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-111shrg57319--197 Mr. Melby," Yes. Senator Levin. She was on your staff. Now, this internal investigation found that WaMu loans marked as containing fraudulent information were nonetheless being sold to investors. This is a very significant issue. Page 3, first bullet point. Here is what it says in that first bullet point near the top: ``Of the 25 loans tested, 11 reflected a sale date after the completion of the investigation which confirmed fraud.'' It goes on to say, ``There is evidence that this control weakness has existed for some time.'' First of all, that is a heck of a way of describing selling securities which contain fraudulent mortgages as a control weakness, but we will let that euphemism stand there for a moment. The important part is that it existed for some time, this failure. Eleven of 25 loans tested reflected a sale date after completion of the investigation which confirmed fraud. Now, this is all serious business, but I have got to tell you, it gets doubly serious when you get into this area, after fraud is found, nonetheless a security containing that fraudulent mortgage is still put on the market. Now, the executive summary at the top of this report, which, according to its front page, went to Mr. Rotella and Mr. Schneider, as well as to you, Mr. Melby, this page 2 says the following: ``The overall system of credit risk management activities and processes exhibits weakness and/or has deficiencies related to multiple business activities. Exposure is considerable and immediate corrective action is essential in order to limit or avoid considerable losses, reputation damage, or financial statement errors. Repeat findings, if any, are significant.'' So it looks like to me that there was not sufficient interest at WaMu to fix the shoddy lending practices. As long as Wall Street had a big enough appetite for junk mortgages, WaMu would just dump defective loans into the pool of commerce and just hope that they would be diluted and that nobody would notice. Again, I do not know if you have a comment on this, but we would welcome it. First, Mr. Melby, do you have a comment on this? Do you remember receiving this? " CHRG-111shrg57319--294 Mr. Beck," We informed investors, Senator, of the risk characteristics of the loans, and as I said in my previous testimony, we had internal processes in place to remove loans that had identified fraud before we sold them. Having said that, some fraudulent loans do slip through, some loans with underwriting defects, and the investor had the opportunity to put those loans back to us. Senator Kaufman. Mr. Schneider, did you ever--I think you said you decided to stop stated income loans. " FinancialCrisisReport--105 Extent of Fraud. At the Subcommittee hearing, when asked about these matters, Mr. Vanasek, WaMu’s Chief Risk Officer from 2004 to 2005, attributed the loan fraud to compensation incentives that rewarded loan personnel and mortgage brokers according to the volume of loans they processed rather than the quality of the loans they produced: “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.” 360 When asked by Senator Coburn if he thought the type of fraud at the Downey and Montebello loan offices extended beyond those two offices, Mr. Vanasek replied: “Yes, Senator.” 361 Another sobering internal WaMu report, issued in September 2008, a few weeks before the bank’s failure, found that loans marked as containing fraudulent information had nevertheless been securitized and sold to investors. The report blamed ineffective controls that had “existed for some time”: “The controls that are intended to prevent the sale of loans that have been confirmed by Risk Mitigation to contain misrepresentations or fraud are not currently effective. There is not a systematic process to prevent a loan in the Risk Mitigation Inventory and/or confirmed to contain suspicious activity from being sold to an investor. ... Of the 25 loans tested, 11 reflected a sale date after the completion of the investigation which confirmed fraud. There is evidence that this control weakness has existed for some time.” 362 Loans not meeting the bank’s credit standards, deliberate risk layering, sales associates manufacturing documents, offices issuing loans in which 58%, 62%, or 83% contained evidence of loan fraud, and selling fraudulent loans to investors are evidence of deep seated problems that existed within WaMu’s lending practices. Equally disturbing is evidence that when WaMu senior managers were confronted with evidence of substantial loan fraud, they failed to take corrective action. WaMu’s failure to strengthen its lending practices, even when problems were identified, is emblematic of how lenders and mortgage brokers produced billions of dollars in high risk, poor quality home loans that contributed to the financial crisis. 360 April 13, 2010 Subcommittee Hearing at 17. 361 Id. at 30. 362 9/8/2008 “WaMu Risk Mitigation and Mortgage Fraud 2008 Targeted Review,” JPM_WM00312502, Hearing Exhibit 4/13-34. (d) Steering Borrowers to High Risk Option ARMs FinancialCrisisReport--177 During the five-year period reviewed by the Subcommittee, from 2004 through 2008, OTS examiners identified over 500 serious deficiencies in Washington Mutual’s lending, risk management, and appraisal practices. 647 OTS examiners also criticized the poor quality loans and mortgage backed securities issued by Long Beach, and received FDIC warnings regarding the bank’s high risk activities. When WaMu failed in 2008, it was not a case of hidden problems coming to light; the bank’s examiners were well aware of and had documented the bank’s high risk, poor quality loans and deficient lending practices. (a) Deficiencies in Lending Standards From 2004 to 2008, OTS Findings Memoranda and annual Reports of Examination (ROE) repeatedly identified deficiencies in WaMu’s lending standards and practices. Lending standards, also called “underwriting” standards, determine the types of loans that a loan officer may offer or purchase from a third party mortgage broker. These standards determine, for example, whether the loan officer may issue a “stated income” loan without verifying the borrower’s professed income, issue a loan to a borrower with a low FICO score, or issue a loan providing 90% or even 100% of the appraised value of the property being purchased. When regulators criticize a bank’s lending or “underwriting” standards as weak or unsatisfactory, they are expressing concern that the bank is setting its standards too low, issuing risky loans that may not be repaid, and opening up the bank to later losses that could endanger its safety and soundness. When they criticize a bank for excessively high lending or underwriting “errors,” regulators are expressing concern that the bank’s loan officers are failing to comply with the bank’s standards, such as by issuing a loan that finances 90% of a property’s appraised value when the bank’s lending standards prohibit issuing loans that finance more than 80% of the appraised value. In addition to errors, regulators may express concern about the extent to which a bank allows its loan officers to make “exceptions” to its lending standards and issue a loan that does not comply with some aspects of its lending standards. Exceptions that are routinely approved can undermine the effectiveness of a bank’s formal lending standards. Another common problem is inadequate loan documentation indicating whether or not a particular loan complies with the bank’s lending standards, such as loan files that do not include a property’s appraised value, the source of the borrower’s income, or key analytics such as the loan-to-value or debt-to- income ratios. In the case of Washington Mutual, from 2004 to 2008, OTS examiners routinely found all four sets of problems: weak standards, high error and exception rates, and poor loan documentation. 2004 Lending Deficiencies. In 2004, OTS examiners identified a variety of problems with WaMu’s lending standards. In May of that year, an OTS Findings Memorandum stated: 647 See IG Report at 28. “Several of our recent examinations concluded that the Bank’s single family loan underwriting was less than satisfactory due to excessive errors in the underwriting process, loan document preparation, and in associated activities.” 648 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 FinancialCrisisReport--51 At the same time that WaMu was implementing its High Risk Lending Strategy, WaMu and Long Beach engaged in a host of shoddy lending practices that contributed to a mortgage time bomb. Those practices included qualifying high risk borrowers for larger loans than they could afford; steering borrowers to higher risk loans; accepting loan applications without verifying the borrower’s income; using loans with teaser rates that could lead to payment shock when higher interest rates took effect later on; promoting negatively amortizing loans in which many borrowers increased rather than paid down their debt; and authorizing loans with multiple layers of risk. In addition, WaMu and Long Beach failed to enforce compliance with their lending standards; allowed excessive loan error and exception rates; exercised weak oversight over the third party mortgage brokers who supplied half or more of their loans; and tolerated the issuance of loans with fraudulent or erroneous borrower information. They also designed compensation incentives that rewarded loan personnel for issuing a large volume of higher risk loans, valuing speed and volume over loan quality. WaMu’s combination of high risk loans, shoddy lending practices, and weak oversight produced hundreds of billions of dollars of poor quality loans that incurred early payment defaults, high rates of delinquency, and fraud. Long Beach mortgages experienced some of the highest rates of foreclosure in the industry and their securitizations were among the worst performing. Senior WaMu executives described Long Beach as “terrible” and “a mess,” with default rates that were “ugly.” WaMu’s high risk lending operation was also problem-plagued. WaMu management knew of evidence of deficient lending practices, as seen in internal emails, audit reports, and reviews. Internal reviews of WaMu’s loan centers, for example, described “extensive fraud” from employees “willfully” circumventing bank policy. An internal review found controls to stop fraudulent loans from being sold to investors were “ineffective.” On at least one occasion, senior managers knowingly sold delinquency-prone loans to investors. Aside from Long Beach, WaMu’s President Steve Rotella described WaMu’s prime home loan business as the “worst managed business” he had seen in his career. Documents obtained by the Subcommittee reveal that WaMu launched its High Risk Lending Strategy primarily because higher risk loans and mortgage backed securities could be sold for higher prices on Wall Street. They garnered higher prices, because higher risk meant they paid a higher coupon rate than other comparably rated securities, and investors paid a higher price to buy them. Selling or securitizing the loans also removed them from WaMu’s books and appeared to insulate the bank from risk. From 2004 to 2008, WaMu originated a huge number of poor quality mortgages, most of which were then resold to investment banks and other investors hungry for mortgage backed securities. For a period of time, demand for these securities was so great that WaMu formed its own securitization arm on Wall Street. Over a period of five years, WaMu and Long Beach churned out a steady stream of high risk, poor quality loans and mortgage backed securities that later defaulted at record rates. Once a prudent regional mortgage lender, Washington Mutual tried – and ultimately failed – to use the profits from poor quality loans as a stepping stone to becoming a major Wall Street player. 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 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. CHRG-111shrg57320--132 Mr. Reich," I was not. Senator Levin. All right. Well, let me read them to you. I am going to again read the somewhat longer context that these are from, Exhibits 1d and 1e. In Exhibit 1d,\2\ ``2004 Underwriting of these SFR loans remains less than satisfactory.''--------------------------------------------------------------------------- \2\ See Exhibit No. 1d, which appears in the Appendix on page 200.--------------------------------------------------------------------------- ``The level of SFR underwriting exceptions in our samples has been an ongoing examination issue''--that means OTS was unhappy with them--``for several years and one that management has found difficult to address. . . .'' Next, still 2004, this is what your folks found: ``[Residential Quality Assurance]'s review of 2003 originations disclosed critical error rates as high as 57 percent of certain loan samples. . . .'' In 2005, ``SFR [Single Family Residential] Loan Underwriting . . . has been an area of concern for several exams.'' That means several years. ``[Securitizations] prior to 2003 have horrible performance.'' Continuing reading down under 2005, ``. . . concerns regarding the number of underwriting exceptions and with issues that evidence lack of compliance with bank policy.'' Next, still 2005, ``[W]e remain concerned with the number of underwriting exceptions and with issues that evidence lack of compliance with bank policy. . . . [T]he level of deficiencies, if left unchecked, could erode the credit quality of the portfolio. Our concerns are increased when the risk profile of the portfolio is considered''--and it was risky--``including concentrations in Option ARM loans to higher-risk borrowers, in low and limited documentation loans, and loans with subprime or higher-risk characteristics.'' In 2006, the next page, ``[U]nderwriting errors continue to require management's attention.'' ``Overall, we concluded that the number and severity of underwriting errors noted remain at higher than acceptable levels.'' In 2007, ``Underwriting policies, procedures, and practices were in need of improvement, particularly with respect to stated income lending.'' Your people are finding all this stuff. ``Based on our review of 75 subprime loans originated by [Long Beach], we concluded that subprime underwriting practices remain less than satisfactory.'' How is that for an understatement? ``Given that this is a repeat concern . . . we informed management that underwriting must be promptly corrected''--``promptly corrected''--``or heightened supervisory action would be taken.'' No, it would not. Year after year after year, it was not taken. Why should they believe it was going to be taken now? In 2008, ``High [Single Family Residential] losses due in part to downturn in real estate market but exacerbated by: geographic concentrations, risk layering, liberal underwriting policy, poor underwriting.'' That is 2008, July. Then in Exhibit 1e,\1\ 2006, ``Within [Enterprise Risk Management], fraud risk management at the enterprise level is in the early stage of development.'' Heck, they are just beginning to manage the fraud risk in 2006.--------------------------------------------------------------------------- \1\ See Exhibit No. 1e, which appears in the Appendix on page 202.--------------------------------------------------------------------------- In 2007, ``Risk management practices in the . . . Home Loans Group during most of the review period were inadequate. . . . We believe that there were sufficient negative credit trends that should have elicited more aggressive action by management''--how about more aggressive management by your . . . agency? ``In particular, as previously noted, the risk misrepresentation''--here you go. Now you are talking fraud. ``. . . the risk misrepresentation in stated income loans has been generally reported for some time.'' For some time it has been going on. On and on, year after year. So what do you do about it? What does OTS do about it? Not one single formal enforcement action against WaMu from 2004 until 2008. " CHRG-111shrg52619--122 Chairman Dodd," We are going back around. Chairman Bair, let me ask you to comment on this as well. Ms. Bair. Well, I think John is right. These practices became far too pervasive. For the most part, the smaller State-chartered banks we regulate did not do this type of lending they do more traditional lending, and then obviously they do commercial real estate lending, which had a separate set of issues. We had one specialty lender who we ordered out of the business in February of 2007. There have been a few others. We have had some other actions, and I would have to go back to the examination staff to get the details for you. But I was also concerned that even after the guidance on the nontraditional mortgages, which quite specifically said you are not going to do low-doc and no-doc anymore, that we still had very weak underwriting in 2007. So I think that is a problem that all of us should look back on and try to figure out, because clearly by 2007 we knew this was epidemic in proportion, and the underwriting standards did not improve as well as you would have thought they should have, and the performance of those loans had been very poor as well. I do think we need to do a lot more---- " FinancialCrisisReport--178 After reviewing an OTS examination of a loan sample, the FDIC examiner wrote that the loans: “reflected inconsistencies with underwriting and documentation practices, particularly in the brokered channel. Additionally, examiners noted that Washington Mutual’s SFR [Single Family Residential] portfolio has an elevated level of risk to a significant volume of potential negative amortization loans, high delinquency and exception rates, and a substantial volume of loans with higher risk characteristics, such as low FICO scores.” 649 A few months later, in September, an OTS review of a sample of 2003 WaMu loans found “critical error rates as high as 57.3%”: “[Residential Quality Assurance]’s review of 2003 originations disclosed critical error rates as high as 57.3 percent of certain loan samples, thereby indicating that SFR [Single Family Residential] underwriting still requires much improvement. While this group has appropriately identified underwriting deficiencies, it has not been as successful in effecting change.” 650 The same OTS Report of Examination observed that one of the three causes of underwriting deficiencies was “a sales culture focused on building market share.” It also stated: “Notwithstanding satisfactory asset quality overall, some areas still require focused management and Board attention. Most important is the need to address weaknesses in single-family residential (SFR) underwriting, which is an ongoing issue from prior exams.” 651 The OTS ROE concluded: “Underwriting of SFR loans remains less than satisfactory.” 652 The next month, when OTS conducted a field visit to follow up on some of the problems identified earlier, it concluded: “The level of SFR [Single Family Residential] underwriting exceptions in our samples has been an ongoing examination issue for several years and one that management has found difficult to address. The institution instituted a major organizational/staffing 648 5/12/2004 OTS Memo 5, “SFR Loan Origination Quality,” OTSWME04-0000004883. 649 5/20/2004 FDIC-DFI Memo 3, “Single Family Residential Review,” OTSWME04-0000004889. 650 9/13/2004 OTS Report of Examination, at OTSWMS04-0000001498, Hearing Exhibit 4/16-94 [Sealed Exhibit]. 651 9/13/2004 OTS Report of Examination, at OTSWMS04-0000001492, Hearing Exhibit 4/16-94 [Sealed Exhibit]. 652 9/13/2004 OTS Report of Examination, at OTSWMS04-0000001497, Hearing Exhibit 4/16-94 [Sealed Exhibit]. realignment in September 2003 and has continued to make additional adjustments since that time to address accumulating control issues.” 653 2005 Lending Deficiencies. In early 2005, OTS elevated the problems with the bank’s lending standards to the attention of the WaMu Board of Directors. In a letter to the Board, OTS wrote: “SFR Loan Underwriting – This has been an area of concern for several exams. As management continues to make change in organization, staffing, and structure related to SFR loan underwriting, delays in meeting target dates become inevitable. The board should closely monitor these delays to ensure they do not become protracted.” 