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 cha