com/newsletters/2008/Feb2008/Credit_Feb08.pdf and ``Securitization: After the Fall'', Anthony Sanders and Andrew Davidson, forthcoming.--------------------------------------------------------------------------- I have constructed a simple model of monitoring fraudulent loans. \7\ Some preliminary results are shown in Table 1. These simulations show the impact of increasing the required capital for a seller and of instituting a fine for fraudulent loans beyond the losses incurred. These results show that under the model assumptions, without a fine for fraud, sellers benefit from originating fraudulent loans. The best results are obtained when the seller faces fines for fraud and has sufficient capital to pay those fines. The table below shows the profitability of the seller and buyer for various levels of fraudulent loans. In the example below, the profits of the seller increase from .75 with no fraudulent loans to .77 with 10 percent fraudulent loans, even when the originator retains 5 percent capital against 5 percent of the credit risk. On the other hand, the sellers profit falls from .75 to .44 with 10 percent fraudulent loans even though the retained capital is only 1 percent, but there is a penalty for fraudulent loans. Thus the use of appropriate incentives can reduce capital costs, while increasing loan quality.--------------------------------------------------------------------------- \7\ The IMF has produced a similar analysis and reached similar conclusions. http://www.imf.org/external/pubs/ft/gfsr/2009/02/pdf/chap2.pdf.[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] Under this analysis the Treasury proposals would not have a direct effect on fraud. In fact, there is substantial risk the recommended approach of requiring minimum capital requirements for originators to bear credit risk would lead to either higher mortgage rates or increased risk taking. A better solution is to create new mechanisms to monitor and enforce the representations and warranties of originators. With adequate disclosure of risks and a workable mechanism for enforcing quality controls the securitization market can more effectively price and manage risk. Recommendation 3 addresses the information available to investors: 3. The SEC should continue its efforts to increase the transparency and standardization of securitization markets and be given clear authority to require robust reporting by issuers of asset backed securities (ABS). Increased transparency and standardization of securitization markets would likely to better functioning markets. In this area, Treasury charges the SEC and ``industry'' with these goals. I believe there needs to be consideration of a variety of institutional structures to achieve these goals. Standardization of the market can come from many sources. Possible candidates include the SEC, the American Securitization Forum, the Rating Agencies and the GSEs, Fannie Mae and Freddie Mac. I believe the best institutions to standardize a market are those which have an economic interest in standardization and disclosure. Of all of these entities the GSEs have the best record of standardizing the market; this was especially true before their retained portfolios grew to dominate their income. (As I will discuss below, reform of the GSEs is essential for restoring securitization.) I believe a revived Fannie Mae and Freddie Mac, limited primarily to securitization, structured as member-owned cooperatives, could be an important force for standardization and disclosure. While the other candidates could achieve this goal they each face significant obstacles. The SEC operates primarily through regulation and therefore may not be able to adapt to changing markets. While the ASF has made substantial strides in this direction, the ASF lacks enforcement power for its recommendations and has conflicting constituencies. The rating agencies have not shown the will or the power to force standardization, and such a role may be incompatible with their stated independence. Recommendations 4 and 5 address the role of rating agencies in securitization. 4. The SEC should continue its efforts to strengthen the regulation of credit rating agencies, including measures to require that firms have robust policies and procedures that manage and disclose conflicts of interest, differentiate between structured and other products, and otherwise promote the integrity of the ratings process. 5. Regulators should reduce their use of credit ratings in regulations and supervisory practices, wherever possible. In general I believe that the conflicts of interest facing rating agencies and their rating criteria were well known and easily discovered prior to the financial crisis. Thus I do not believe that greater regulatory authority over rating agencies will offer substantial benefits. In fact, increasing competition in ratings or altering the compensation structure of rating agencies may not serve to increase the accuracy of ratings, since most users of ratings issuers as well as investors are generally motivated to seek higher ratings. (Only if the regulatory reliance on rating agencies is reduced will these structural changes be effective.) To the extent there is reliance on rating agencies in the determination of the capital requirement for financial institutions, a safety and soundness regulators for financial institutions, such the FFIEC or its successor, should have regulatory authority over the rating agencies. Rather than focus on better regulation, I support the second aspect of Treasury's recommendations on rating agencies (recommendation 5) and believe it would be better for safety and soundness regulators to reduce their reliance on ratings and allow the rating agencies to continue their role of providing credit opinions that can be used to supplement credit analysis performed by investors. To reduce reliance on ratings, regulators, and others will need alternative measures of credit and other risks. I believe that the appropriate alternative to ratings is analytical measures of risk. Analytical measures can be adopted, refined, and reviewed by regulators. In addition regulators should insist that regulated entities have sufficient internal