654 FinancialCrisisReport--5 WaMu also originated an increasing number of its flagship product, Option Adjustable Rate Mortgages (Option ARMs), which created high risk, negatively amortizing mortgages and, from 2003 to 2007, represented as much as half of all of WaMu’s loan originations. In 2006 alone, Washington Mutual originated more than $42.6 billion in Option ARM loans and sold or securitized at least $115 billion to investors, including sales to the Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac). In addition, WaMu greatly increased its origination and securitization of high risk home equity loan products. By 2007, home equity loans made up $63.5 billion or 27% of its home loan portfolio, a 130% increase from 2003. At the same time that WaMu was implementing its high risk lending strategy, WaMu and Long Beach engaged in a host of shoddy lending practices that produced billions of dollars in high risk, poor quality mortgages and mortgage backed securities. Those practices included qualifying high risk borrowers for larger loans than they could afford; steering borrowers from conventional mortgages to higher risk loan products; accepting loan applications without verifying the borrower’s income; using loans with low, short term “teaser” rates that could lead to payment shock when higher interest rates took effect later on; promoting negatively amortizing loans in which many borrowers increased rather than paid down their debt; and authorizing loans with multiple layers of risk. In addition, WaMu and Long Beach failed to enforce compliance with their own lending standards; allowed excessive loan error and exception rates; exercised weak oversight over the third party mortgage brokers who supplied half or more of their loans; and tolerated the issuance of loans with fraudulent or erroneous borrower information. They also designed compensation incentives that rewarded loan personnel for issuing a large volume of higher risk loans, valuing speed and volume over loan quality. As a result, WaMu, and particularly its Long Beach subsidiary, became known by industry insiders for its failed mortgages and poorly performing residential mortgage backed securities (RMBS). Among sophisticated investors, its securitizations were understood to be some of the worst performing in the marketplace. Inside the bank, WaMu’s President Steve Rotella described Long Beach as “terrible” and “a mess,” with default rates that were “ugly.” WaMu’s high risk lending operation was also problem-plagued. WaMu management was provided with compelling evidence of deficient lending practices in internal emails, audit reports, and reviews. Internal reviews of two high volume WaMu loan centers, for example, described “extensive fraud” by employees who “willfully” circumvented bank policies. A WaMu review of internal controls to stop fraudulent loans from being sold to investors described them as “ineffective.” On at least one occasion, senior managers knowingly sold delinquency-prone loans to investors. Aside from Long Beach, WaMu’s President described WaMu’s prime home loan business as the “worst managed business” he had seen in his career. 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? " 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 CHRG-111shrg57319--457 Mr. Killinger," Well, again, Senator, we entered Long Beach Mortgage, as you know, back in 1999 to help better serve that community. When we--it was a relatively very small--part of our business, and when they first encountered some of the securitization problems or some of the loan quality, we sent a team in to work on that. We believed that they had made substantial progress with that. And then they started to increase the originations again because we felt that the operational issues were under control. And then we started to see some additional evidences of difficulties there. The actions that we took were to change out managements, to go in and do some organizational redesign to get to a point where we felt comfortable that we could proceed with doing both the whole loan sales and the securitizations that the company did. Senator Levin. Let us talk about those years where you got comfortable. Mr. Rotella, take a look at Exhibit 11,\1\ if you would. This is an email chain from April 2006 between you and Mr. Killinger. You describe the situation at Long Beach. This is April 2006.--------------------------------------------------------------------------- \1\ See Exhibit 11, which appears in the Appendix on page 414.--------------------------------------------------------------------------- ``The major weak point was the review of Long Beach. . . . delinquencies are up 140% and foreclosures close to 70%. . . . First payment defaults are way up and the 2005 vintage is way up relative to previous years. It is ugly.'' Then you cite a number of factors for why the problems should be solved. Five months later, you sent Mr. Killinger another email about Long Beach, which we have marked Exhibit 12,\2\ if you want to look at that. In this email chain from September 2006, you wrote Mr. Killinger the following. ``Long Beach is terrible, . . . Repurchases, [early payment defaults], manual underwriting, very weak servicing/collection practices, and a weak staff.'' You said that you were addressing the problems.--------------------------------------------------------------------------- \2\ See Exhibit 12, which appears in the Appendix on page 415.--------------------------------------------------------------------------- But the problems didn't get addressed. A year later, now August 20, 2007, and the audit of Long Beach loan origination and underwriting. This is Exhibit 19.\3\ If you look at page 3 of Exhibit 19, here is what it says. It is basically the same old problems. ``Repeat Issue,'' so this is a repeat issue, ``Underwriting guidelines established to mitigate the risk of unsound underwriting decisions are not always followed. . . . accurate reporting and tracking of exceptions to policy does not exist. . . .''--------------------------------------------------------------------------- \3\ See Exhibit 19, which appears in the Appendix on page 462.--------------------------------------------------------------------------- So that takes us up to August 20, 2007. So now let me ask you, Mr. Rotella, why did these problems exist year after year? What is the explanation for that? " CHRG-111shrg57319--100 Mr. Vanasek," Well, as indicated by my earlier statement, at the end of 2004, and I believe that is the correct date, I sat down with the chairman and made a one-on-one, which I found to be the most effective way to reach him, impassioned argument to stand up and take an industry-leading position. I thought he could stand out as the leading mortgage executive if he could blow a whistle and say, enough is enough. The deterioration in mortgage underwriting has gone too far and we at Washington Mutual will not participate any further. Senator Coburn. You mentioned earlier the Community Reinvestment Act (CRA) and you correlated it with the two areas that Senator Levin had noted that were high, actually fraudulent mortgage applications. Do you think that WaMu's decisions, especially in these two areas, were more likely related to getting the points up on the CRA versus just too good sales or agents that were closing loans and brokering loans? " FinancialCrisisReport--125 Home Loans President David Schneider replied: “Ok – thanks .… Are we sure there isn’t a reporting issue?” Today, those securities have all been downgraded to junk status and more than half of the underlying loans are delinquent or in foreclosure. 451 Despite their poor performance, it is unclear that any investment bank refused to do business with either Long Beach or WaMu. As long as investors expressed interest in purchasing the securities, banks continued selling them until the entire subprime market collapsed. Before the market collapsed, WaMu earned hundreds of millions of dollars a year from its home loans sales and securitizations. 452 Securitizing Fraudulent Loans. WaMu and Long Beach securitized not just poor quality loans, but also loans that its own personnel had flagged as containing fraudulent information. That fraudulent information included, for example, misrepresentations of the borrower’s income and of the appraised value of the mortgaged property. In September 2008, WaMu’s Corporate Credit Review team released a report which found that internal controls intended to prevent the sale of fraudulent loans to investors were ineffective: “The controls that are intended to prevent the sale of loans that have been confirmed by Risk Mitigation to contain misrepresentations or fraud are not currently effective. There is not a systematic process to prevent a loan in the Risk Mitigation Inventory and/or confirmed to contain suspicious activity from being sold to an investor. ... Of the 25 loans tested, 11 reflected a sale date after the completion of the investigation which confirmed fraud. There is evidence that this control weakness has existed for some time.” 453 In other words, even loans marked with a red flag indicating fraud were being sold to investors. The review identified several factors contributing to the problem, including insufficient resources devoted to anti-fraud work, an absence of automated procedures to alert personnel to fraud indicators, and inadequate training on fraud awareness and prevention. The 2008 review warned: “Exposure is considerable and immediate corrective action is essential in order to limit or avoid considerable losses, reputation damage, or financial statement errors.” 454 (3) Securitizing Delinquency-Prone Loans The Subcommittee uncovered an instance in 2007 in which WaMu securitized certain types of loans that it had identified as most likely to go delinquent, but did not disclose its analysis to investors who bought the securities. Investors who purchased these securities without the benefit of that analysis quickly saw the value of their purchases fall. 451 As of December 2010, the total loan delinquency rate of the WMALT 2007-OC1 series was 57.37%. See wamusecurities.com. 452 See 3/1/2007 Washington Mutual Inc. 10-K filing with the SEC, at 82, 87. 453 9/8/2008 “Risk Mitigation and Mortgage Fraud 2008 Targeted Review,” WaMu Corporate Credit Review, JPM_WM00312502, Hearing Exhibit 4/13-34. 454 Id. CHRG-110hhrg46591--15 Mr. Manzullo," Thank you, Mr. Chairman, for holding this hearing today. This committee needs to examine ways to ameliorate the impact of this crisis while examining long-term solutions to ensure that a crisis of this magnitude never happens again. As we examine the underlying causes of this crisis, it is clear to me that Fannie Mae and Freddie Mac were right in the thick of things. Some of us in Congress have been fighting the unethical, illegal, and outright stupid underwriting practices at Fannie and Freddie for many years. Our efforts are a matter of public record, at least in the last 8 years, of going so far as to publicly confront Franklin Raines, who took $90 million in 6 years from Fannie Mae, and with regard to his fraudulent, unethical lobbying campaign in 2000 and in regard to the use of unethical accounting practices to inflate the bonuses of Fannie Mae's executives in 2004. In 2005, we finally got a bill to the Floor, a vote in favor of GSE reform, including the tough Royce amendment, to make even more difficult the types of practices to continue that we see have led to this crisis. Any solution to this crisis undoubtedly needs to include a serious reexamination of the role that these GSEs will play in any future housing market. It is obvious that new regulations are necessary both to ease this crisis and to ensure that it never happens again. One thing for sure is that these two organizations need to be dissected, ripped apart, and examined thoroughly. Because once we find out what happened there as the root cause of the problem, we will make sure it never occurs again. Thank you, Mr. Chairman. " fcic_final_report_full--434 The Commission heard convincing testimony of serious mortgage fraud prob- lems. Excruciating anecdotes showed that mortgage fraud increased substantially during the housing bubble. There is no question that this fraud did tremendous harm. But while that fraud is infuriating and may have been significant in certain ar- eas (like Florida), the Commission was unable to measure the impact of fraud rela- tive to the overall housing bubble. The explosion of legal but questionable lending is an easier explanation for the creation of so many bad mortgages. Lending standards were lax enough that lenders could remain within the law but still generate huge volumes of bad mortgages. It is likely that the housing bubble and the crisis would have occurred even if there had been no mortgage fraud. We therefore classify mortgage fraud not as an essential cause of the crisis but as a contributing factor and a deplorable effect of the bubble. Even if the number of fraudulent loans was not substantial enough to have a large im- pact on the bubble, the increase in fraudulent activity should have been a leading in- dicator of deeper structural problems in the market. Conclusions: • Beginning in the late s and accelerating in the s, there was a large and sustained housing bubble in the United States. The bubble was characterized both by national increases in house prices well above the historical trend and by more rapid regional boom-and-bust cycles in California, Nevada, Arizona, and Florida. • There was also a contemporaneous mortgage bubble, caused primarily by the broader credit bubble. • The causes of the housing bubble are still poorly understood. Explanations in- clude population growth, land use restrictions, bubble psychology, and easy fi- nancing. • The causes of the mortgage bubble and its relationship to the housing bubble are also still poorly understood. Important factors include weak disclosure standards and underwriting rules for bank and nonbank mortgage lenders alike, the way in which mortgage brokers were compensated, borrowers who bought too much house and didn’t understand or ignored the terms of their mortgages, and elected officials who over years piled on layer upon layer of gov- ernment housing subsidies. • Mortgage fraud increased substantially, but the evidence gathered by the Com- mission does not show that it was quantitatively significant enough to conclude that it was an essential cause. FinancialCrisisReport--271 In 2005, in its 11th Annual Survey on Credit Underwriting Practices, the Office of the Comptroller of the Currency (OCC), which oversees nationally chartered banks, described a significant lowering of retail lending standards, noting it was the first time in the survey’s history that a net lowering of retail lending practices had been observed. The OCC wrote: “Retail lending has undergone a dramatic transformation in recent years as banks have aggressively moved into the retail arena to solidify market positions and gain market share. Higher credit limits and loan-to-value ratios, lower credit scores, lower minimum payments, more revolving debt, less documentation and verification, and lengthening amortizations - have introduced more risk to retail portfolios.” 1048 Starting in 2004, federal law enforcement agencies also issued multiple warnings about fraud in the mortgage marketplace. For example, the Federal Bureau of Investigation (FBI) made national headlines when it warned that mortgage fraud had the potential to be a national epidemic, 1049 and issued a 2004 report describing how mortgage fraud was becoming more prevalent. The report noted: “Criminal activity has become more complex and loan frauds are expanding to multitransactional frauds involving groups of people from top management to industry professionals who assist in the loan application process.” 1050 The FBI also testified about the problem before Congress: “The potential impact of mortgage fraud on financial institutions and the stock market is clear. If fraudulent practices become systemic within the mortgage industry and mortgage fraud is allowed to become unrestrained, it will ultimately place financial institutions at risk and have adverse effects on the stock market.” 1051 In 2006, the FBI reported that the number of Suspicious Activity Reports describing mortgage fraud had risen significantly since 2001. 1052 1047 “Housing Bubble Concerns and the Outlook for Mortgage Credit Quality,” FDIC Outlook (Spring 2004), available at http://www.fdic.gov/bank/analytical/regional/ro20041q/na/infocus.html. 1048 6/2005 “Survey of Credit Underwriting Practices,” report prepared by the Office of the Comptroller of the Currency, at 6, available at http://www.occ.gov/publications/publications-by-type/survey-credit-underwriting/pub- survey-cred-under-2005.pdf. 1049 “FBI: Mortgage Fraud Becoming an ‘Epidemic,’” USA Today (9/17/2004). 1050 FY 2004 “Financial Institution Fraud and Failure Report,” prepared by the Federal Bureau of Investigation, available at http://www.fbi.gov/stats-services/publications/fiff_04. 1051 Prepared statement of Chris Swecker, Assistant Director of the Criminal Investigative Division, Federal Bureau of Investigation, “Mortgage Fraud and Its Impact on Mortgage Lenders,” before the U.S. House of Representatives Financial Services Subcommittee on Housing and Community Opportunity, Cong.Hrg. 108-116 (10/7/2004), at 2. 1052 “Financial Crimes Report to the Public: Fiscal Year 2006, October 1, 2005 – September 30, 2006,” prepared by the Federal Bureau of Investigation, available at http://www.fbi.gov/stats- services/publications/fcs_report2006/financial-crimes-report-to-the-public-2006-pdf/view. FinancialCrisisReport--214 Senator Levin: I did not use the word ‘wholly.’ You could tell them it was not wholly adequate, but you could not tell them it was inadequate. That is what you are telling us. Mr. Carter: Yes. Senator Levin: That is the kind of bureaucratic speech which I think sends the message to people you regulate that, hey, folks, you are making progress, instead of telling them it is inadequate. 808 At times, WaMu took advantage of its special relationship with OTS and lobbied for leniency. In one instance from May 2006, a WaMu official from the Regulatory Relations division sent an email to his colleagues stating that he was able to convince the agency to reduce an audit “criticism” to the less serious category of a “recommendation”: “OTS confirmed today that they will re-issue this memo without the ‘Criticism.’ It will be a ‘Recommendation.’” 809 His colleague forwarded the email to bank executives noting: “Good news - John was able to get the OTS to see the light and revise the Underwriting rating to a Recommendation.” 810 A more serious incident involved WaMu’s 2005 discovery, after almost a year-long investigation by an internal Home Loans Risk Mitigation Team, of substantial loan fraud taking place at two high volume loan offices in California, known as Downey and Montebello. The WaMu investigators found that 83% of the loans reviewed from the Downey office and 58% of the loans reviewed from the Montebello office contained fraudulent information, either with respect to the borrower or the appraised value of the property. The investigators wrote up their findings and presented them to WaMu’s Chief Risk Officer and the President of Home Loans. 811 No one, however, informed OTS, and WaMu took no action to stop the fraudulent loans. Two years later, in 2007, after a mortgage insurer refused to insure any more loans issued by the lead loan officer in the Montebello office, OTS directed WaMu to investigate the matter. WaMu’s internal auditors launched an investigation, confirmed the loan fraud problem at the Montebello office, and also uncovered the 2005 investigation whose fraud findings had been ignored. WaMu took until April 2008 to produce a report documenting its findings. 812 WaMu also initially resisted providing the report to OTS, claiming it was protected by attorney-client 808 April 16, 2010 Subcommittee Hearing at 60-61. 809 5/30/2006 email from John Robinson, WaMu VP of Regulatory Relations, to colleagues, JPM_WM02619435. Hearing Exhibit 4/16-34. 