capacity to assess the credit and other risks of their investments. In this way regulators would have greater focus on model assumptions and model validation and reduced dependence on the judgment of rating agencies. The use of quantitative risk measures also requires that investors and regulators have access to sufficient information about investments to perform the necessary computations. Opaque investments that depend entirely upon rating agency opinions would be clearly identified. Quantitative measures can also be used to address the concerns raised in the report about concentrations of risk and differentiate structured products and direct corporate obligations. I recently filed a letter with the National Association of Insurance Commissioners on the American Council of Life Insurers' proposal to use an expected loss measure as an alternative to ratings for nonagency MBS in determining risk based capital. Here I would like to present some of the key points in that letter: An analytical measure may be defined as a number, or a value, that is computed based on characteristics of a specific bond, its collateral and a variety of economic factors both historical and prospective. One such analytical measure is the probability of default and another measure is the expected loss of that bond. While an analytical measure is a numeric value that is the result of computations, it should be noted that there may still be some judgmental factors that go into its production. In contrast, a rating is a letter grade, or other scale, assigned to a bond by a rating agency. While ratings have various attributes, generally having both objective and subjective inputs, there is not a particular mathematical definition of a rating. Analytical measures may be useful for use by regulators because they have several characteristics not present in ratings. 1. An analytical measure can be designed for a specific purpose. Specific analytical measures can be designed with particular policy or risk management goals in mind. Ratings may reflect a variety of considerations. For example, there is some uncertainty as to whether ratings represent the first dollar of loss or the expected loss, or how expected loss is reflected in ratings. 2. Analytical measures can be updated at any frequency. Ratings are updated only when the rating agencies believe there has been sufficient change to justify an upgrade, downgrade or watch. Analytical measures can be computed any time new information is available and will show the drift in credit quality even if a bond remains within the same rating range. 3. Analytical measures can take into account price or other investor specific information. Ratings are computed for a bond and generally reflect the risk of nonpayment of contractual cash flows. However, the risk to a particular investor of owning a bond will at least partially depend on the price that the bond is carried in the portfolio or the composition of the portfolio. 4. Regulators may contract directly with vendors to produce analytical results and may choose the timing of the calculations. On the other hand, ratings are generally purchased by the issuer at the time of issuance. Not only may this introduce conflicts of interest, but it also creates a greater focus on initial ratings than on surveillance and updating of ratings. In addition, once a regulator allows the use of a particular rating agency it has no further involvement in the ratings process. 5. Analytical measures based on fundamental data may also be advantageous over purely market-based measures. As market conditions evolve values of bonds may change. These changes reflect economic fundamentals, but may also reflect supply/ demand dynamics, liquidity and risk preferences. Measures fully dependent on market prices may create excessive volatility in regulatory measures, especially for companies with the ability to hold bonds to maturity. Even if regulators use analytical measures of risk, ratings from rating agencies as independent opinions would still be valuable to investors and regulators due to the multifaceted nature of ratings and rating agency analysis can be used to validate the approaches and assumptions used to compute particular analytical measures. Additional measures beyond the credit risk of individual securities such as stress tests, market value sensitivity and measures of illiquidity may also be appropriate in the regulatory structure. The use of analytical measures rather than ratings does not eliminate the potential for mistakes. In general, any rigid system can be gamed as financial innovation can often stay ahead of regulation. To reduce this problem regulation should be based on principles and evolve with the market. Regulators should always seek to build an a margin of safety as there is always a risk that the theory underlying the regulatory regime falls short and that some participants will find mechanisms to take advantage of the regulatory structure. Finally, as discussed by the Administration in the white paper, the future of securitization for mortgages requires the resolution of the status of Fannie/Freddie and role of FHA/GNMA. As stated above, I believe that continuation of Fannie Mae and Freddie Mac as member owned cooperatives would serve to establish standards, and provide a vehicle for the delivery of Government guarantees if so desired. The TBA, or to be announced, market has been an important component in the success of the fixed rate mortgage market in the United States. Careful consideration should be given to the desirability of fixed rate mortgages and the mechanisms for maintaining that market in discussions of the future of the GSEs. ______ CHRG-111hhrg54868--84 Mr. Scott," Thank you, Mr. Chairman. Let me ask, it is a great pleasure to have the three of you here, who are our primary regulators in our system. But I would like to take the gist of my questions on the state of the economy now. Because in the final analysis, a major reason why we are putting these financial reforms in place is to, quite honestly, save our economy and our financial system. But if I am the American people out watching us and trying to glean something from what is a very complex, complicated