810 5/30/2006 email from Wayne Pollack, WaMu SVP, to David Schneider, et al., JPM_WM02619434, Hearing Exhibit 4/16-34. 811 See 11/17/2005 WaMu internal memorandum, “re So. CA Emerging Markets Targeting Loan Review Results,” JPM_WM01083051, Hearing Exhibit 4/13-22a; 11/16/2005 WaMu internal PowerPoint presentation, “Retail Fraud Risk Overview,” JPM_WM02481934-49, Hearing Exhibit 4/13-22b; 11/19/2005 email from Cheryl Feltgen to colleagues, “Re: Retail Fraud Risk Overview,” JPM_WM03535694-95, Hearing Exhibit 4/13-23a; 8/29/2005 email from Jill Simons to Timothy Bates, “Risk Mit Loan review data ‘Confidential,’” JPM_WM04026076-77, Hearing Exhibit 4/13-23b. 812 4/4/2008 WaMu internal memorandum, from June Thoreson-Rogers, Corporate Fraud Investigations, and Michele Snyer, Deputy General Auditor, to Stewart Landefeld, Acting Chief Legal Officer, and others, Hearing Exhibit 4/13-24. privilege. 813 The OTS Examiner-in-Charge at the time told the Subcommittee that he insisted on seeing the report. After finally receiving it and reading about the substantial loan fraud occurring at the two loan offices since 2005, he told the Subcommittee that it was “the last straw” that ended his confidence that he could rely on WaMu to combat fraudulent practices within its own ranks. FinancialCrisisReport--187 Failure to Correct Poor Risk Management. By neglecting to exercise its enforcement authority, OTS chronicled WaMu’s inadequate risk management practices over a period of years, but ultimately failed to change its course of action. During a hearing of the Subcommittee, the Department of the Treasury Inspector General, Eric Thorson, whose office conducted an in-depth review of WaMu’s regulatory oversight, testified: “Issues related to poor underwriting and weak risk controls were noted as far back as 2003, but the problem was OTS did not ensure that WaMu ever corrected those weaknesses. We had a hard time understanding why OTS would allow these satisfactory ratings to continue given that, over the years, they found the same things over and over.” 689 (c) Deficiencies in Home Appraisals Still another area in which OTS failed to take appropriate enforcement action involves WaMu’s appraisal practices. OTS failed to act even after other government entities accused WaMu of systematically inflating property values to justify larger and more risky home loans. Appraisals provide estimated dollar valuations of property by independent experts. They play a key role in the mortgage lending process, because a property’s appraised value is used to determine whether the property provides sufficient collateral to support a loan. Lending standards at most banks require loans to meet, for example, certain loan-to-value (LTV) ratios to ensure that, in the event of a default, the property can be sold and the proceeds used to pay off any outstanding debt. From 2004 to mid-2006, WaMu conducted its own property appraisals as part of the loan approval process. During that period, OTS repeatedly expressed concerns about WaMu’s appraisal efforts. 690 In May 2005, OTS criticized WaMu – the most severe type of finding – regarding its practice of allowing sellers to estimate the value of their property. OTS directed WaMu to stop including an Owner’s Estimate of Value in documents sent to appraisers since it biased the review; this criticism had been repeatedly noted in prior examinations, yet WaMu did not satisfactorily address it until the end of 2005. 691 A second finding criticized WaMu’s use of automated appraisal software, noting “significant technical document weaknesses.” 692 OTS ultimately determined that none of WaMu’s automated appraisals complied with standard appraisal practices and some even had “highly questionable value conclusions.” 693 Despite this 688 7/15/2008 OTS presentation to WaMu Board of Directors based on Comprehensive Examinations, Polakoff_Scott-00061303-028, Hearing Exhibit 4/16-12b. 689 See April 16, 2010 Subcommittee Hearing at 25. 690 See, e.g., 10/3/2005 OTS Report of Examination, at OTSWMEF-0000047601, Hearing Exhibit 4/16-94 [Sealed Exhibit]. 691 5/20/2005 OTS Memo 4, “Safety and Soundness Examination,” at OTSWME06-039 0000214 . 692 Id. 693 3/14/2005 OTS Report of Examination, at OTSWMEN-000001794, Hearing Exhibit 4/16-94 [Sealed Exhibit]. dramatic criticism, OTS found in the next year’s examination that WaMu had continued to use noncompliant automated appraisals. 694 Before any enforcement action was taken, WaMu management agreed to cease using automated appraisals by October 2006. FinancialCrisisReport--143 F. Destructive Compensation Practices Washington Mutual and Long Beach’s compensation practices contributed to and deepened its high risk lending practices. Loan officers and processors were paid primarily on volume, not primarily on the quality of their loans, and were paid more for issuing higher risk loans. Loan officers and mortgage brokers were also paid more when they got borrowers to pay higher interest rates, even if the borrower qualified for a lower rate – a practice that enriched WaMu in the short term, but made defaults more likely down the road. Troubling compensation practices went right to the top. In 2008, when he was asked to leave the bank that failed under his management, CEO Kerry Killinger received a severance payment of $15 million. 532 (1) Sales Culture WaMu’s compensation policies were rooted in the bank culture that put loan sales ahead of loan quality. As early as 2004, OTS expressed concern about WaMu’s sales culture: “The overt causes for past underwriting concerns were many, but included: (1) A sales culture focused heavily on market share via loan production, (2) extremely high lending volumes.” 533 In early 2005, WaMu’s Chief Credit Officer complained to Mr. Rotella that: “[a]ny attempts to enforce [a] more disciplined underwriting approach were continuously thwarted by an aggressive, and often times abusive group of Sales employees within the organization.” 534 The aggressiveness of the sales team toward underwriters was, in his words, “infectious and dangerous.” 535 In late 2006, as home mortgage delinquency rates began to accelerate and threaten the viability of WaMu’s High Risk Lending Strategy, Home Loans President David Schneider presided over a “town hall” meeting to rally thousands of Seattle based employees of the WaMu Home Loans Group. 536 At the meeting, Mr. Schneider made a presentation, not just to WaMu’s sales force, but also to the thousands of risk management, finance, and technology staff in 532 See “Washington Mutual CEO Kerry Killinger: $100 Million in Compensation, 2003-2008,” chart prepared by the Subcommittee, Hearing Exhibit 4/13-1h. 533 5/12/2004 OTS Safety & Soundness Examination Memo 5, “SFR Loan Origination Quality,” at 1, Hearing Exhibit 4/16-17. 534 Undated draft WaMu memorandum, “Historical Perspective HL – Underwriting: Providing a Context for Current Conditions, and Future Opportunities,” JPM_WM00783315 (a legal pleading states this draft memorandum was prepared for Mr. Rotella by WaMu’s Chief Credit Officer in or about February or March 2005; FDIC v. Killinger , Case No. 2:2011cv00459 (W.D. Wash.), Complaint (March 16, 2011), at ¶ 35). 535 Undated draft WaMu memorandum, “Historical Perspective HL – Underwriting: Providing a Context for Current Conditions, and Future Opportunities,” JPM_WM00783315, at JPM_WM00783322. 536 Mr. Schneider told the Subcommittee that this meeting was held in early 2007, but Ms. Feltgen’s end of 2006 email to her staff quotes Mr. Schneider’s language from this presentation. 1/3/2007 email from Ron Cathcart to Cheryl Feltgen, Hearing Exhibit 4/13-73. attendance. 537 The title and theme of his presentation was: “Be Bold.” 538 One slide demonstrates the importance and pervasiveness of the sales culture at WaMu: 539 CHRG-111shrg57319--27 Mr. Melby," That is correct. Senator Levin. Then on page 2, the first bullet point, ``Management Control Weaknesses'' were identified by you at that first bullet point, which is about two-thirds of the way down. ``Relaxed credit guidelines, breakdowns in manual underwriting processes, inexperienced subprime personnel, coupled with a push to increase loan volume and the lack of an automated fraud monitoring tool exacerbated the deterioration in loan quality.'' Is that correct? " CHRG-111shrg57320--24 Mr. Rymer," Well, sir, we have done 56 material loss reviews so far. I would say that the comment made earlier about examiners' ability to identify problems is consistent, and I think they have done a good job. I would not necessarily say that of those 56 that we have not seen enforcement actions. We have seen enforcement actions in many of them. So I would not say that the FDIC was not taking or not acting on enforcement actions. Senator Levin. In that regard, you have a somewhat different conclusion or experience than does Mr. Thorson. That is fair enough. Now, if you look at Exhibit 32,\1\ here you will see Lawrence Carter, who is the examiner-in-charge at WaMu, writing to his boss, Darrel Dochow, who will be testifying later, writing in 2006, ``At some level, it seems we have to rely on our relationship and their understanding that we are not comfortable with current underwriting practices and don't want them to grow significantly without having the practices cleaned up first. I'm sure we made that very clear.''--------------------------------------------------------------------------- \1\ See Exhibit No. 32, which appears in the Appendix on page 328.--------------------------------------------------------------------------- What is your reaction to the comment of the examiner-in-charge that OTS has to rely on its relationship with WaMu to get them to clean up their underwriting practices? Does it have to rely on its relationship? What about enforcement power? What about the tools that it has to enforce? " CHRG-111shrg57319--390 Mr. Beck," Yes. Senator Levin. Were you aware that for some time, WaMu had been selling loans to investors even after the loans had been marked as containing fraudulent information? " 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. CHRG-111shrg57320--136 Mr. Reich," But it also included BSA and anti-money-laundering violations. Senator Levin. That is a money-laundering violation. We are talking about what they were doing in terms of the underwriting practices, the credit practices here, the mortgages they were issuing. No board resolutions required, no Memorandums of Understanding required, no fines. So the bank--I forgot what the number was. It came out. I think Senator Coburn used a number as to how many warnings, how many findings, how many deficiencies, year after year after year. " CHRG-111shrg57319--321 Mr. Beck," I was aware that there was fraud, as I said earlier, and I was aware that certain loans had underwriting defects. And as part of the post-closing review that Origination was conducting, I understood that loans with identified fraud or underwriting defects would have been removed from the pool of loans that I was going to be securitizing. Senator Levin. You thought they were going to be removed? " CHRG-111shrg52619--125 Chairman Dodd," Well, it might be helpful to find out whether or not there were violations, and punishments meted out at all. Again, many of us have heard over the last couple of years the complaint is that Congress in 1994 passed the HOEPA legislation which mandated that the Federal Reserve promulgate regulations to deal with fraudulent and deceptive residential mortgage practices. Not a single regulation was ever promulgated until the last year or so, and obviously that is seen as a major gap in terms of the responsibility of moving forward. OTS quickly, do you have any---- " CHRG-111shrg57319--278 Mr. Beck," Yes, we did a couple of things, Dr. Coburn. In the course of our securitization before the loans are pooled, there are post-closing reviews, many of which you have seen in this documentation that are done by Origination, and their intent is to identify and remove loans from the pool or that will come to me and my team that have underwriting defects. After we receive the salable loans, an underwriting due diligence process is undertaken where a statistically significant sample of the loans is taken, both adverse as well as random, to try to identify any further underwriting defects and have those loans removed from the pool so that when we come to the process of securitization, the loans are all performing, they are current, and loans with underwriting defects should have been removed. Now, as you know, and as we have seen, some loans with fraud and with underwriting defects do slip through. That happens. And it is not a good thing for us ever. We have an operational and reputational problem, and we have a big financial problem, as we have talked about, in terms of repurchase liability. Each transaction, though, does have a warrant on it, and the investors can ask us to repurchase the loans. Senator Coburn. All right. So your ability to sell into the future is dependent on the quality of the product that you are selling today? " FinancialCrisisReport--89 To address the problem, WaMu invested millions of dollars in a technology program called Optis, which WaMu President Rotella described in the end as “a complete failure” that the bank “had to write off” and abandon. 272 In 2004, an OTS Report of Examination (ROE), which was given to the bank’s Board of Directors, included this observation: “Our review disclosed that past rapid growth through acquisition and unprecedented mortgage refinance activity placed significant operational strain on [Washington Mutual] during the early part of the review period. Beginning in the second half of 2003, market conditions deteriorated, and the failure of [Washington Mutual] to fully integrate past mortgage banking acquisitions, address operational issues, and realize expectations from certain major IT initiatives exposed the institution’s infrastructure weaknesses and began to negatively impact operating results.” 273 The records reviewed by the Subcommittee showed that, from 2004 until its shuttering in 2008, WaMu constantly struggled with information technology issues that limited its ability to monitor loan errors, exception rates, and indicators of loan fraud. From 2004 to 2008, WaMu’s regulators also repeatedly criticized WaMu’s failure to exercise sufficient oversight of its loan personnel to reduce excessive loan error and exception rates that allowed the issuance of loans in violation of WaMu’s credit standards. 274 In 2004, Craig Chapman, then the President of WaMu Home Loans, visited a number of the bank’s loan centers around the country. Lawrence Carter, then OTS Examiner-in-Charge at WaMu, spoke with Mr. Chapman about what he found. Recalling that conversation in a later email, Mr. Carter wrote: “Craig has been going around the country visiting home lending and fulfillment offices. His view is that band-aids have been used to address past issues and that there is a fundamental absence of process.” 275 The regulators’ examination reports on WaMu indicate that its oversight efforts remained weak. In February 2005, OTS stated that WaMu’s loan underwriting “has been an area of 272 Subcommittee interview of Steve Rotella (2/24/2010). 273 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.”). 274 See, e.g., OTS examination reports cited in Chapter IV, below. 275 8/13/2004 email from Lawrence Carter to Michal Finn, Finn_Michael-00005331. concern for several exams.” 276 In June 2005, OTS expressed concern about the bank’s underwriting exceptions and policy compliance. 277 In August of the same year, the OTS Report of Examination stated that, “the level of deficiencies, if left unchecked, could erode the credit quality of the portfolio,” and specifically drew attention to WaMu concentrations in higher risk loans that were a direct result of its High Risk Lending Strategy. 278 2006 was no better. OTS repeatedly criticized the level of underwriting exceptions and errors. 279 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-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-111shrg57319--388 Mr. Beck," We had a significantly higher level of repurchase requests from Long Beach and---- Senator Levin. Take a look, if you would, at Exhibit 34.\1\ Now, Exhibit 34 is a report from WaMu's corporate credit review group and it found that WaMu's loans marked as containing fraudulent information was nonetheless sold to investors. If you will take a look at page 3, in the first bullet point------------------------------------------------------------------------------- \1\ See Exhibit 34, which appears in the Appendix on page 564.--------------------------------------------------------------------------- Here is what it says. ``The controls that are intended to prevent the sale of loans that have been confirmed by Risk Mitigation to contain misrepresentations or fraud are not currently effective.'' So the controls are not effective. ``There is not a systematic process to prevent a loan in the Risk Mitigation Inventory and/or confirmed to contain suspicious activity from being sold to an investor. The coding of the user to defined risk mitigation field in Fidelity does not directly affect the salability of the loans.'' ``A review was completed of a sample of the 25 loans . . .''--this is a sample of 25 loans closed in 2008--``with the appropriate coding in the Risk Mitigation field. . . . Of the 25 loans tested, 11 reflected a sale date after the completion of the investigation which confirmed fraud. There is evidence that this control weakness has existed for some time.'' Do you recall this report and that finding, Mr. Beck? " FOMC20080130meeting--316 314,MR. LACKER.," You characterized underwriting as weak, and I guess the document circulated had some heavy criticism for the credit rating agencies. I want to understand more what the nature of that assessment involves. Basically is it ex post regret, or do we have objective evidence about the quality of the decisionmaking ex ante? That evidence, of course, would involve assessments of the probability they should have placed on things we saw. " CHRG-111hhrg67816--38 Mr. Scalise," Thank you, Mr. Chairman. I appreciate you holding this hearing. Fraudulent and deceptive practices that prey upon consumers are deplorable and shameful especially during these tough economic times because consumers are even more vulnerable to unethical scams. We need to make sure that the FTC is fully utilizing the tools they already have available to them and also ensure that the FTC is working with our local, state attorneys general, those people that are closest in many cases to the practices of those illegal and unethical practices that are going on where we would have the ability to actually go and get prosecutions and root out the things that are being done to take advantage of our consumers in this country. Another critical issue that we need to look at is the coordination with other federal agencies like the FBI, who are also involved in some of these investigates themselves as well as local attorneys general that were not duplicating the scarce resources that we do have, so I look forward to hearing from Chairman Leibowitz of the Federal Trade Commission, and yield back the balance of my time. " FinancialCrisisReport--194 Significant Deficiency in its financial reporting. Despite the sudden evidence of Long Beach’s poor quality loans, inadequate repurchase reserves, and negative earnings impact on its parent company, Washington Mutual Inc., OTS approved the bank’s application to purchase Long Beach. OTS explained its decision to the Subcommittee by contending that the change in status gave WaMu more control over Long Beach to ensure its improvement. 731 WaMu ultimately purchased Long Beach on March 1, 2006. 732 After the purchase, Long Beach’s practices did not improve, but continued to exhibit numerous problems, as described in the prior chapter. A May 2006 OTS examination of Long Beach loans concluded, for example, “that the number and severity of underwriting errors noted remain at higher than acceptable levels.” 733 In a June 2006 internal email to his colleagues, the OTS Regional Deputy Director wrote: “We gave them the benefit of doubt based on commitments and some progress when we allowed them to bring [Long Beach] into the bank, but … we have the same type of concerns remaining 6 months later.” 734 In the annual 2006 ROE and again in the annual 2007 ROE, OTS found that Long Beach’s lending practices “remain[ed] less than satisfactory.” 735 At a hearing of the Subcommittee on April 13, 2010, WaMu’s chief credit risk officers from 2004 to 2008 uniformly condemned Long Beach’s poor performance and testified that it had never developed an effective risk management system. 736 730 See 4/17/2006 memorandum by WaMu General Auditor to Board of Directors’ Audit Committees of Washington Mutual Inc. and Washington Mutual Bank, “Long Beach Repurchase Reserve Root Cause Analysis,” JPM_WM02533760, Hearing Exhibit 4/13-10 (Long Beach “experienced a dramatic increase in EPD’s [early payment defaults], during the third quarter of 2005 [which] … led to a large volume of required loan repurchases. The unpaid principal balance repurchased as a result of the EPD provision for the year ended December 31, 2005 was $837.3 million. The net loss from these repurchases was approximately $107 million.”). 731 Subcommittee interview of Benjamin Franklin (2/18/2010). 732 See “Washington Mutual Regulators Timeline,” chart prepared by the Subcommittee, Hearing Exhibit 4/16-1j. 733 5/25/2006 OTS Findings Memorandum, “Loan Underwriting Review - Long Beach Mortgage,” OTSWMS06- 008 0001243, Hearing Exhibit 4/16-35. See also 1/20/2006 email from Darrel Dochow to Michael Finn, et al., “LBMC EDP Impact,” OTSWMS06-007 0001020 (emphasis added). 734 6/9/2006 email from Darrel Dochow to Richard Kuczek, Lawrence Carter, and Benjamin Franklin, “Findings Memos,” OTSWMS06-008 0001253, Hearing Exhibit 4/16-36. 735 8/29/2006 OTS Report of Examination, at OTSWMS06-008 0001680, Hearing Exhibit 4/16-94 [Sealed Exhibit]; 9/18/2007 OTS Report of Examination, OTSWMEF-0000047146, Hearing Exhibit 4/16-94 (“Based on our review of 75 subprime loans originated by LBMC, we concluded that subprime underwriting practices remain less than satisfactory . . . . Given that this is a repeat concern and MRBA, we informed management that underwriting must be promptly corrected, or heightened supervisory action would be taken, including limiting the Bank’s ability to continue SFR subprime underwriting.”) [Sealed Exhibit]. 736 April 13, 2010 Subcommittee Hearing at 22. (e) Over 500 Deficiencies in 5 Years FinancialCrisisReport--236 In 2007, after the company announced its intent to restate its 2006 financial results, investors lost confidence in the company, its stock plummeted, and New Century collapsed. In April 2007, it filed for bankruptcy. 918 In February 2008, the bankruptcy examiner released a detailed report that found New Century was responsible for “significant improper and imprudent practices related to its loan originations, operations, accounting and financial reporting processes.” 919 Like WaMu, New Century had engaged in a number of harmful mortgage practices, including “increasing loan originations, without due regard to the risks associated with that business strategy”; risk layering in which it issued high risk loans to high risk borrowers, including originating in excess of 40% of its loans on a stated income basis; allowing multiple exceptions to underwriting standards; and utilizing poor risk management practices that relied on the company’s selling or securitizing its high risk mortgages rather than retaining them. After New Century’s bankruptcy, a 2007 class action complaint was filed by the New York State Teachers’ Retirement System and others alleging that New Century executives had violated federal securities laws and committed fraud. 920 Among other matters, the complaint alleged that the company sold poor quality loans that incurred early payment defaults, received numerous demands from third party buyers of the loans to repurchase them, and built up a huge backlog of hundreds of millions of dollars in repurchase requests that the company deliberately delayed paying to make its 2005 and 2006 financial results appear better than they actually were. 921 The complaint also alleged that New Century issued loans using lax underwriting standards to maximize loan production, 922 and “routinely and increasingly lent money to people who were unable to repay the debt shortly after the loans were closed.” 923 The suit took note of a news article stating: “Loans made by New Century, which filed for bankruptcy protection in March, have some of the highest default rates in the industry.” 924 In December 2009, the SEC filed a civil complaint charging three former New Century executives, the CEO, CFO, and controller, with fraudulent accounting that misled investors about the company’s finances. 925 The SEC alleged that, while the company’s financial disclosures painted a picture that the company’s performance exceeded that of its peers, its executives had failed to disclose material negative information, such as significant increases in its loans’ early 917 In re New Century TRS Holdings, Inc. , Case No. 07-10416 (KJC) (US Bankruptcy Court, Del.), 2/29/2008 Final Report of Michael J. Missal, Bankruptcy Court Examiner, at 2, http://graphics8.nytimes.com/packages/pdf/business/Final_Report_New_Century.pdf (hereinafter “New Century Bankruptcy Report”). See also New Century Class Action Complaint at ¶ 59-60. 918 In re New Century TRS Holdings, Inc. , Case No. 07-10416 (KJC) (US Bankruptcy Court, Del.). 919 New Century Bankruptcy Report. 920 New Century Class Action Complaint. 921 Id. at ¶¶ 75-79. 922 Id. at ¶ 112. See also ¶¶ 126-130. 923 Id. at ¶ 113. See also ¶¶ 114-116. 924 Id. at ¶ 123. 925 SEC Complaint against New Century Executives; See also 12/7/2009 SEC Press Release, “SEC Charges Former Offices of Subprime Lender New Century With Fraud.” payment defaults and a backlog of loan repurchases, which had the effect of materially overstating the company’s financial results. The SEC complaint also stated that, although New Century had represented itself as a prudent subprime lender, it “soon became evident that its lending practices, far from being ‘responsible,’ were the recipe for financial disaster.” 926 The complaint detailed a number of high risk lending practices, including the issuance of interest only loans; 80/20 loans with loan-to-value ratios of 100%; and stated income loans in which the borrower’s income and assets were unverified. 927 The complaint charged the New Century executives with downplaying the riskiness of the company’s loans and concealing their high delinquency rates. 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. CHRG-111hhrg52397--281 Mr. Duffy," Well, what I think Mr. Gensler was referring to was some of the marketing practices that have gone on historically that have targeted some of the uninformed people who may be in a retirement area, such as California, Florida, and others, trying to target them to solicit them to trade foreign exchange product, promising them 60 percent gains in 60 days. And the problem, what happened with the CFTC, most of their budget, I think it was roughly 70 percent was the number, was going to police off exchange fraudulent activity. And I think that is what Mr. Gensler is referring to, that it has to stop. I mean they have to either police it or they are not going to police it but that is a big part of what their budget was going towards. " FinancialCrisisReport--184 Management] in terms of effectiveness and resource adequacy. … ERM provides an important check and balance on the company’s profit-oriented units and warrants ongoing strong Board commitment given the institution’s current strategic direction.” 673 The same ROE noted that the bank did not have effective procedures in place to evaluate the many exceptions being granted to allow loan officers to issue loans that failed to comply with the bank’s lending standards, and urged attention to the risks being established: “Until full exception data collection, reporting, and follow-up processes are in place and stabilized, senior management and the Board cannot fully assess whether quality assurance processes are having a meaningful impact on line activities, including loan underwriting. We are particularly concerned with the establishment of good quality assurance process for SFR underwriting, which has been an issue for the past several examinations.” 674 A follow-up field examination, conducted in September 2005, stated: “We criticized the lack of Trend and Dashboard Report to senior management and the board, without which it is impossible to determine whether line functions are performing acceptably and, more specifically, whether the quality assurance process is having a meaningful impact on improving loan underwriting.” 675 2006 Risk Management Deficiencies. In 2006, OTS again expressed concern about WaMu’s risk management practices, but took no further steps to compel improvements. The annual ROE urged the Board of Directors to: “[c]ontinue to monitor and obtain reports from management on the status of ERM to ensure its effectiveness and adequacy of resources. . . . ERM should provide an important check and balance on profit-oriented units … particularly given the bank’s current strategy involving increased credit risk.” 676 The 2006 ROE also commented that: “[w]ithin ERM, fraud risk management at the enterprise level is in the early stage of development. … Currently, fraud management is decentralized and does not provide a streamlined process to effectively track fraud events across all business lines. In addition, consistent fraud reporting capabilities are not in place to consolidate data for analysis, reporting, and risk management at the enterprise level.” 677 673 8/29/2005 OTS Report of Examination, at OTSWMS05-003 0001783, Hearing Exhibit 4/16-94 [Sealed Exhibit]. 674 Id. at OTSWMS05-004 0001792. 675 10/3/2005 OTS Field Visit Report of Examination, at OTSWMEF-0000047602, Hearing Exhibit 4/16-94 [Sealed Exhibit]. 676 8/29/2006 OTS Report of Examination, at OTSWMS06-008 0001671, Hearing Exhibit 4/16-94 [Sealed Exhibit]. 677 Id. at OTSWMS06-008 0001687, 91. 2007 Risk Management Deficiencies. In 2007, as high risk loan delinquencies and defaults accelerated and WaMu began to incur losses, OTS examiners used harsher language to describe the deficiencies in WaMu’s risk management practices, criticizing the bank’s failure to institute stronger risk controls and procedures at an earlier date, as recommended. CHRG-111shrg57320--5 Mr. Thorson," Chairman Levin, Senator Coburn, and Members of the Subcommittee, we thank you for the opportunity to be here today with my colleague, Mr. Rymer, to testify about our joint evaluation of the failure of Washington Mutual Savings Bank.--------------------------------------------------------------------------- \1\ The prepared statement of Mr. Thorson appears in the Appendix on page 101.--------------------------------------------------------------------------- Over the past 2 years, our country has found itself immersed in a financial crisis that started when housing prices stopped rising and borrowers could no longer refinance their way out of financial difficulty. Since then, we have seen record levels of delinquency, defaults, foreclosures, and declining real estate values. As a result, securities tied to real estate prices have plummeted. Financial institutions have collapsed. In many cases, these financial institutions seemed financially sound, but the warning signs were there as they were in the case of WaMu. At the time of its failure in September 2008, WaMu was one of the largest federally insured financial institutions, operating 2,300 branches in 15 States with assets of $307 billion. A very brief background. My office performs audits and investigations of most Treasury bureaus and offices and that includes OTS. We are required to conduct what is known as a material loss review (MLR), whenever a failed Treasury regulated bank or thrift results in a loss of $25 million or more to the FDIC's Deposit Insurance Fund. These MLRs determine the causes of an institution's failure and assess the supervision exercised over that failed institution. Since the WaMu failure did not result in a loss, it did not trigger a MLR by my office. Nonetheless, given the size of WaMu, Mr. Rymer and I decided that a MLR-like review was warranted. We completed that review on April 9, 2010. I will discuss the principal findings regarding the causes of WaMu's failure and OTS' supervision of WaMu. Mr. Rymer will then follow with a discussion of FDIC's role. WaMu failed because its management pursued a high-risk business strategy without adequately underwriting its loans or controlling its risks. WaMu's high-risk strategy, combined with the housing and mortgage market collapse in mid-2007, left WaMu with loan losses, borrowing capacity limitations, and a falling stock price. In September 2008, WaMu was unable to raise capital to counter significant depositor withdrawals sparked by rumors of WaMu's problems and other high-profile failures at the time. Mr. Chairman, as you pointed out in your opening statement, during the 8 days following the collapse of Lehman Brothers in 2007, they experienced net deposit outflows of $16.7 billion. With the severity and swiftness of the financial crisis, while that contributed to WaMu's failure, it is also true that WaMu was undone by a flawed business strategy. In 2005, it shifted away from originating traditional single-family homes towards the riskier subprime loans and Option Adjustable Rate Mortgages, also known as Option ARMs. They pursued this new strategy in anticipation of higher earnings and to compete with Countrywide Financial Corporation, who it viewed as its strongest competitor. To give the Subcommittee a sense of the profits that could be made, at least in the short term, with the type of non-traditional loan products that WaMu pursued, in 2006, WaMu estimated that its internal profit margin on Option ARMs was more than eight times that of government-backed loans, FHA or VA, and nearly six times that of normal fixed-rate 30-year loans. WaMu saw these riskier loan vehicles as an easy way to substantially increase its profitability. Unfortunately, they expanded into these riskier products without the appropriate level of risk management controls needed to effectively manage that risk. With respect to OTS' supervision, WaMu was the largest institution under OTS' regulation. At the time, it represented as much as 15 percent of OTS' fee revenue, and I should point out that like the other bank regulators, OTS is not taxpayer funded. It is funded with fees collected from those that it regulates. So that meant that OTS was collecting more than $30 million from WaMu annually. OTS conducted regular risk assessments and examinations that rated their overall performance satisfactory through the early part of 2008, though supervisory efforts, however, did identify the core weaknesses that eventually led to WaMu's demise--high-risk products, poor underwriting, and weak risk controls. Issues related to poor underwriting and weak risk controls were noted as far back as 2003, but the problem was OTS did not ensure that WaMu ever corrected those weaknesses. We had a hard time understanding why OTS would allow these satisfactory ratings to continue given that, over the years, they found the same things over and over. Even in WaMu's asset quality in their reports of examination, they wrote, ``We believe the level of deficiencies, if left unchecked, could erode the credit quality of the portfolio. We are concerned further that the current market environment is masking potentially higher credit risk.'' And despite what I just read to you, which was out of their own reports, it was not until WaMu began experiencing losses in 2007 and into 2008 that they began to downgrade their rating. When we asked OTS examiners why they did this, why they didn't lower it earlier, they told us that even though underwriting risk management practices were less than satisfactory, they were making money and loans were performing. As a result, they thought it would be difficult to lower the asset quality rating, and this position surprised us because their own guidance states, ``If an association has high exposure to credit risk, it is not sufficient to demonstrate that the loans are profitable or that the association has not experienced significant losses in the near term.'' Given this guidance, those things should have been done much sooner. In fact, OTS did not take a single safety and soundness enforcement action until 2008, and even then, what they took was quite weak. As troubling as that was, we became even more concerned when we discovered that OTS West Region Director overruled issues raised by his own staff with regard to one of those enforcement actions, which you mentioned, Mr. Chairman, the March 2008 Board Resolution. The Board Resolution only addressed WaMu's short-term liquidity issues and did not require it to address systemic problems repeatedly noted by OTS. Despite the concerns of his own staff, the OTS West Region Director approved the version of the Board Resolution written by WaMu. And as previously reported by my office, this was the same OTS official who also gave approval for IndyMac to improperly backdate a capital contribution to maintain its well-capitalized position just 2 months before IndyMac collapsed. As a final note, I just want to make one comment quickly about the contributions of our outstanding staff, which I always do in these things. I want to mention Marla Freedman, Bob Taylor, Don Benson, Jason Madden, and Maryann Costello, because it is their work that allows me to come here and read these statements. I thank you for the opportunity to be here and will answer whatever questions you have. Senator Levin. Thank you. Your appreciation of staff, I know, comes from long experience on Capitol Hill some years ago. We remember you well. " Mr. Rymer," TESTIMONY OF HON. JON T. RYMER,\1\ INSPECTOR GENERAL, FEDERAL 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 FinancialCrisisReport--224 In addition to a policy of deference to management, weak standards, and demoralized examiners, OTS employed an overly narrow regulatory focus that allowed WaMu’s short term profits to excuse its risky practices and that ignored systemic risk. For a time, its short term profits masked the problems at Washington Mutual, and regulators allowed practices which they knew to be risky and problematic to continue. Because it mishandled its responsibilities, OTS gave the illusion to investors, economists, policy makers, and others that the bank was sound, when in reality, it was just the opposite. Unfortunately, the truth of the matter was not revealed until it was too late, and the bank collapsed. Using Short Term Profits to Excuse Risk. OTS justified not taking enforcement action against WaMu in part by pointing to Washington Mutual’s profits and low loss rates during the height of the mortgage boom, claiming they made it difficult to require the bank to reduce the risks threatening its safety and soundness. In 2005, when faced with underwriting problems at WaMu, the OTS Examiner-in-Charge put it this way: “It has been hard for us to justify doing much more than constantly nagging (okay, ‘chastising’) through ROE [Reports of Examination] and meetings, since they [WaMu] have not been really adversely impacted in terms of losses. It has been getting better and has not recently been bad enough to warrant any ratings downgrade.” 854 The OTS Handbook was explicit, however, in stating that profits should not be used to overlook or excuse high risk activities: 853 10/7/2008 emails from OTS examiner Thomas Constantine to OTS Examiner-in-Charge Benjamin Franklin, “West Region Update,” Franklin_Benjamin-00034415_002, Hearing Exhibit 4/16-14. 