issue, our report card for the American people would get an ``F'' right now. And I want to ask you, Ms. Bair, Comptroller Dugan, Mr. Bowman, and also you, Mr. Smith, why are we at the state that we are after spending $700 billion in TARP money, $700 billion in bailout money, $700 billion in economic recovery? We are looking at almost $2 trillion that we directly put out within the last 7 or 8 months, and yet, as you and I have discussed, Ms. Bair, and I would like for you to lead off, because the indicators are not very good for us. Home foreclosures are still ratcheting through the roof. Bank closings are at a record rate, especially in my home State of Georgia. Unemployment is at 10 percent, and in some areas at Depression levels. Banks that we are supervising and you are regulators of are not lending, particularly to small businesses, therefore bringing out bankruptcies there. So to me, the American people are probably saying, what good does it do for us to be sitting up dealing with these regulatory reforms when, in fact, where is the report on what we have been doing? Why is it that we can't see the jobless numbers go down? Why is it that banks are not moving to mitigate loans? Why is it that banks are not restructuring? And at the same time that this is happening, many of them are going back to their same old ways of bonuses and salaries. The American people have a right to be very angry. So could you please respond to why we are in the state we are in? And what are we doing to get these banks to unleash this money and make loans and mitigate loans so that people can--we can really stimulate the economy and keep people in their homes? I think if we do that, that is the way in which we are going to stop all of these bank foreclosures and small businesses going into bankruptcy. And Ms. Bair, I would particularly like for you, because we moved to give the FDIC the authority and funding to move within the foreclosure area particularly to deal with this area, could you really tell us how we are progressing there, and why we are not doing more? Ms. Bair. Well, a couple of things. Regarding loan modifications, that is something certainly we advocated. And some of the work we did with the IndyMac loan modification program was used by Treasury and HUD to launch their own HAMP program. This is not something we are doing, though we support it and have tried to provide technical assistance. They estimate they can get about 500,000 loans modified in the near future. It is making a dent, but it was never meant to be the complete cure. It is not, but it can help a significant number of folks stay in their homes. To get banks to lend, we have taken a number of steps. We are asking our examiners to do a lot. There was some bad lending going on. There was some lending based on rising collateral values that shouldn't have happened. So, because there was too much credit out there, there needed to be some type of pull back. But the challenge is to make sure it doesn't pull back so far that the credit-worthy loans, the prudent loans, are not being made. We have tried to strike this balance with our examiners. We want our banks to lend. We want prudent lending. But, we don't want them to overreact. There are a lot of cross-currents. There are a lot of people saying that regulation wasn't tough enough; we need to be tougher. And there are other people saying, you are being too tough. It is a hard balance to strike. We have tried to provide clarity in a number of key areas. We have said very specifically that we want commercial loans restructured also. We want small business loans restructured, too. Loss mitigation is a good business practice, whether it is for residential mortgages or commercial mortgages. That needs to be disclosed and done properly. We want the appropriate loans restructured. We don't want good loans written down just because the collateral value has fallen. We don't want that to happen. We have made that very clear. " CHRG-111hhrg54867--129 Mr. Castle," Along the same lines, worrying about the CFPA, I am concerned about the whole mission creep aspect of this. There are clearly problems, and you are absolutely right; I think we all agree there are things we need to do. I am concerned about mortgages. That could have been spelled out better. We have already dealt with credit cards to a degree, and the Federal Reserve actually had a good plan on credit cards, which we pretty much emulated to a degree. And there are subjects like student loans, which may go by the wayside if the new legislation on direct lending goes through the Senate, etc. But there are many things that financial institutions, particularly banks, do that have not been questioned in terms of how they carried out--commercial lending, I don't think, has been questioned; the way they handled deposits, for example, even auto loans. And you could go through perhaps 10 or 12 subjects. And I am concerned that if we get a very activist agency, that the agency may go beyond where it belongs and all of a sudden be disruptive to normal banking procedures in the United States. I cannot tell you what percentage of customers were actually impacted negatively by problems that perhaps could have been prevented. My hunch is it is a relatively small percentage, versus those satisfied with their banking. But at agencies like this concerns me and the authority that we are giving them. Do you have any thoughts about how to restrict what they could do, other than, obviously, we could do it legislatively, or are taking that up with the Administration as you prepare-- " FinancialCrisisReport--425 In May 2007, Goldman’s Structured Product Group (SPG) continued to work to cover the Mortgage Department’s short position by offering to take the long side of CDS contracts referencing RMBS and CDO securities, but found few buyers. Many market participants had already shorted subprime mortgage assets, driving the price relatively high, and few wanted to buy additional short positions at the prevailing price. In order to turn the situation to its benefit, SPG’s traders attempted to carry out a “short squeeze” of the subprime CDS market in May 2007. 1737 The ABS Desk’s traders were already offering single name CDS contracts in which Goldman would take the long position, in order to cover the Mortgage Department’s short position. 1738 To effectuate a short squeeze, they appear to have decided to offer the short positions on those contracts at lower and lower prices, in order to drive down the market price of subprime CDS shorts to artificially low levels. Once prices fell below what the existing CDS holders had paid for their short positions, the CDS holders would have to record a loss on their holdings and might have to post additional cash collateral with their opposing long parties. Goldman hoped the CDS holders would react by selling their short positions at the lower market price. When the sell off was large enough and the price low enough, Goldman planned to move in and buy more shorts for itself at the artificially low price. This short-squeeze strategy was later laid out in a 2007 performance self-evaluation by one of the traders on Goldman’s ABS Desk who participated in the activity, Deeb Salem. In the self- evaluation he provided to senior management, Mr. Salem wrote: “In May, while we were remain[ing] as negative as ever on the fundamentals in sub-prime, the market was trading VERY SHORT, and susceptible to a squeeze. We began to encourage this squeeze, with plans of getting very short again, after the short squeezed [sic] cause[d] capitulation of these shorts. This strategy seemed do-able and brilliant, but once the negative fundamental news kept coming in at a tremendous rate, we stopped waiting for the shorts to capitulate, and instead just reinitiated shorts ourselves immediately.” 1739 When interviewed by the Subcommittee, Mr. Salem denied that the ABS Desk ever intended to squeeze the market, and claimed that he had wrongly worded his self-evaluation. 1740 He said that reading his self-evaluation as a description of an intended short squeeze put too much emphasis on “words.” 1741 1737 1738 See, e.g., Salem 2007 Self-Review. See, e.g. 4/5/2007 email from Deeb Salem, “let’s sell ~200mm in Baa2 protection . . .,” GS MBS-E-004516519 (Mr. Swenson ’s reply: “Make that 500mm ”). 1739 1740 1741 Deeb Salem 2007 Self-Review [emphasis in original]. Subcommittee interview of Deeb Salem (10/6/2010). Id. fcic_final_report_full--515 Table 10. 114 GSEs’ Success in Meeting Affordable Housing Goals, 1996-2007 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 Low & Mod 40% 42% 42% 42% 42% 50% 50% 50% 50% 52% 53% 55% 56% Housing Goals Fannie Actual 45% 45% 44% 46% 50% 51% 52% 52% 53% 55% 57% 56% 54% Freddie Actual 41% 43% 43% 46% 50% 53% 50% 51% 52% 54% 56% 56% 51% Special 12% 14% 14% 14% 14% 20% 20% 20% 20% 22% 23% 25% 27% Affordable Goal Fannie Actual 15% 17% 15% 18% 19% 22% 21% 21% 24% 24% 28% 27% 26% Freddie Actual 14% 15% 16% 18% 21% 23% 20% 21% 23% 26% 26% 26% 23% Underserved 21% 24% 24% 24% 24% 31% 31% 31% 31% 37% 38% 38% 39% Goal Fannie Actual 25% 29% 27% 27% 31% 33% 33% 32% 32% 41% 43% 43% 39% Freddie Actual 28% 26% 26% 27% 29% 32% 31% 33% 34% 43% 44% 43% 38% As the table shows, Fannie and Freddie exceeded the AH goals virtually each year, but not by significant margins. They simply kept pace with the increases in the goals as these requirements came into force over the years. This alone suggests that they did not increase their purchases in order to earn profits. If that was their purpose they would have substantially exceeded the goals, since their financial advantages (low financing costs and low capital requirements) allowed them to pay more for the mortgages they wanted than any of their competitors. As HUD noted in 2000: “Because the GSEs have a funding advantage over other market participants, they have the ability to underprice their competitors and increase their market share .” 115 As early as 1999, there were clear concerns at Fannie about how the 50 percent LMI goal—which HUD had signaled as its next move—would be met. In a June 15, 1999, memorandum, 116 four Fannie staff members proposed three categories of rules changes that would enable Fannie to meet the goals more easily: (i) persuade HUD to change the goals accounting (what goes into the numerator and denominator); (ii) enter other businesses where the pickings might be goals- rich, such as manufactured housing and, significantly, Alt-A and subprime (“Efforts to expand into Alt-A and A-markets (the highest grade of subprime lending) should also yield incremental business that will have a salutary effect on our low-and moderate-income score”); and (iii) persuade HUD to adopt different methods of goals scoring. By 2000, Fannie was effectively in competition with banks that were required to make mortgage loans under CRA to roughly the same population of low-income borrowers targeted in HUD’s AH goals. Rather than selling their CRA loans to Fannie and Freddie, banks and S&Ls had begun to retain the loans in portfolio. In a presentation in November 2000, Barry Zigas, a Senior Vice President of Fannie, noted that “Our own anecdotal evidence suggests that this increase [in banks’ and 114 FHFA Mortgage Market Note 10-2, http://www.fhfa.gov/webfiles/15408/Housing%20Goals%201996- 2009%2002-01.pdf.pdf. 115 http://frwebgate.access.gpo.gov/cgi-bin/getdoc.cgi?dbname=2000_register&docid=page+65093 -65142. 116 Bell, Kinney, Kunde and Weech, through Zigas and Marks internal memo Frank Raines, “RE: HUD Housing Goals Options,” June 15, 1999. 