854 9/15/2005 email from Examiner-in-Charge Lawrence Carter to Western Region Deputy Director Darrel Dochow, OTSWMS05-002 0000535, Hearing Exhibit 4/16-6. “If an association has high exposure to credit risk, it is not sufficient to demonstrate that the loans are profitable or that the association has not experienced insignificant losses in the near term.” 855 CHRG-111shrg57319--339 Mr. Schneider," We did not. Senator Levin. OK. And did you go after the securities that included the fraudulent mortgages to notify the people that there may be fraud in those securities? Did you take that initiative? " CHRG-110shrg50415--84 Chairman Dodd," Let me ask quickly Mr. Stein and Mr. Rokakis this question. I raised in my opening statement, again, the issue of the HOEPA legislation in 1994 that required--it was not a request; it was a requirement--that there be regulations promulgated to protect against deceptive and fraudulent practices in the residential mortgage market, and nothing happened for 14 years. Let's assume nothing had happened for 10. If 4 or 5 years ago regulations had been promulgated--and look at the ones that came out this July. Let's just assume that is what sort of emerged. We will not try to pretend they are a higher standard, just the ones the present Fed has put out. Could we have avoided this mess we are in today? " FinancialCrisisReport--152 Ms. Kosch told the Subcommittee that from late 2005 until early 2007, loan volume increased and loan quality remained very poor. She said that just about every loan she reviewed was a stated income loan, sloppy, or appeared potentially fraudulent. Yet she was not given the resources or support to properly review each loan. Ms. Kosch said that she was told by a Quality Control manager that she should spend 15 minutes on each file, which she felt was insufficient. Yet, because Quality Assurance Controllers received a bonus on the basis of the number of loans they reviewed, she said some of her colleagues spent only ten minutes on each file. 565 Ms. Kosch found that often, when she tried to stop the approval of a loan that did not meet quality standards, it would be referred to management and approved anyway. She said good Quality Assurance Controllers were treated like “black sheep,” and hated because they got in the way of volume bonuses. She said certain brokers were identified as “elite,” and the Dublin LFC employees were told to, “take care of them.” Ms. Kosch even suspected some underwriters were getting kickbacks, in part, because of the clothes they wore and cars they drove, which she believed would have been unaffordable to even the top back office employees. She reported her suspicions to her supervisor, but she was not aware of any action taken as a result. As it turns out, Ms. Kosch’s concerns about fraud were not unfounded. The September 2004 Daily Productivity email also lauds the work of a Senior Loan Coordinator (SLC) named John Ngo: “ SLC – This one is still tight with Sandy holding on to the first place slot! Sandy funded 4 more on Friday for a MTD total of 46! 2nd place is John Ngo with 4 fundings on Friday and 44 MTD – only 2 back!” About a year after this email was sent, the FBI began to question Mr. Ngo about a scheme to buy houses in Stockton, California with fake documents and stolen identities. According to court records, the FBI had uncovered documents that showed Mr. Ngo had received more than $100,000 in payments from a mortgage broker, allegedly bribes to approve bad loans. Mr. Ngo’s estranged wife told the FBI that she didn’t know how he could afford their $1.4 million home for which he made a down payment of $350,000. At the time, his salary at Long Beach was $54,000. 566 Mr. Ngo later pled guilty to perjury and agreed to testify against his Long Beach sales associate, Joel Blanford. Long Beach paid Mr. Blanford more than $1 million in commissions each year from 2003-2005. According to the Department of Justice: “NGO admitted in his plea agreement that most of the payments were to ensure that fraudulent loan applications were processed and funded. NGO also admitted he received payments from Long Beach Mortgage sales representatives to push applications through the funding process. He knew many of these applications were fraudulent, and he and 565 Subcommittee interview of Diane Kosch (2/18/2010). 566 “At Top Subprime Mortgage Lender, Policies Were an Invitation to Fraud,” Huffington Post Investigative Fund (12/21/2009), http://www.huffingtonpost.com/2009/12/21/at-long-beach-mortgage-a_n_399295.html. others took steps to ‘fix’ applications by creating false documents or adding false information to the applications or the loan file.” 567 (3) WaMu Executive Compensation FinancialCrisisReport--82 Beach. 232 OTS had expressed a number of concerns about Long Beach in connection with the purchase request, 233 but in December 2005, after obtaining commitments from WaMu to strengthen Long Beach’s lending and risk management practices, OTS agreed to the purchase. 234 The actual purchase date was March 1, 2006. 235 Immediately after the purchase, in April 2006, after reviewing Long Beach’s operations, WaMu President Rotella sent an email to WaMu CEO Killinger warning about the extent of the problems: “[D]elinquencies are up 140% and foreclosures close to 70%. … First payment defaults are way up and the 2005 vintage is way up relative to previous years. It is ugly.” 236 Mr. Rotella, however, expressed hope that operations would improve: “Early changes by the new team from HL [Home Loans], who have deep subprime experience, indicate a solid opportunity to mitigate some of this. I would expect to see this emerge in 3 to 6 months. That said, much of the paper we originated in the 05 growth spurt was low quality. … I have the utmost confidence in the team overseeing this now and no doubt this unit will be more productive and better controlled, but I figured you should know this is not a pretty picture right now. We are all over it, but as we saw with repurchases, there was a lot of junk coming in.” Despite the new management and direct oversight by WaMu’s Home Loans Division, Long Beach continued to perform poorly. Five months later, expected improvements had not materialized. In September 2006, Mr. Rotella sent another email to Mr. Killinger stating that Long Beach was still “terrible”: “[Long Beach] is terrible, in fact negative right now. … We are being killed by the lingering movement of EPDs [early payment defaults] and other credit related issues …. [W]e are cleaning up a mess. Repurchases, EPDs, manual underwriting, very weak servicing/collections practices and a weak staff. Other than that, well you get the picture.” 237 231 Id. at OTSWMS06-007 0001010. 232 Id. at OTSWMS06-007 0001011. 233 See, e.g., 6/3/2005 OTS internal memorandum by OTS examiner to OTS Deputy Regional Director, at OTSWMS06-007 0002683, Hearing Exhibit 4/16-28. 234 See 12/21/2005 OTS memorandum, “Long Beach Mortgage Corporation (LBMC),” OTSWMS06-007 0001009, Hearing Exhibit 4/16-31. 235 “Washington Mutual Regulators Timeline,” chart prepared by the Subcommittee, Hearing Exhibit 4/16-1j. 236 4/27/2006 email from Steve Rotella to Kerry Killinger, JPM_WM05380911, Hearing Exhibit 4/13-11. 237 9/14/2006 WaMu internal email, Hearing Exhibit 4/13-12. CHRG-111shrg57319--325 Mr. Beck," I understood that there was fraud. Senator Levin. Shouldn't you have checked to make sure that the fraudulent, tainted mortgages were not part of those securities before you peddled them? Isn't that part of your job? " 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-111shrg57319--366 Mr. Beck," Yes. Senator Levin [continuing]. That fraudulent mortgages had been securitized---- " FinancialCrisisInquiry--198 ZANDI: No, now, the CDOing that was going on—CDO would be like the best example of the wildest euphoria, meaning we were bundling up securities and putting them—putting them into one big security, that CDOing was going on with every single security out there at the height of the—at the height of the hubris. CHAIRMAN ANGELIDES: OK. Mr. Rosen, you were talking about the development of bad products, bad underwriting and fraud in the marketplace. And obviously it was—went all the way up the chain. And in terms of those products then moving throughout the system. I guess my question is, to what extent were those products available historically as predatory loan products? In a sense, to what extent did what used to be considered predatory loans, focused perhaps on certain neighborhoods, essentially get transported to the larger economy? Because there were lenders who offered some of these products on a narrow basis, correct? ROSEN: They were, and many of these practices have been around for a long time, very successfully done, not the risk element—we heard that earlier—but narrowly based. It’s when they became—layered the risk. So if you underwrote a subprime mortgage but underwrote the person’s income, gave them counseling, did all the right things, you didn’t have this issue. Defaults were always higher, but not dramatically higher. Same thing with option ARMs. What happened is we layered the risk. We decided to give a person a subprime mortgage, not verify their income, give them no down payment. And I have charts in the paper which I sent to you guys that—it was hard to believe they were doing it; it’s layering all the risks. And it is because the owner of these mortgages was distant from the origination process. I think that’s why it happened. So the proliferation of products that were sound for certain categories of people with the right underwriting, became—underwriting just disappeared, and it proliferated throughout the system, so we ended up writing, instead of 5 percent subprime mortgages, all of a sudden, it was 20 percent. FinancialCrisisInquiry--106 But I do believe that one of the issues we must explore is, was this purely a perfect storm? Or was it a manmade perfect storm in which the clouds receded? And that’s why I’m driving towards questions and answers about responsibility. I’m going to put aside for a minute my view that I’m troubled by your inability to accept the probability or certainty that your firm would not have made it through the storm but for the vast array of federal assistance. But I really want to turn to this issue of mortgages, which you securitized, as did other firms. BofA stopped making subprime loans in 2001, but you still did securitize mortgage packages, Alt-A, jumbo, that had significant problems, 16 to 25 percent default. So maybe those are like the Murder on the OrientExpress, everyone did it. Having said that, Mr. Blankfein, I read your testimony you said there was cheap money. Albeit there was, there was public policy driving this mortgage business, but you weren’t subject to the Community Reinvestment Act. They were the standards at the time, but I would hope that we always would try to elevate standards. I think what I’m bothered by is this. You weren’t just a market maker. You were securitizing and underwriting packages of mortgages, and when it was clear the market was going bad, even though there was information about bad lending practices that other people moved on, you kept moving this product in the market. And I guess what I’d ask you is what is your responsibility when you put your name on a security to investor to underwrite that thoroughly? There were FBI warnings. There were loan tapes available. Did you fail in that respect in that you did not underwrite the loans that you then securitized and moved into the market? BLANKFEIN: Mr. Chairman, all these loans—what we did in that business was underwrite to again the most sophisticated investors who sought that exposure. I know it’s become part of the narrative to some extent that people knew what was going to happen at every minute. We did not know at any minute what would happen next, even though there was a lot of writing. The FBI may have wrote a report in ‘04, but I will tell you that there were people in the market who thought that -- was going down and there were others who thought, gee, these prices have gone down so much they’re going to bounce up again. CHRG-111hhrg56767--68 Mr. Alvarez," Congressman Bachus, what we are speaking of is employees who are given incentive compensation. A lot of organizations do not provide incentive compensation to the vast majority of their employees. It is selected groups that receive targeted incentives. An example of the type of lower level non-executive employee that we would consider an organization should look at would be their mortgage brokers, where volume of mortgages produced--compensation is often tied to the volume of mortgages produced. We have seen in this crisis that can encourage some employees to generate mortgages with weak underwriting so they can increase their own compensation. " CHRG-111shrg57319--73 Mr. Vanasek," Yes. Senator Coburn. I mean, your own internal sources said there were fraudulent activity. " CHRG-111shrg57322--221 Mr. Sparks," No, Senator. Senator McCaskill [continuing]. Because half of them were fraudulent? Are you talking about those assets? " CHRG-111hhrg51592--85 Chairman Kanjorski," Well, knowing the system, is there? " Mr. Joynt," --that can underwrite or re-underwrite those securities, those individual loans. It has not been our expertise. We have not developed expertise to underwrite individual loans in these securities. " CHRG-111shrg57319--369 Mr. Beck," Yes. Tom Lehmann worked for me, the person that is making this report, and---- Senator Levin. You told him at the time, go and find every single one of these loans, and on all these other documents, as well, now, where you found all these fraudulent loans---- " CHRG-111shrg57319--372 Mr. Beck," Yes. Senator Levin. When you saw these documents, you are saying, in every case, you told your people, go and find every single security that incorporated these fraudulent loans. We are going to buy them back. Is that what you---- " CHRG-111shrg57319--374 Mr. Beck," Yes, I believe we did. I believe we made a filing on this particular issue. Senator Levin. Now, what about the earlier ones where the fraud was identified in those offices? Did you go back and identify what securities incorporated those mortgages that were fraudulent from those offices? " CHRG-111shrg52619--113 Mr. Dugan," People were watching. I think what drove that initially--my own personal view on this--is that most of those loans were sold into the secondary market. They were not loans held on the books of the institutions that originated them. And so for someone to sell it and get rid of the risk, it did not look like it was something that was presenting the same kind of risk to the institution. And if you go back and look at the time when house prices were rising and there were not high default rates on it, people were making the argument that these things are a good thing and provide more loans to more people. It made our examiners uncomfortable. We eventually, I think too late, came around to the view that it was a practice that should not occur, and that is exactly why I was talking earlier, if we could do one thing--two things that we should have done as an underwriting standard earlier is, one, the low-documentation loans and the other is the decline in downpayments. " FinancialCrisisReport--182 Over the same five-year period, from 2004 to 2008, in addition to identifying deficiencies associated with WaMu’s lending practices, OTS repeatedly identified problems with WaMu’s risk management practices. Risk management involves identifying, evaluating, and mitigating the risks that threaten the safety, soundness, and profitability of an institution. At thrifts, the primary risk issues include setting lending standards that will produce profitable loans, enforcing those standards, evaluating the loan portfolio, identifying home loans that may default, establishing adequate reserves to cover potential losses, and advising on measures to lower the identified risks. When regulators criticize a bank’s risk management practices as weak or unsatisfactory, they are expressing concern that the bank is failing to identify the types of risk that threaten the bank’s safety and soundness and failing to take actions to reduce and manage those risks. Within WaMu, from 2004-2005, oversight of risk management practices was assigned to a Chief Risk Officer. In 2006, it was assigned to an Enterprise Risk Management (ERM) Department headed by a Chief Enterprise Risk Officer. ERM employees reported, not only to the department, but also to particular lines of business such as the WaMu Home Loans Division, and reported both to the Chief Risk Officer and to the head of the business line, such as the president of the Home Loans Division. WaMu referred to this system of reporting as a “Double- Double.” 666 As with the bank’s poor lending standards, OTS allowed ongoing risk management problems to fester without taking enforcement action. From 2004 to 2008, OTS explicitly and repeatedly alerted the WaMu Board of Directors to the need to strengthen the bank’s risk management practices. 2004 Risk Management Deficiencies. In 2004, prior to the bank’s adoption of its High Risk Lending Strategy, OTS expressed concern about the bank’s risk management practices, highlighted the issue in the annual ROE, and brought it to the attention of the WaMu Board of Directors. The 2004 ROE stated: 666 Subcommittee interviews of Ronald Cathcart (2/23/2010), David Schneider (2/17/2010), and Cheryl Feltgen (2/6/2010). “Board oversight and management performance has been satisfactory … but … increased operational risks warrant prompt attention. These issues limit the institution’s flexibility and may threaten its ability to remain competitive and independent.” 667 FinancialCrisisReport--95 In order to issue these loans as soon as possible in 2006, WaMu set up an underwriting team to provide “manual” approvals outside of its automated systems: “Our team is currently focused on several HE [Home Equity] modeling initiatives to include higher risk lending …. [W]e are adjusting our decision engine rules for a July roll out to allow for 580-620 [FICO scores] and LT 80% CLTV [combined loan-to-value] loans to be referred to a manual ‘sub-prime’ underwriting team that we are putting in place. … [W]e see this 580-620 segment as the biggest opportunity where we aren’t lending today.” 304 Also in 2006, WaMu began issuing so-called “80/20 loans,” in which a package of two loans are issued together, imposing an 80% LTV first lien and a 20% LTV second lien on the property, for a total combined LTV (CLTV) of 100%. 305 Loans that provide financing for 100% of a property’s value are extremely high risk, because the borrower has no equity in the property, the borrower can stop payments on the loan without losing a personal investment, and a subsequent home sale may not produce sufficient funds to pay off the debt. 306 Yet in 2006, Home Loans Division President David Schneider approved issuing 80/20 loans despite the risk and despite the fact that WaMu’s automatic underwriting system was not equipped to accept them, and loan officers initially had to use a manual system to issue the loans. 307 Using Low Interest Rates to Qualify Borrowers. A third risk layering practice at WaMu was allowing loan officers to qualify prospective borrowers for short term hybrid ARMs or Option ARMs based upon only the initial low rate and not the higher interest rate that would take effect later on. In a filing with the SEC, for example, Washington Mutual Inc. wrote that its “underwriting guidelines” allowed “borrowers with hybrid adjustable-rate home loans … where the initial interest rate is fixed for 2 to 5 years” to be “qualified at the payment associated with the fixed interest rate charged in the initial contractual period.” 308 In addition, in 2005, WaMu personnel informed OTS that, since 2004, the bank had not been qualifying its Option ARM 303 6/13/2006 email from Cheryl Feltgen to David Schneider who forwarded it to Steve Rotella, JPM_WM01311922-23. 304 6/14/2006 email from Mark Hillis to Cheryl Feltgen, included in a longer email chain involving Mr. Rotella and Mr. Schneider, among others, JPM_WM01311922. 305 See, e.g., 6/2006 email chain between Mr. Rotella, Mr. Schneider, Mr. Hillis, and Ms. Feltgen, JPM_WM01311922-23. 306 See NTM Guidance at 58614. See also SEC v. Mozilo , Case No. CV09-03994 (USDC CD Calif.), Complaint (June 4, 2009), at ¶ 50 (quoting an email by Countrywide CEO Angelo Mozilo who, when discussing the 80/20 loans being issued by his bank, wrote: “In all my years in the business I have never seen a more toxic pr[o]duct.”). 307 Id.; Subcommittee interview of Cheryl Feltgen (2/6/2010). 