511 CHRG-110hhrg41184--110 Mr. Watt," Thank you, Mr. Chairman. Welcome, Chairman Bernanke. In the 108th Congress, Congressman Brad Miller and I introduced the first predatory lending bill as H.R. 3974. In the 109th Congress, we introduced it in 2005 as H.R. 1182. The regulators weren't paying much attention to this, say minimizing the significance of it, and it took a crisis to finally get a bill passed. My concern is that looking finally at the last page of your testimony, you finally reached the credit card part of the equation, one paragraph, and my concern is that a lot of people who are seeing their credit dry up on the mortgage side are getting more and more credit on the credit card side, and that could portend potentially a similar kind of effect in the credit card market as we have seen in the mortgage market. Now I have not yet signed on to Ms. Maloney's bill, because we are still looking at it, but I have been meeting with industry participants, and one of the things that they have said is that we should give them more time for the regulator to do more. That is the same argument that we were hearing back in 2004 and 2005 and 2006: Give the regulators more time. And I asked them, does the regulator have enough authority to really do anything if they were inclined to do something? And it appears to me from page 9 of your testimony, the one paragraph we have, the only authority you appear to have is the Federal Trade Commission Act, or the Truth in Lending Act, which is a disclosure act. Actually the Truth in Lending Act is the one that is under your authority, which is a disclosure statute. I'm not even going to get into the issue that Ms. Maloney raised, do you think we need to do something, but tell me what authority the regulators would need, what authority would you need to be more aggressive in this area, as we were trying to get the Fed to be in 2004 and 2005 in the mortgage area? Even if you were inclined to be more aggressive, if you didn't have the authority, you really couldn't do it, and one of the concerns I'm seeing is that disclosure won't do everything. Unfair and Deceptive Trade Practices won't do anything if both of those things are required. Some things are unfair that are not necessarily deceptive. What kind of additional authority should we be considering giving to the Fed or to somebody, some regulator if it's not the Fed, and to whom in this area? " FinancialCrisisReport--265 Although neither Moody’s nor S&P produced documentation on its internal decision- making process related to the mass downgrades, one bank, UBS, produced an email in connection with a court case indicating that Moody’s was meeting with a series of investment banks to discuss the upcoming downgrades. In an email dated July 5, 2007, five days before the mass downgrades began, a UBS banker sent an email to a colleague about a meeting with Moody’s: “I just got off the phone with David Oman …. Apparently they’re meeting w/ Moodys to discuss impacts of ABS subprime downgrades, etc. Has he been in contact with the [UBS] Desk? It sounds like Moodys is trying to figure out when to start downgrading, and how much damage they’re going to cause – they’re meeting with various investment banks.” 1027 It is unclear how much notice Moody’s or S&P provided to investment banks regarding their planned actions. One senior executive at S&P, Ian Bell, the head of European structured finance ratings, provided his own views in a post-mortem analysis a few days after the initial downgrades. He expressed frustration and concern that S&P had mishandled its public explanation of the mass downgrades, writing: “[O]ne aspect of our handling of the subprime that really concerns me is what I see as our arrogance in our messaging. Maybe it is because I am away from the center of the action and so have more of an ‘outsider’s’ point of view. … I listened to the telecon TWICE. That guy [who asked a question about the timing of the mass downgrades] was not a ‘jerk’. He asked an entirely legitimate question that we should have anticipated. He then got upset when we totally fluffed our answer. We did sound like the Nixon White House. Instead of dismissing people like him or assuming some dark motive on their part, we should ask ourselves how we could have so mishandled the answer to such an obvious question. I have thought for awhile now that if this company suffers from an Arthur Andersen event, we will not be brought down by a lack of ethics as I have never seen an organisation more ethical, nor will it be by greed as this plays so little role in our motivations; it will be arrogance.” 1028 In August 2007, Eric Kolchinsky, a managing director of Moody’s CDO analysts, sent an urgent email to his superiors about the pressures to rate still more new CDOs in the midst of the mass downgrades: 1027 7/5/2007 email from David Goldsteen (UBS) to Dayna Corlito (UBS), “ABS Subprime & Moody’s downgrades,” UBS-CT 021485, Hearing Exhibit 4/23-94o. 1028 7/13/2007 internal S&P email from Ian Bell to Tom Gillis and Joanne Rose, Hearing Exhibit 4/23-54a. “[E]ach of our current deals is in crisis mode. This is compounded by the fact that we have introduced new criteria for ABS CDOs. Our changes are a response to the fact that we are already putting deals closed in the spring on watch for downgrade. This is unacceptable and we cannot rate the new deals in the same away [sic] we have done before. ... [B]ankers are under enormous pressure to turn their warehouses into CDO notes.” 1029 FinancialCrisisReport--8 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 (CDO). 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 that were 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.” CHRG-111hhrg50289--44 Mr. Luetkemeyer," Thank you, Madam Chairwoman. Ms. Blankenship, you made a comment a minute ago and during your testimony with regards to the impact of regulatory authorities coming into the bank. Can you elaborate on that a little bit more? Ms. Blankenship. Certainly. What we have seen is just because of the past six months and the financial meltdown that we are all getting painted with the same brush, and while the big banks got bailed out and were given the TARP money, their primary intent for that was to lend money. But yet what we are hearing from small businesses is that they cannot get it. This is a double-edged sword because the banks are willing to lend. They have capital to lend. We have heard that here today, and that continues to be true the community banks, but the examiners are painting us all with one brush. They are painting the small banks the same way they do the two big to fail banks. And so when they come in and say, ``Okay. If you have got commercial real estate,'' and we have heard stories like this, ``we are going to classify it across the board,'' well, even if you are using an SBA program for our reporting purposes, that has to be reported as commercial real estate, and if you have a regional office, regardless of what the mandate is from Washington, sometimes the examiners in the field do not always carry the same operating procedures and practices as we hear out of the head offices in Washington. So it can make banks hesitant to make those types of loans because at a time like this, we cannot afford for perhaps you are a well capitalized bank, and if you have certain classifications, your ratings go down and you fall into adequately capitalized. Then your FDIC assessment goes up, and all of our costs. There is a tremendous amount of cost being levied on the small banks right now. " CHRG-110hhrg41184--76 The Chairman," The gentlewoman from California. Ms. Waters. Thank you very much, Mr. Chairman, for holding this hearing, and I thank Chairman Bernanke for once again being here and helping us to understand his vision for how we deal with our economy, and, of course, we are all pretty much focused on the subprime crisis, because I think we all understand the role that it is playing in our economy--the negative role that it is playing in our economy at this time. Yesterday, Mr. Bernanke, we had some economists here testifying before this committee, and there was some discussion about the role of regulatory agencies, and some discussion about public policymakers and whether or not we were going to overdo it and come up with new laws that may prove to be harmful to the overall industry and thus the economy. And let me just say that I think that you have been very forthcoming in talking about some missed opportunities maybe early on, you know, with maybe what could have been done based on information that regulatory agencies should have known about, should have had access to, should have acted on. So that is behind us, but I am concerned about voluntary efforts by the financial institutions who have some role in responsibility in the subprime crisis. For example, I held a hearing where Countrywide said that it had made 18 million contacts, had done 60,000 workouts, and out of that, there were 40,000 loan modifications. This other coalition called HOPE NOW said they had done 545,000 workouts, 150 loan modifications, and 72 percent of these were what we found, that 72 percent of these were kind of repayment plans and they were not real modifications. Now we are trying to act on the best information. And here we have these voluntary efforts that are representing to us that they are making these contacts. They are doing these workouts, and we look at this. We don't see it in our communities. We don't have people who are saying that they got a workout that made good sense and that they had been contacted. How can you help us if we are to have any faith in voluntary efforts at all and not get so focused on trying to produce laws that will do some corrections? How can you help us with determining whether or not this information we are getting is true; whether or not they are doing these workouts; whether or not they are doing this outreach. What do you do to track this voluntary effort? " CHRG-111shrg57322--125 Mr. Sparks," Senator, I did not mean to imply that we did not know anything. We had a team that did diligence to understand originators and loan packages that we bought. But I would like to make the point---- Senator Kaufman. Sure. Mr. Sparks [continuing]. That that team may have liked that risk and, in fact, did. And on that deal---- Senator Kaufman. Liked the risk that somebody could go in and originate a loan just on their stated income that 90 percent--the stated income started out as something that was for high-wealth individuals. It was a very small percentage. But starting around 2005, 2006, it grew and grew and grew. But when you are talking about 90 percent of the prime home equity loans, 73 percent of the Option ARMs, and 50 percent of the subprime loans where the basis for income for the borrower is what they say their income is. " CHRG-111shrg57320--85 Mr. Rymer," Well, I think the bank employees as they found it would have an obligation to complete a Suspicious Activity Report and that would work its way up through to the Justice Department. Senator Kaufman. But if they didn't, would the regulators do--clearly in this example, everybody--if, in fact, there was fraud--everybody was doing well. We had a report yesterday where it showed that the compensation for people that did the Option ARMs and subprime, they were compensated better if, in fact, they could turn up more mortgages in that market. So it is in nobody's interest in the bank--you don't even hear about it. I mean, this isn't even up here on the things where people are talking about what the bank is doing. And the regulations in the report that they are doing way too many stated income loans, as far as I know, anyway, it wasn't raised the other day and I am not seeing it anywhere else. So nobody in the bank was worried about the risk regulators. Mr. Vanasek and Mr. Cathcart were concerned. So how does it work, then? Does the regulator, is this up to OTS to make the referral? " fcic_final_report_full--578 Greater Bakersfield, session 2: Local Banking, transcript, p. 60. 107. Gary Witt, testimony before the FCIC, Hearing on the Credibility of Credit Ratings, the Invest- ment Decisions Made Based on Those Ratings, and the Financial Crisis, session 1: The Ratings Process, June 2, 2010, transcript, p. 41. 108. Moody’s Investors Service, “Introducing Moody’s Mortgage Metrics: Subprime Just Became More Transparent,” September 7, 2009. 109. David Teicher, Moody’s Investors Service, interview by FCIC, May 4, 2010; “Moody’s Mortgage Metrics: A Model Analysis of Residential Mortgage Pools,” April 1, 2003. 110. Jay Siegel, interview by FCIC, May 26, 2010. 111. Teicher, interview. 112. Jay Siegel, testimony before the FCIC, Hearing on the Credibility of Credit Ratings, the Invest- ment Decisions Made Based on Those Ratings, and the Financial Crisis, session 1: The Ratings Process, June 2, 2010, transcript, p. 29. 113. Roger Stein, interview by FCIC, May 26, 2010. 114. Moody’s Investors Service, “Introducing Moody’s Mortgage Metrics.” 115. Stein, interview. 116. Jerome Fons, interview by FCIC, April 22, 2010. 117. Moody’s Rating Committee Memorandum, August 29, 2006. 118. FCIC staff estimates based on analysis of Moody’s PDS database. 