2/2006 WaMu internal email chain, “FW: 80/20,” JPM_WM03960778. See also 3/19/2007 email from Ron Cathcart to David Schneider, JPM_WM02571598, Hearing Exhibit 4/16-75 (indicating WaMu issued loans with CLTVs in excess of 95% until ending the practice in March 2007). 308 See 3/1/2007 Washington Mutual Inc. 10-K filing with the SEC at 56. borrowers using the “fully indexed rate.” 309 Instead, WaMu was using a lower “administrative” rate that was “significantly less than the fully indexed rate.” 310 fcic_final_report_full--175 Ed Parker, the head of mortgage fraud investigation at Ameriquest, the largest subprime lender in , , and , told the FCIC that fraudulent loans were very common at the company. “No one was watching. The volume was up and now you see the fallout behind the loan origination process,” he told the FCIC.  David Gussmann, the former vice president of Enterprise Management Capital Markets at Fannie Mae, told the Commission that in one package of  securitized loans his an- alysts found one purchaser who had bought  properties, falsely identifying himself each time as the owner of only one property, while another had bought five proper- ties.  Fannie Mae’s detection of fraud increased steadily during the housing bubble and accelerated in late , according to William Brewster, the current director of the company’s mortgage fraud program. He said that, seeing evidence of fraud, Fan- nie demanded that lenders such as Bank of America, Countrywide, Citigroup, and JP Morgan Chase repurchase about  million in mortgages in  and  mil- lion in .  “Lax or practically non-existent government oversight created what criminologists have labeled ‘crime-facilitative environments,’ where crime could thrive,” said Henry N. Pontell, a professor of criminology at the University of Califor- nia, Irvine, in testimony to the Commission.  The responsibility to investigate and prosecute mortgage fraud violations falls to local, state and federal law enforcement officials. On the federal level, the Federal Bu- reau of Investigation investigates and refers cases for prosecution to U.S. Attorneys, who are part of the Department of Justice. Cases may also involve other agencies, in- cluding the U.S. Postal Inspection Service, the Department of Housing and Urban Development, and the Internal Revenue Service. The FBI, which has the broadest ju- risdiction of any federal law enforcement agency, was aware of the extent of the fraudulent mortgage problem.  FBI Assistant Director Chris Swecker began noticing a rise in mortgage fraud while he was the special agent in charge of the Charlotte, North Carolina, office from  to . In , that office investigated First Bene- ficial Mortgage for selling fraudulent loans to Fannie Mae, leading to the successful criminal prosecution of the company’s owner, James Edward McLean Jr., and others. First Beneficial repurchased the mortgages after Fannie discovered evidence of fraud, but then—without any interference from Fannie—resold them to Ginnie Mae.  For not alerting Ginnie, Fannie paid . million of restitution to the government. McLean came to the attention of the FBI after buying a luxury yacht for , in cash.  Soon after Swecker was promoted to assistant FBI director for investigations in , he turned a spotlight on mortgage fraud. “The potential impact of mortgage fraud is clear,” Swecker told a congressional committee in . “If fraudulent prac- tices become systemic within the mortgage industry and mortgage fraud is allowed to become unrestrained, it will ultimately place financial institutions at risk and have adverse effects on the stock market.”  In that testimony, Swecker pointed out the inadequacies of data regarding fraud and recommended that Congress mandate a reporting system and other remedies and require all lenders to participate, whether federally regulated or not. For exam- ple, suspicious activity reports, also known as SARs, are reports filed by FDIC-in- sured banks and their affiliates to the Financial Crimes Enforcement Network (FinCEN), a bureau within the Treasury Department that administers money-laun- dering laws and works closely with law enforcement to combat financial crimes. SARs are filed by financial institutions when they suspect criminal activity in a finan- cial transaction. But many mortgage originators, such as Ameriquest, New Century, and Option One, were outside FinCEN’s jurisdiction—and thus the loans they gener- ated, which were then placed into securitized pools by larger lenders or investment banks, were not subject to FinCEN review. William Black testified to the Commis- sion that an estimated  of nonprime mortgage loans were made by noninsured lenders not required to file SARs. And as for those institutions required to do so, he believed he saw evidence of underreporting in that, he said, only about  of feder- ally insured mortgage lenders filed even a single criminal referral for alleged mort- gage fraud in the first half of .  FOMC20070918meeting--57 55,MR. STOCKTON.," In this particular forecast, the housing revision is basically all driven off our assumptions about the difficulties in financial markets. There are no additional sentiment-type effects there. On commercial real estate, I’d say pretty much the same thing. As I noted in my briefing, the area where we have ventured into a looser sort of approach would be on the consumer spending side, where we are not really expecting a significant amount. We would expect some restraint on consumer lending and consumer borrowing associated with tighter underwriting, so there will be some increase in cost. But I don’t think those effects are likely to be large. Here we are relying more on an assumption that some disturbance to consumer sentiment will persist into next year. One thing that I would be looking for—for that piece of the forecast to be wrong and, therefore, for there to be more underlying strength in the economy—would be a quicker rebound in consumer sentiment and a moving up to the low 90s in relatively short order. That piece of what we built into the forecast would look to be questionable and might be worth a couple of tenths on the level of GDP next year. The other area where I would be looking if I were in your shoes and auditing our forecast is that we are expecting the labor market to be quite weak moving into the fourth quarter and, by the end of the fourth quarter, no employment growth, basically flat employment. Thus far, we have seen some uptick in initial claims for unemployment insurance. That seems consistent with some of the slowing that we have already seen. But I think we would have to see a further rise there to be consistent with the weakness that we are expecting in the labor markets. If that were not to occur, it would suggest, again, that we are likely to be off the mark on the weakness in activity that we are projecting. So I would say that those two areas would be at the top of my list for monitoring the weakness of the forecast. The factory sector would be the final area where I think, again, we get relatively timely information—some of it physical product data, not just data based on the labor market. We are expecting things to be a little weaker than they were in the middle of the summer but not so weak as they were in August. However, if we saw continued strength there, I think that would suggest some inconsistency with the weakness of our forecast." CHRG-111shrg57319--77 Mr. Vanasek," Yes. Senator Coburn. When did you, at any point in time in your time as a Risk Manager for them, believe that this was widespread fraudulent activity? " CHRG-111hhrg48868--125 Mr. Ackerman," They're underwriting the underwriters that are doing the underwriting? " CHRG-111shrg57320--182 Mr. Dochow," And even their automated underwriting, Desktop Underwriter or Loan Prospector, started accepting more liberal terms. Senator Kaufman. Exactly. " 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 CHRG-111shrg57319--174 Mr. Melby," We did not sit down specifically and talk. I know Mr. Schneider had some concerns with some of the issues, but for the most part did not dispute the overall results of the report. Senator Levin. On page 2 of this exhibit, the second bullet point there, it says that Home Loans Risk Mitigation ``generated alerts that identified patterns of fraudulent loan practices and provided remediation recommendations that were not acted upon by [Home Loans] Senior Management. Employee interviews conducted during this investigation consistently described an environment where production volume rather than quality and corporate stewardship were the incented focus.'' Then if you go back again on page 3, if you look at that bullet point at the top of page 3 of that exhibit, it says there that, ``Loan Producers were compensated for volume of loans closed and Loan Processors were compensated for speed of loan closing rather than a more balanced scorecard of timeliness and loan quality.'' It says there that, ``Employee interviews conducted during this investigation consistently described an environment where production volume rather than quality and corporate stewardship were the incented focus.'' How did senior management, Mr. Melby, react to the finding that compensation incentives put loan speed and volume over loan quality? " CHRG-111hhrg67816--95 Mr. Rush," The chair thanks the gentleman. The chair now recognizes the gentlelady from California, Ms. Matsui, for 5 minutes for questioning. Ms. Matsui. Chairman Leibowitz, as I mentioned in my opening statement, the issue of loan modification scams is a growing problem, particularly in California where we have the highest number of homes going into foreclosure. We hear individuals and companies advertising on radio and television with a simple message that they can lower your mortgage payments, stop your foreclosure. And many of these people are calling themselves foreclosure consultants or in some cases acting like they were government agencies like HUD. They make guarantees and promises to homeowners seeking help to save their home, but this help usually comes with a price tag in the form of an advanced fee between $1,500 up to $9,000. That being said, I would like to hear what the FTC is doing to crack down on these fraudulent loan modification scams. In your written testimony, you announced two new cases targeting mortgage foreclosure rescue scams bringing the total to eight such cases. Is enforcement the right approach to ending this type of fraud? You initiated 8 cases. Will those cases serve as a deterrent to other scammers and other steps that the FTC can take to end these practices? " CHRG-111hhrg74090--38 Mrs. Matsui," Thank you, Mr. Chairman, and thank you for calling today's hearing. I applaud your leadership in addressing this important issue. I would also like to thank the witnesses for joining us today. In today's economic recession, many families in home district of Sacramento are struggling to make ends meet. I have heard countless stories of people struggling to keep their homes, their jobs and their way of life. California and in particular my constituents in Sacramento have been greatly impacted by the economic crisis. Many of my constituents were and continue to be victims of predatory home loan lending, unfair credit card practices, payday loans and other forms of unscrupulous business practices. Just recently, the President signed into law credit card reform legislation to regulate unfair credit card practices. The ink is hardly dry. The companies are already trying to find ways to arbitrarily raise credit card interest rates and fees on consumers. Struggling homeowners are also seeking assistance to keep their homes but continue to be tricked into contacting scam artists who just so happen to be the same crowd that initially steered homeowners into subprime loans. This is also occurring as job losses mount, foreclosures continue to rise and Americans are increasingly turning to other forms of credit to make ends meet. It is clear that consumers are not being properly protected from unfair and deceptive financial practices. When is enough enough? The President's proposal to create a new financial consumer protection agency could be the answer that American consumers are seeking but it must be done in a thoughtful way to ensure consumers are protected from fraudulent activity. We must make sure any new agency has real authority and just as much bite as it has bark. Consumers need to feel protected and have confidence in our financial system. Right now it is clear that they do not. I thank you, Mr. Chairman, for holding this important hearing today and I look forward to working with you and the committee on this issue moving forward. I yield back the balance of my time. " CHRG-111shrg57319--331 Mr. Beck," I did not. Senator Levin. Mr. Schneider, take a look at Exhibit 24,\1\ if you would. Fraud problems resurfacing with a gusto in early 2008. This is an April 4 memo from the WaMu Corporate Fraud Investigation and Audit Section. It says that one of the mortgage insurers refused to insure any more loans issued by the loan officer from the Montebello loan office. That was the same loan officer who was investigated in 2005. It describes the earlier 2005 investigation, and states that virtually no actions were taken in response to it. It says that another review of loans issued by the Montebello office in 2007--and this is what is now reported in this April 2008 audit--found that 62 percent contained fraudulent information.--------------------------------------------------------------------------- \1\ See Exhibit No. 24, which appears in the Appendix on page 515.--------------------------------------------------------------------------- Were you aware of this audit? " FinancialCrisisReport--101 Examiner-in-Charge at WaMu at the time, Benjamin Franklin, asked the bank to conduct an investigation into the matter. 336 WaMu’s legal department asked the WaMu Corporate Fraud Investigation (CFI) group and the Audit department to conduct a joint inquiry. Seven months later, in April 2008, CFI and the Audit department issued a 12-page memorandum with their findings. 337 The memorandum not only confirmed the presence of fraud in the Montebello office, citing a loan file review that found a fraud rate of 62%, it also uncovered the 2005 investigation that had identified the problem two years earlier, but was ignored by management. The 2008 memorandum stated: “In 2005, HL [Home Loans] Risk Mitigation provided Senior HL Management with an assessment of fraud and loan performance in the Retail Broker Program and two Southern California Emerging Markets [loan centers] for the period of September 2003 through August 2005. This assessment identified excessive levels of fraud related to loan qualifying data …. It also highlighted the Downey and Montebello [loan centers] as the primary contributors of these fraudulent loan documents based upon volume and articulated strategies to mitigate fraud. The report also stated that delinquency performance on these [loan centers] … were significantly worse that the delinquency performance for the entire open/active retail channel book of business. In 2007, HL Risk Mitigation mirrored their 2005 review with a smaller sample of loans and found that, for the September and October 2007 sampled time period, the volume of misrepresentation and suspected loan fraud continued to be high for this [loan center] (62% of the sampled loans).” 338 Examples of fraudulent loan information uncovered in the 2007 review included falsified income documents, unreasonable income for the stated profession, false residency claims, inflated appraisal values, failure of the loan to meet bank guidelines, suspect social security numbers, misrepresented assets, and falsified credit information. 339 The memorandum found that, in 2005, the WaMu Risk Mitigation Team had reported its findings to several WaMu managers whom it “felt were very aware of high volumes of fraud” in the loans issued by the two loan officers. 340 The memorandum reported that one individual believed that David Schneider “was made aware of these findings” and wanted Risk Mitigation 334 4/4/2008 WaMu Memorandum of Results, “AIG/UG and OTS Allegation of Loan Frauds Originated by [name redacted],” at 1, Hearing Exhibit 4/13-24. 335 Id. 336 Subcommittee interview of Benjamin Franklin (2/18/2010). 337 4/4/2008 WaMu Memorandum of Results, “AIG/UG and OTS Allegation of Loan Frauds Originated by [name redacted],” at 1, Hearing Exhibit 4/13-24. 338 Id. at 2. 339 Id. at 3. 340 Id. at 7. to “monitor the situation.” 341 But no one knew “of additional monitoring that was done, or efforts to bring additional attention to” the fraudulent loans from the Downey and Montebello offices. The memorandum also noted that no personnel action had been taken against either of the loan officers heading the two offices. 342 David Schneider was interviewed and “recalled little about the 2005 fraud findings or actions taken to address them.” 343 He “thought the matter was handled or resolved.” The WaMu memorandum concluded: “Outside of training sessions … in late 2005, there was little evidence that any of the recommended strategies were followed or that recommendations were operationalized. There were no targeted reviews conducted … on the Downey or Montebello loan portfolios between 2005 and the actions taken in December 2007.” 344 FinancialCrisisReport--218 At another point, the same Examiner-in-Charge wrote a long email discussing issues related to a decision by WaMu to qualify borrowers for adjustable rate mortgages using an interest rate that was less than the highest rate that could be charged under the loan. He complained that it was difficult to force WaMu to comply with the OTS “policy of underwriting at or near the fully indexed rate,” when “in terms of policy, I am not sure we have ever had a really hard rule that institutions MUST underwrite to the fully indexed rate.” 823 He also noted that OTS sometimes made an exception to that rule for loans held for sale. NTM Guidance. While some OTS examiners were complaining about the agency’s weak standards, other OTS officials worked to ensure that new standards being developed for high risk mortgages would not restrain WaMu’s lending practices. The effort began in 2006 with an aim to address concerns about lax lending standards and the risks posed by subprime, negatively amortizing, and other exotic home loans. The federal banking agencies convened a joint effort to reduce the risk associated with those mortgages by issuing interagency guidance for “nontraditional mortgage” products (NTM Guidance). Washington Mutual filed public comments on the proposed NTM Guidance and argued that Option ARM and Interest-Only loans were “considered more safe and sound for portfolio lenders than many fixed rate mortgages,” so regulators should “not discourage lenders from offering these products.” 824 It also stated that calculating a potential borrower’s “DTI [debt-to-income ratio] based on the potential payment shock from negative amortization would be highly speculative” and “inappropriate to use in lending decisions.” 825 During subsequent negotiations to finalize that guidance, OTS argued for less stringent lending standards than other regulators were advocating and bolstered its points using data supplied by Washington Mutual. 826 In one July 2006 email, for example, an OTS official expressed the view that early versions of the new guidance focused too much on negative amortization loans, which were popular with several thrifts and at WaMu in particular, and failed to also look closely at other high risk lending products more common elsewhere. 827 He also wrote that OTS needed to address this issue and “should consider going on the offensive, rather than defensive to refute the OCC’s positions” on negatively amortizing loans, defending the loans using WaMu Option ARM loan data. 828 In August, several OTS officials discussed over email how to prevent the 822 Id. 823 9/15/2005 email from OTS Examiner-in-Charge Lawrence Carter to OTS Western Region Deputy Director Darrel Dochow, OTSWMS05-002 0000535, Hearing Exhibit 4/16-6. 824 3/29/2006 letter from Washington Mutual Home Loans President David C. Schneider to OTS Chief Counsel, Proposed Guidance – Interagency Guidance on Nontraditional Mortgage Products 70 Fed. Reg. 77249, JPM_WM04473292. 