119. Invoice from Moody’s Investors Service to Susan Mills, Citigroup Global Markets Inc., October 12, 2006. 120. Standard & Poor’s, Global New Issue Billing Form, Citigroup Mortgage Loan Trust 2006-NC2, September 28, 2006. 121. FCIC staff estimates based on analysis of Moody’s SFDRS data as of April 2010. 122. Chris Cox, SEC chairman, prepared testimony before the Senate Banking Committee, 109th Cong., 2nd sess., June 15, 2006; “Freddie Mac, Four Former Executives Settle SEC Action Relating to Multi-Billion Dollar Accounting Fraud,” SEC press release, September 27, 2007. 123. James Lockhart, director, FHFA, speech to American Securitization Forum in Las Vegas, New Mexico, February 9, 2009 (p. 2, slide 4 of presentation shows the chart). 124. OFHEO Special Examination Report, December 2003. 125. In 2006, OFHEO issued its final Report of the Special Examination of Fannie Mae . OFHEO said that management engaged in numerous acts of misconduct, involving well over a dozen different forms of accounting manipulation and violations of generally accepted accounting principles. As in the case of Freddie, OFHEO said Fannie’s management sought to hit ambitious earnings-per-share targets that were linked to their own compensation. 126. Donald Bisenius, interview by FCIC, September 29, 2010. 127. Mortgage Market Statistical Annual 2009 . 128. See Tables 5.1/5.2 in FHFA Conservatorship report for third-quarter 2010. 129. OFHEO Special Examination Report, September 2004, pp. 9–10. 130. Ibid., pp. 2, 10. 131. OFHEO, “2005 Report to Congress,” June 15, 2005, p. 15. 575 132. Alan Greenspan, testimony before the FCIC, Hearing on Subprime Lending and Securitization and Government-Sponsored Enterprises (GSEs), day 1, session 1: The Federal Reserve, April 7, 2010, transcript, p. 13. 133. FHFA, “Mortgage Market Note: Goals of Fannie Mae and Freddie Mac in the Context of the CHRG-111shrg62643--229 RESPONSES TO WRITTEN QUESTIONS OF SENATOR DEMINT FROM BEN S. BERNANKEQ.1. In the past months, the European Central Bank has spent billions of dollars to purchase sovereign debt from overleveraged EU countries, in essence bailing out these countries by supporting their ability to continue to finance further debt rather than impose needed budgetary discipline. Prior to this program, the ECB, through liquidity facilities, was accepting sovereign debt collateral from European banks. Here at home in the U.S., some States and municipalities have similarly overleveraged themselves and failed to make the difficult decisions necessary to get their finances in order--the clearest example being the States of Illinois and California. Being concerned that the Federal Reserve could choose to pursue a similar course, is it your opinion that the Fed has the authority: a. To accept municipal debt as collateral from commercial or investment banks? b. To create a special lending facility for private-sector purchases of municipal bonds, similar to what the Fed did in 2009 for commercial real estate securitizations? c. To guarantee or directly purchase municipal bonds in the secondary market, similar to the purchase program for the more than $1 trillion of mortgage-backed securities now on the Fed's balance sheet? d. To lend directly to overleveraged States or municipalities?A.1. Answer not received by time of publication.Q.2. If your answer to any of Question Number 1's subparts is yes, please explain, for each and with specific references, from where this authority is derived?A.2. Answer not received by time of publication.Q.3. Would you ever support any of the following courses of action for the Federal Reserve: a. To accept municipal debt as collateral from commercial or investment banks? b. To create a special lending facility for private-sector purchases of municipal bonds, similar to what the Fed did in 2009 for commercial real estate securitizations? c. To guarantee or directly purchase municipal bonds in the secondary market, similar to the purchase program for the more than $1 trillion of mortgage-backed securities now on the Fed's balance sheet? d. To lend directly to overleveraged States or municipalities?A.3. Answer not received by time of publication.Q.4. If your answer to any of Question Number 3's subparts is yes, please explain your rationale for each.A.4. Answer not received by time of publication. ------ CHRG-111shrg57322--1210 Mr. Blankfein," No, inherent, not inherited. Senator Levin. Both. Much of it was inherited, right? They were in your inventory, and some of it for a long time, but OK. You don't know the breakdown of it. I am going to keep reading. ``Because starting early in 2007, our mortgage trading desk started putting on big short positions.'' OK. Those aren't my words. Those are Goldman Sachs' words. ``Big short positions, mostly using the ABX, which is a family of indices designed to replicate cash bonds, and did so in enough quantity that we were net short and made money, substantial money in the third quarter as the subprime market weakened. This remains our position today.'' That is your Tax Department's presentation. You made ``substantial money in the third quarter.'' I am sorry, that was the Chief Risk Officer who said this in an internal presentation to Goldman's Tax Department, to be perfectly accurate. Then you did that Form 8-K filing, which we have already read about, talking about you did very well that year. You did very well because you had a big short. And then Exhibit 45.\2\ That is the conference call that Goldman held for the third quarter of 2007. ``Our risk bias from that market was to be short and that net short position was profitable.'' No hedge there. Profitable because of our short position.--------------------------------------------------------------------------- \2\ See Exhibit No. 45, which appears in the Appendix on page 349.--------------------------------------------------------------------------- Then there is that September conference call. Let me go on. Now, what had happened is that you had a meeting with your Board of Directors--I assume that you would have been there--in March 2007. That is Exhibit 22.