825 Id. at JPM_WM04473298. 826 Subcommittee interviews of Sheila Bair (4/5/2010) and George Doerr (3/30/2010). The Subcommittee was told that OTS was the “most sympathetic to industry” concerns of the participating agencies and was especially protective of Option ARMs. 827 7/27/2006 email from Steven Gregovich to Grovetta Gardineer and others, “NTM Open Issues,” OSWMS06-008 0001491-495, Hearing Exhibit 4/16-71. 828 Id. proposed restrictions on negatively amortizing loans from going farther than they believed necessary, noting in part the “profitable secondary market” for Option ARMs and the fact that “hybrid IO [interest only] ARMs are a huge product for Wamu.” One OTS official wrote: “We have dealt with this product [negatively amortizing loans] longer than any other regulator and have a strong understanding of best practices. I just don’t see us taking a back seat on guidance that is so innate to the thrift industry.” 829 CHRG-111hhrg48868--695 Mr. Liddy," Yes, I would say there are no signs of this here. What we had at AIG is too much appetite for risk, too much appetite for businesses outside of our core competencies, contractual commitments, which, when left in place and the market melted down, exposed their weaknesses. So we could and should be roundly criticized for aggressive business practices, but nothing like an Enron or a WorldCom or the things that you just referred to. " FinancialCrisisInquiry--361 CHAIRMAN ANGELIDES: Thank you, Mr. Vice Chairman, members. There is, I know you’ll be glad to know, a little remaining time. So I’d like to just ask a few follow-up questions before we move out of here. And, Mr. Blankfein, maybe you’re going to suffer from me having been A all my life and you having been B, but I do want to revisit some of the issues we talked January 13, 2010 about. And let me preface this by saying if I die 51 percent right and 49 percent wrong I will be a happy man. But I do believe that one of the issues we must explore is, was this purely a perfect storm? Or was it a manmade perfect storm in which the clouds receded? And that’s why I’m driving towards questions and answers about responsibility. I’m going to put aside for a minute my view that I’m troubled by your inability to accept the probability or certainty that your firm would not have made it through the storm but for the vast array of federal assistance. But I really want to turn to this issue of mortgages, which you securitized, as did other firms. BofA stopped making subprime loans in 2001, but you still did securitize mortgage packages, Alt-A, jumbo, that had significant problems, 16 to 25 percent default. So maybe those are like the Murder on the OrientExpress, everyone did it. Having said that, Mr. Blankfein, I read your testimony you said there was cheap money. Albeit there was, there was public policy driving this mortgage business, but you weren’t subject to the Community Reinvestment Act. They were the standards at the time, but I would hope that we always would try to elevate standards. I think what I’m bothered by is this. You weren’t just a market maker. You were securitizing and underwriting packages of mortgages, and when it was clear the market was going bad, even though there was information about bad lending practices that other people moved on, you kept moving this product in the market. And I guess what I’d ask you is what is your responsibility when you put your name on a security to investor to underwrite that thoroughly? There were FBI warnings. There were loan tapes available. Did you fail in that respect in that you did not underwrite the loans that you then securitized and moved into the market? CHRG-111shrg57320--395 Mr. Corston," Through the same exam process we do now. They are underwriting the loan so we can see the underwriting standards and we can sample them. Senator Levin. The same standards that you are now using to check---- " 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. 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. CHRG-111shrg57320--60 Mr. Rymer," I think that people in leadership positions have to be willing to make the tough calls and be experienced enough to know that today's risky practices may show today profitability, but to explain to management and enforce with regulatory action that risky profitability is going to have a cost. It either has a cost in control processes an institution would have to invest in now, or it is going to have a cost ultimately to the bank's profitability and perhaps eventually to the Deposit Insurance Fund. So that is the tough decision I think that has to be made, that has to be enforced constantly. Senator Kaufman. And, Mr. Thorson, I have been around this place for a long time, not as a Senator but as a staff person, and we can only write the laws so much. But it is truly scary when you read this report--where it seems to me clear that the problem here was that we had good Federal examiners out there saying there is a problem here, and the management not doing it. And I just do not see it in the report, and I think it is key as we move forward--we have good people out there doing the jobs and being the examiners, the career employees that we have. But if you put the wrong people in charge, we can write the laws any way we want to, but if they are not going to go after a company because they are making money. I want to shift to something a little different, but it is all on the same point, and that is, I read your causes of WaMu's failure, and I see WaMu failed because its management pursued a high-risk business strategy without adequately underwriting its loans or controlling its risks. That sounds great. I do not think that is what went on here. I really do not. And I think unfortunately you were not here for the hearing the other day, but I think if you sat there and watched what went on and listened to the Chairman's questioning and went through the exhibits, you would say that is not why they failed. Right, Mr. Chairman? They did not fail because management pursued a high-risk business strategy without adequately underwriting its loans or controlling its risks. Would both of you comment on what you believe happened here? " CHRG-111shrg57319--177 Mr. Melby," Yes. Senator Levin. OK. How does a bank that turns out loans of which 58 or 62 or 83 percent contain misrepresentations or fraudulent borrower information, how does a bank operate that way and expect that there is going to be any confidence in the loans that it is issuing? In other words, how does it claim to be a reliable institution with these kind of numbers, Mr. Vanasek? " 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-111shrg57319--333 Mr. Schneider," This audit was actually conducted by the Legal and HR group. I was aware of it, but they were conducting it. Whenever I found out about cases of fraud, I asked that an investigation happen. We had no interest in fraud, no interest in our originators perpetrating the fraud. Senator Levin. Yet it continued to happen year after year after year, and you are selling the securities that those fraudulent mortgages are included in. Now, what action did you insist upon? You are out there selling these securities. " CHRG-111shrg57319--72 Mr. Vanasek," I had originally agreed with Mr. Killinger when I was employed that I would work 6 years with Washington Mutual. I was 62 years old. I have a heart condition and four cardiac stents. I thought it time for the sake of my health to leave. Senator Coburn. There is no question in what Senator Levin had laid out that there, in several of the offices of WaMu, especially in Downey and Montebello, that there was fraudulent activity going on, correct? " 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-111shrg382--18 Mr. Tarullo," Thank you, Senator. Let me reemphasize the premise of your question, which is that resolution is very much of a challenge. Let me step back for a second and suggest why it is such a challenge, even more than a lot of the other areas we are talking about. If we want to make changes in capital standards and the FSB gets together and we converge around a set of changes, we all have ample domestic legal authority under our own constitutional structures to go back and make those changes. In the area of resolution, of course, we are talking about bankruptcy law. We are talking about bank insolvency law under the FDI Act, things that the Congress and parliaments around the world have put into legislation. So here, each country has its own set of legal rights and priorities for creditors. We have our own set of laws on what constitutes a fraudulent conveyance, for example. We have our own set of practices as to what kinds of creditor adjustments can be made during a bankruptcy or resolution procedure. So, from some people's point of view, the first best or at least the cleanest solution would be one that would have to harmonize the bankruptcy and resolution mechanisms and laws all around the world---- Senator Shelby. And that is no easy task. " CHRG-111shrg56415--35 Mr. Tarullo," What I hope is that this Committee and the Congress as a whole will pass a strong set of reforms, no matter what other people out there are saying. Senator Tester. OK. Thank you very much. Thank you, Mr. Chairman. Senator Johnson. Senator Gregg. Senator Gregg. Thank you, Mr. Chairman, and I want to thank the panel for their excellent testimony. It has been most interesting. First off, I want to congratulate the FDIC for deciding to forward-fund the fees. I think that is the right approach. You do a lot of things right. You have done a lot of things right during this problem. You did a lot of things right when I was Governor in 1989 in New Hampshire and five of our seven largest banks closed. Mr. Seidman came in and basically was our white knight. But you did say something that really concerns me, and that is, how you interpret the TARP, this idea that the TARP should be now used as a capital source for a lot of smaller banks that are having problems raising capital. I think all of you basically in your testimony have said we are past the massive systemic risk of a financial meltdown that would have caused a cataclysmic event. TARP came about because of that massive potential cataclysmic event, and its purpose was to basically stabilize the financial markets and be used in that manner in order to accomplish that. As one of the authors, along with Senator Dodd--we sat through the negotiations of that--I think I am fairly familiar with that purpose. That was the goal. It should not now be used as a piggy bank for housing. It should not be used as a piggy bank for whatever the interest of the day is that can be somehow--it should not have been used for the automobile industry, and it really should not be used in order to have a continuum of capital available to smaller banks who have problems, in my opinion, because then you are just going to set up a new national program which will essentially undermine the forces of the market, and that would be a mistake. I did hear you say, Madam Chairman, that you expect $100 billion in losses. Is that a net number? Or do you expect to recoup some percentage of that? Ms. Bair. No, that is what we project our losses to be over the next 5 years. Senator Gregg. So that is a net number after recoupment? Ms. Bair. Yes. Senator Gregg. Well, is it--do you expect of that $100 billion in bad loans to be getting back 30 percent of---- Ms. Bair. The $100 billion would be our losses. So let us say we had a 25-percent loss rate on our bank failures so far, so you would be talking about $400 billion in failed bank assets. Senator Gregg. Well, OK, so it---- Ms. Bair. That is since the beginning of 2009, though. And, again, a lot of that has already been realized and reserved for. Senator Gregg. And you have got $64 billion, you said, or something, that has been realized and reserved against, so you have got about---- Ms. Bair. That is right, yes. Senator Gregg.----$36 billion to go. OK. I have got a philosophical question here. If we look at this problem--granted, commercial real estate is now the problem, but commercial real estate, as I understand it from your testimony, is not--it is a serious problem. It is just not a systemic event. It is not going to cause a meltdown of our industries--of our financial industry. It may impact rather significantly especially the middle-sized regional banks and some of the smaller banks, but it is not systemic. The systemic event was caused in large part in the banking industry by the primary residence lending activity--subprime, Alt-A, and regular loans. And all I heard about as the proposals for getting at this is regulatory upon regulatory layers to try to figure out a way to basically protect ourselves from having that type of excess in this arena occur again. But when you get down to it, it is all about underwriting. I mean, the bottom line is this is about underwriting. It is about somebody lent to somebody who either did not have the wherewithal to pay it back or who had an asset which was not worth what they lent on that asset. And probably the person who lent it did not really care because they were just getting the fee and they were going to sell it into the securitized market anyway. So if you really want to get at this issue, wouldn't it be more logical and simpler and--it is not the whole solution. Clearly, there has to be regulatory reform. But shouldn't we look at the issue of having different underwriting standards, both of which the OCC and the FDIC have the authority over, in the area of what percentage to asset can you lend? You know, do you have to have 90 percent, 80 percent? Shouldn't we have an underwriting standard that says you either get--that there is recourse? Shouldn't we have underwriting standards that gives you the opportunity to either have an 80-percent or 90-percent choice or a covered loan, something like that? Isn't that really a simpler way from a standpoint of not having--granted, it would chill the ability to get a house because people who could not afford to buy the house and could not afford to pay the loan back probably would not be able to get the loan. But isn't that where we should really start this exercise, with recourse and 80 percent or 90 percent equity--10, 20 percent equity value and/or, alternatively, covered funds? I would ask everybody who actually is on the front lines of lending today. Ms. Bair. Certainly underwriting is key, but poor underwriting is not necessarily the driver of future losses now. We are seeing loans go bad now that were good when they were made. But because of the economy--because people are losing their jobs, or retailers are having to close, or hotels cannot fill up--those loans are going bad. The economic dynamic is kicking in in terms of the credit distress that we are increasingly seeing on bank balance sheets. You are right, the subprime mortgage mess got started with very weak underwriting. It started in the non-bank sector. It spilled back into the banking sector. I think all of us wish we had acted sooner, but we did move to tighten underwriting standards, and strongly encouraged the Federal Reserve Board to impose rules across the board for both banks and non-banks. This, again, is the reason why you need to make sure that the stronger underwriting standards going forward apply to both banks and non-banks. Senator Gregg. Well, what should those underwriting standards be? Ms. Bair. You should have to document income. You should do teaser-rate underwriting. The Federal Reserve Board has put a lot of these in effect now under the HOEPA rules. You have to document income. You cannot do payment shock loans. You have got to make sure the borrower can repay the loan if it is an adjustable rate mortgage that resets. These are just common-sense underwriting principles that have applied to banks for a long time. Senator Gregg. Or should there be recourse? Ms. Bair. That has been a prerogative of the States. Some mortgage lending is recourse, some is non-recourse, depending on the State. Senator Gregg. Should there be a requirement that you cannot lend to 100 percent of value? Ms. Bair. I think there is a strong correlation with loan-to-value ratios (LTVs). We actually recognize that in our capital standards that we are working on now. We would require a much higher risk weighting of loans which have high LTVs. So through capital charges, we are recognizing and trying to incent lower LTVs. Senator Gregg. I am running out of time unfortunately. " CHRG-111shrg55739--116 Mr. Coffee," I think that what some of us are saying is that you could certainly have alternatives that did not involve the use of an NRSRO agency. But to the extent that there already is this reputational capital out there in the public's mind and they are going to want you to have an NRSRO rating, some of us want to make that real and not illusory by insisting on due diligence. And that due diligence, to answer your earlier question, would probably be paid for by the underwriters. If the underwriters could get this market jump-started again, they would be happy to pay the cost of due diligence. Senator Corker. Thank you all. I appreciate it. Senator Reed. Thank you, Senator Corker. Senator Bunning. Senator Bunning. Thank you. Five minutes turns into 10 in a big hurry up here, and that is the only reason--since some of us have another meeting to go to. This is for anyone who would like to answer it. During the housing boom--the boom--rating agencies rated mortgage-backed securities without verifying any of the information about the mortgages. If they had, maybe they would have detected some of the fraud and bad lending practices. Do you think rating agencies should be required to verify the information provided to them by the issuer? And I am going to give you a caveat. The first mortgage that I ever took, I had to take three of my Federal tax returns in with me to verify that I had the income that I wrote on my application. You do not have to do any of those things right now, and I am asking if you think we ought to have a little more verification of what is on the list that the person who is looking for the mortgage at the time--and that is how we got into all this mischief with mortgage-backed securities being sold into the market without any verification, even though they were AAA rated. " CHRG-111hhrg54868--189 Mr. Bachus," But if you had underwriting standards, and you said, we are going to regulate underwriting standards, you could-- " FinancialCrisisReport--80 To analyze what happened, WaMu conducted a “post mortem” review of 213 Long Beach loans that experienced first payment defaults in March, April, and May of 2005. 219 The review found that many early defaults were not only preventable, but that in some instances fraud should have been easily detected from the presence of “White Out” on an application or a borrower having two different signatures: “First Payment Defaults (FPD’s) are preventable and / or detectable in nearly all cases (~99%)[.] Most FPD cases (60%) are failure of current control effectiveness[.] … High incident rate of potential fraud among FPD cases[.] … All roles in the origination process need to sharpen watch for misrepresentation and fraud[.] … Underwriting guidelines are not consistently followed and conditions are not consistently or effectively met[.] … Underwriters are not consistently recognizing non-arm’s length transactions and/or underwriting associated risk effectively[.] … Credit Policy does not adequately address certain key risk elements in layered high risk transactions[.] … “66% of reviewed FPD cases had significant variances in the file[.] … Stated Income should be reviewed more closely ([fraud] incidence rate of 35%) …. Signatures should be checked – 14% Borrowers signature vary[.] Altered documents are usually detectable –5% White-out on documentation[.] … 92% of the Purchases reviewed are 100% CLTV [combined loan-to-value][.] … 52% are Stated Income.” 