\3\ You had made a decision. There were big problems, we have heard all day long, about the subprime sector, about mortgages, and that shows on page 8 of Exhibit 22, if we are together. The first quarter: ``Long position grows with increased market activity.'' This is back in 2006, first and second quarter of 2006. Do you see that arrow? Going back to 2006, you reported------------------------------------------------------------------------------- \3\ See Exhibit No. 22, which appears in the Appendix on page 276.--------------------------------------------------------------------------- " CHRG-110hhrg46591--347 Mr. Washburn," Could you go back over my question? Ms. Bean. Sure. Yours was on mortgage reform which eliminated risky lending practices, put liability to the securitizers so they would make sure the originators did what they were supposed to do to avoid that liability; is that a good thing, is that what we need now? Or do we need something else, because I think that bill would have addressed it. And second, if we had done it, would we have avoided some of this fallout? " CHRG-111hhrg53244--73 Mr. Baca," Okay. In the second paragraph, you state that, ``These actions have softened the economic impact of the financial crisis. They have also improved the functioning of key credits, including the market for interbank lending, commercial papers, consumer, small lot, business credit, residential mortgages.'' How does that impact, then, those whoe in foreclosure right now? " CHRG-111shrg57322--782 Mr. Broderick," Yes, it does. Senator Levin. OK. Take a look at page 2, the fourth full paragraph. I am going to read it to you. ``So what happened to us? A quick word on our own market and credit risk performance in this regard. In market risk - you saw in our 2nd and 3rd qtr results that we made money despite our inherently long cash positions. - because starting early in '07 our mortgage trading desk started putting on big short positions,''--big short positions--``mostly using the ABX index, which is a family of indicies designed to replicate cash bonds. And did so in enough quantity that we were net short, and made money (substantial $$ in the 3rd quarter) as the subprime market weakened. (This remains our position today)'' Was that accurate when you wrote it? " CHRG-111shrg56415--39 Mr. Tarullo," So, Senator, I don't want to step on the prerogatives of the Congress, the Administration, various agencies that may have---- Senator Bennet. You can step on my prerogatives. I---- " Mr. Tarullo,"----but here is what I think. So what did we as a government, as a country, try to do with residential mortgages--not yet as successfully as I think many people would have wanted? We tried to do something about people losing their homes and to provide some mechanisms, some special mechanisms that would address those issues specifically, even as we all tried to put a foundation under the economy and get it growing again. And my thought was that something similar probably needs to be done in the small business arena, because I don't think I hear as many of the stories as you do, but I hear enough of them, because I do try to get out and talk to borrowers as well as lenders. So, whether that is trying to streamline SBA lending and make the direct lending possibilities more real, or whether it is a new program which tries to provide guarantees, I don't have a strong view on that and the Federal Reserve certainly has no view on it. But I do think that something targeted is going to be an important complement to the macro, bank regulatory, and TALF efforts that we have. Senator Bennet. Does anyone else have a view on that? Mr. Smith? " FOMC20080310confcall--89 87,MR. LACKER.," Scott, I'd like you to elaborate a bit on this last part. This was a little confusing. This lending apparently is by the New York Bank. How does it relate to the System Open Market Account? Is it by the New York Bank out of the System Open Market Account? " CHRG-111hhrg53244--117 Mr. Bernanke," The Fed on book value is a little bit underwater on the AIG, Bear Stearns interventions, which we would very much not liked to have done, but we didn't have the resolution regime. On all other lending and all other programs, which is more than 95 percent of our balance sheet, we are making a nice profit, which we are sharing with the Treasury. " FOMC20060510meeting--49 47,MR. LACKER.," I intend to vote “no” on this motion for the reasons related to those I gave in January for voting against the foreign exchange authorization: a general sense of opposition to our central bank’s being involved in foreign exchange operations, much less lending to foreign central banks." CHRG-110hhrg46593--48 Mr. Bernanke," Well, I think we need to do what we need to do to keep the U.S. credit system working and to try to create a recovery in the financial system. By law, our lending has to be against fully collateralized, secure backing. We are actually making money in some of our programs. I don't see us as having a substantial exposure. It is a liquidity provisioning process, not a credit or a fiscal process. " CHRG-110hhrg41184--39 Mr. Bernanke," Well, mortgage rates are down some from before this whole thing began. But we have a problem, which is that the spreads between, say, Treasury rates and lending rates are widening, and our policy is essentially, in some cases, just offsetting the widening of the spreads, which are associated with various kinds of illiquidity or credit issues. So in that particular area, you are right. It has been more difficult to lower long-term mortgage rates through Fed action. We are able, of course, to lower short-term rates and they do have implications. For example, resets of existing mortgages affect the ability of banks and others to finance their holdings of assets. So I think we still have power to influence the housing market in the broader economy, but your points are well taken. A lot of what we have done has been mostly just to offset the tightening of credit that has arisen because of the financial situation. Mr. Miller of California. I am looking at lending since about January 24th has raised about 56 basis points to the consumer. Yet, your cost to the lenders are down considerably based on what CDs are being, you know, sold out today, and such. "