220 A subsequent review conducted by WaMu’s General Auditor of the “root causes” of the Long Beach loans with early payment defaults pointed not only to lax lending standards and a lack of fraud controls, but also to “a push to increase loan volume”: “In 2004, LBMC [Long Beach] relaxed underwriting guidelines and executed loan sales with provisions fundamentally different from previous securitizations. These changes, coupled with breakdowns in manual underwriting processes, were the primary drivers for the increase in repurchase volume. The shift to whole loan sales, including the EPD provision, brought to the surface the impact of relaxed credit guidelines, breakdowns in manual underwriting processes, and inexperienced subprime personnel. These factors, coupled with a push to increase loan volume and the lack of an automated fraud monitoring tool, exacerbated the deterioration in loan quality.” 221 Due to the early payment defaults, Long Beach was forced to repurchase loans totaling nearly $837 million in unpaid principal, and incurred a net loss of about $107 million. 222 This 219 11/1/2005 “LBMC Post Mortem – Early Findings Read Out,” prepared by WaMu, JPM_WM03737297, Hearing Exhibit 4/13-9. 220 Id. 221 4/17/2006 WaMu memorandum to the Washington Mutual Inc. and WaMu Board of Directors’ Audit Committee, “Long Beach Mortgage Company - Repurchase Reserve Root Cause Analysis,” prepared by WaMu General Auditor, JPM_WM02533760-61, Hearing Exhibit 4/13-10. 222 Id. (Long Beach “experienced a dramatic increase in EPD’s [early payment defaults], during the third quarter of 2005 [which] … led to a large volume of required loan repurchases. The unpaid principal balance repurchased as a loss overwhelmed Long Beach’s repurchase reserves, leading to a reserve shortfall of nearly $75 million. 223 Due to its insufficient loss reserves, its outside auditor, Deloitte and Touche, cited Long Beach for a serious deficiency in its financial reporting. 224 These unexpected repurchases were significant enough that Washington Mutual Inc., Long Beach’s parent company, made special mention of them in its 2005 10-K filing: “In 2004 and 2005, the Company’s Long Beach Mortgage Company subsidiary engaged in whole loan sale transactions of originated subprime loans in which it agreed to repurchase from the investor each ‘early payment default’ loan at a price equal to the loan’s face value plus the amount of any premium paid by the investor. An early payment default occurs when the borrower fails to make the first post-sale payment due on the loan by a contractually specified date. Usually when such an event occurs, the fair value of the loan at the time of its repurchase is lower than the face value. In the fourth quarter of 2005, the Company experienced increased incidents of repurchases of early payment default loans sold by Long Beach Mortgage Company and this trend is expected to continue in the first part of 2006. 225 FOMC20080130meeting--330 328,MS. YELLEN.," I wanted to support President Poole's comment. I remember very well back at Jackson Hole in 2005 that Raghuram Rajan presented a paper in which he emphasized the misalignment of incentives between investors and managers and the fact that almost everyone down the line right up to the investors themselves should have had incentives here. I don't know what they were thinking, but everybody was rewarded for the quantity and not the quality of originations. He warned us before any of this happened that this could come to no good, and I think he did have some suggestions about compensation practices. These were not popular suggestions. So I think this is worth some thought. I don't know what the answer is in terms of changing these practices. Maybe the market will attend to them, but it seems to me that we have had an awful lot of booms and busts in which this type of incentive played a role. Your presentation and the paper started from the fact that you note the deterioration in underwriting, but we should go one step backward. I suppose another issue here is what we saw in our supervision and whether we acted appropriately given what we saw. That raises a number of issues that I won't go into at the moment but that I think we need to be sensitive to. " 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? " fcic_final_report_full--489 This analysis lays the principal cause of the financial crisis squarely at the feet of the unprecedented number of NTMs that were brought into the U.S. financial markets by government housing policy. These weak and high risk loans helped to build the bubble, and when the bubble deflated they defaulted in unprecedented numbers. This threatened losses in the PMBS that were held by financial institutions in the U.S. and around the world, impairing both their liquidity and their apparent stability. The accumulation of 27 million subprime and Alt-A mortgages was not a random event, or even the result of major forces such as global financial imbalances or excessively low interest rates. Instead, these loans and the bubble to which they contributed were the direct consequence of something far more mundane: U.S. government housing policy, which—led by HUD over two administrations— deliberately reduced mortgage underwriting standards so that more people could buy homes. While this process was going on, everyone was pleased. Homeownership in the U.S. actually grew to the highest level ever recorded. But the result was a financial catastrophe from which the U.S. has still not recovered. -----------------------------------------------------Page 512-----------------------------------------------------  CHRG-111shrg57319--459 Mr. Rotella," Mr. Chairman, there was a reason I was hired after 18 years of experience at JP Morgan Chase. As I said earlier, the company, and this was well known in the industry, in the mortgage business, had experienced significant problems in 2003 and 2004. The problems in the main home loans group, which is where I focused a lot of my initial attention, were several. The first I would mention is the management team did not have a great deal of experience in running a mortgage company that size. I went through a process, along with David Schneider, who joined later in the year, of repopulating most of the senior jobs in that business. Second, the technology in the business was antiquated, and as I said earlier, there were literally 12 different production systems as a result of many acquisitions. There were manual processes in the business, and relative to what I had seen at my previous employer, the company had many shortcomings as it related to processing, closing, and servicing loans. Senator Levin. Now, I think you were here earlier this morning when we went through with prior panels the 2005 internal WaMu investigation of the two Southern California loan offices, Montebello and Downey. It found extensive rates of fraud affecting their loans, rates of 83 percent and 58 percent. That was all on Exhibit 23b,\2\ if you want to refer to that.--------------------------------------------------------------------------- \2\ See Exhibit 23b, which appears in the Appendix on page 511.--------------------------------------------------------------------------- We have also reviewed a memorandum, which is Exhibit 24,\3\ which was prepared in 2008 after the frauds and evidence of it resurfaced. It found that virtually no actions had been taken following the 2005 investigation, and after reviewing the loans by Montebello in 2007 found that 62 percent contained fraudulent information.--------------------------------------------------------------------------- \3\ See Exhibit 24, which appears in the Appendix on page 515.--------------------------------------------------------------------------- So year after year after year, we have a couple parts of your company that are apparently engaged in seriously fraudulent loans with misinformation that is pervasive. So starting in 2005, why weren't any actions taken after that first 2005 review? " FinancialCrisisReport--102 After the memorandum was issued, WaMu initially resisted providing a copy to OTS, claiming it was protected by attorney-client privilege. 345 The OTS Examiner-in-Charge Benjamin Franklin told the Subcommittee that he insisted on seeing the memorandum. After finally receiving it and reading about the substantial loan fraud occurring at the two loan offices since 2005, he told the Subcommittee that it was “the last straw” that ended his confidence that he could rely on WaMu to combat fraudulent practices within its own ranks. The 2008 WaMu memorandum and a subsequent OTS examination memorandum 346 included a number of recommendations to address the fraud problem at the Downey and Montebello offices. The recommendations in the WaMu memorandum included actions to “[d]etermine appropriate disciplinary actions for employees”; “[e]nhance Code of Conduct training to stress each employee’s role as a corporate steward and the consequences for passively facilitating the placement of loans into the origination process that could be suspect”; enhance WaMu compensation incentives “to support loan quality”; and determine if further analysis was required of the loans originated by the Montebello office or “the broader loan population (bank owned and securitized)” including “if actions are needed to address put backs or sales to investors of loans that contain misrepresentation[s] or other fraud findings.” 347 By the time WaMu issued the April 2008 memorandum on the Downey and Montebello fraud problem, however, the bank was already experiencing serious liquidity problems and was cutting back on its loan operations and personnel. On April 30, 2008, WaMu put an end to its wholesale loan channel which had accepted loans from third party mortgage brokers, closed 186 341 Id. 342 Id. 343 Id. at 8. 344 Id. at 9. 345 Subcommittee interview of Benjamin Franklin (2/18/2010). 346 1/7/2008 OTS Asset Quality Memo 22, “Loan Fraud Investigation,” JPM_WM02448184, Hearing Exhibit 4/13- 25. 347 4/4/2008 WaMu Memorandum of Results, “AIG/UG and OTS Allegation of Loan Frauds Originated by [name redacted],” at 4, Hearing Exhibit 4/13-24. stand-alone loan centers, and reduced its workforce by 3,000. 348 The Downey and Montebello offices were closed as part of that larger effort. The two loan officers heading those offices left the bank and found other jobs in the mortgage industry that involve making loans to borrowers. CHRG-111shrg57319--78 Mr. Vanasek," When Nancy Gonseth came forward with some pretty credible material. Prior to that, it had been largely rumor. Senator Coburn. OK. But you saw it not just as a specific one or two offices? Did you think that there was fraudulent activity outside of those one or two offices? " FinancialCrisisReport--232 America for $2.8 billion. 885 Neither the OCC nor OTS ever filed a public enforcement action against the bank. In June 2009, the SEC filed suit against the three most senior Countrywide executives, the chief executive officer, the chief operating officer and president, and the chief financial officer, charging them with fraudulently misleading investors by representing that Countrywide had issued loans primarily to “prime” or low risk borrowers, when it had actually written increasingly risky loans that senior executives knew would result in substantial defaults and delinquencies. 886 In addition, the SEC charged that CEO Angelo Mozilo had violated his federal disclosure obligations and engaged in insider trading. 887 The SEC complaint detailed the bank’s increasingly risky underwriting and lending practices from 2005 to 2007, including its use of stated income loans, loan-to-value ratios in excess of 95%, loans to borrowers with low FICO scores, frequent use of loan exceptions, and willingness to match the loan terms of any competitor. Like WaMu, from 2003 to 2007, the bank switched from issuing primarily low risk, 30-year loans, to subprime and other high risk mortgages. 888 The complaint also described how Mr. Mozilo was internally alarmed and critical of the increased credit risks that Countrywide was incurring, while at the same time telling investors that the bank was more prudent than its competitors. 889 The SEC complaint cited, for example, an April 2006 email from Mr. Mozilo discussing Countrywide’s issuance of subprime 80/20 loans, which are loans that have no down payment and are comprised of a first loan for 80% of the home’s value and a second loan for the remaining 20% of the value, resulting in a loan-to- value ratio of 100%. Mr. Mozilo wrote: “In all my years in the business I have never seen a more toxic pr[o]duct.” 890 In another email that same month, after being informed that most borrowers were making the minimum payments allowed on Option ARM loans, Mr. Mozilo wrote: “Since over 70% have opted to make the lower payment it appears it is just a matter of time that we will be faced with much higher resets and therefore much higher delinquencies.” 891 883 OCC, “Annual Report: Fiscal Year 2009,” http://www.occ.gov/static/publications/annrpt/2009AnnualReport.pdf. 884 See, e.g., SEC v. Mozilo , Case No. CV09-03994 (USDC CD Calif.), Complaint (June 4, 2009), at ¶¶ 102-104 (hereinafter “SEC Complaint against Countrywide Executives”). 885 “Countrywide Financial Corporation,” New York Times (10/15/2010). 886 SEC Complaint against Countrywide Executives. 887 Id. 888 See, e.g., SEC Complaint against Countrywide Executives, at ¶¶ 17-19. 889 See, e.g., id. at ¶¶ 6-7. 890 Id. at ¶ 50. 891 Id. at ¶ 63. CHRG-111shrg57321--24 Mr. Raiter," The answer is yes, they do. At the time that this occurred, the policy had been in the past that when information was provided to the analytical staff by investors or other originators, they would look into the matter, and if, in fact, it was justified, it would have resulted in a visit to them and a review of their practices and procedures. It could ultimately have resulted in their deals being put on Credit Watch or, in fact, being held up for ratings until the information could be worked out. At this time, in fairness to what was going on, there were rumors rampant about the quality of appraisals and the quality of underwriting standards that could have been quite overwhelming for the staff to try and track them down. But it routinely would have been investigated---- Senator Levin. Should have been. Mr. Raiter [continuing]. And factored in. It should have been. Senator Levin. It should have been. So when the analyst said no special measures with Fremont, that was not what was supposed to happen. " fcic_final_report_full--182 When securitizers did kick loans out of the pools, some originators simply put them into new pools, presumably in hopes that those loans would not be captured in the next pool’s sampling. The examiner’s report for New Century Financial’s bank- ruptcy describes such a practice.  Similarly, Fremont Investment & Loan had a pol- icy of putting loans into subsequent pools until they were kicked out three times, the company’s former regulatory compliance and risk manager, Roger Ehrnman, told the FCIC. As Johnson described the practice to the FCIC, this was the “three strikes, you’re out rule.”  Some mortgage securitizers did their own due diligence, but seemed to devote only limited resources to it. At Morgan Stanley, the head of due diligence was based not in New York but rather in Boca Raton, Florida. He had, at any one time, two to five individuals reporting to him directly—and they were actually employees of a per- sonnel consultant, Equinox.  Deutsche Bank and JP Morgan likewise also had only small due diligence teams.  Banks did not necessarily have better processes for monitoring the mortgages that they purchased. At an FCIC hearing on the mortgage business, Richard Bowen, a whistleblower who had been a senior vice president at CitiFinancial Mortgage in charge of a staff of -plus professional underwriters, testified that his team con- ducted quality assurance checks on the loans bought by Citigroup from a network of lenders, including both subprime mortgages that Citigroup intended to hold and prime mortgages that it intended to sell to Fannie Mae and Freddie Mac. For subprime purchases, Bowen’s team would review the physical credit file of the loans they were purchasing. “During  and , I witnessed many changes to the way the credit risk was being evaluated for these pools during the purchase processes,” Bowen said. For example, he said, the chief risk officer in Citigroup’s Con- sumer Lending business reversed large numbers of underwriting decisions from “turn down” to “approved.”  Another part of Bowen’s charge was to supervise the purchase of roughly  bil- lion annually in prime loan pools, a high percentage of which were sold to Fannie Mae and Freddie Mac for securitization. The sampling provided to Bowen’s staff for quality control was supposed to include at least  of the loan pool for a given secu- ritization, but “this corporate mandate was usually ignored.” Samples of  were more likely, and the loan samples that Bowen’s group did examine showed extremely high rates of noncompliance. “At the time that I became involved, which was early to mid-, we identified that  to  percent of the files either had a ‘disagree’ deci- sion, or they were missing critical documents.”  Bowen repeatedly expressed concerns to his direct supervisor and company exec- utives about the quality and underwriting of mortgages that CitiMortgage purchased and then sold to the GSEs. As discussed in a later chapter, the GSEs would later re- quire Citigroup to buy back . billion in loans as of November , finding that the loans Citigroup had sold them did not conform to GSE standards. FinancialCrisisReport--164 The Levin-Coburn memorandum contained joint findings of fact regarding the role of federal regulators in the Washington Mutual case history. Those findings of fact, which this Report reaffirms, are as follows. 1. Largest U.S. Bank Failure. From 2003 to 2008, OTS repeatedly identified significant problems with Washington Mutual’s lending practices, risk management, and asset quality, but failed to force adequate corrective action, resulting in the largest bank failure in U.S. history. 2. Shoddy Lending and Securitization Practices. OTS allowed Washington Mutual and its affiliate Long Beach Mortgage Company to engage year after year in shoddy lending and securitization practices, failing to take enforcement action to stop its origination and sale of loans with fraudulent borrower information, appraisal problems, errors, and notoriously high rates of delinquency and loss. 3. Unsafe Option ARM Loans. OTS allowed Washington Mutual to originate hundreds of billions of dollars in high risk Option Adjustable Rate Mortgages, knowing that the bank used unsafe and unsound teaser rates, qualified borrowers using unrealistically low loan payments, permitted borrowers to make minimum payments resulting in negatively amortizing loans ( i.e. , loans with increasing principal), relied on rising house prices and refinancing to avoid payment shock and loan defaults, and had no realistic data to calculate loan losses in markets with flat or declining house prices. 4. Short Term Profits Over Long Term Fundamentals. OTS abdicated its responsibility to ensure the long term safety and soundness of Washington Mutual by concluding that short term profits obtained by the bank precluded enforcement action to stop the bank’s use of shoddy lending and securitization practices and unsafe and unsound loans. 5. Impeding FDIC Oversight. OTS impeded FDIC oversight of Washington Mutual by blocking its access to bank data, refusing to allow it to participate in bank examinations, rejecting requests to review bank loan files, and resisting the FDIC recommendations for stronger enforcement action. 6. FDIC Shortfalls. The FDIC, the backup regulator of Washington Mutual, was unable to conduct the analysis it wanted to evaluate the risk posed by the bank to the Deposit Insurance Fund, did not prevail against unreasonable actions taken by OTS to limit its examination authority, and did not initiate its own enforcement action against the bank in light of ongoing opposition by the primary federal bank regulators to FDIC enforcement authority. 7. Recommendations Over Enforceable Requirements. Federal bank regulators undermined efforts to end unsafe and unsound mortgage practices at U.S. banks by issuing guidance instead of enforceable regulations limiting those practices, failing to prohibit many high risk mortgage practices, and failing to set clear deadlines for bank compliance. 8. Failure to Recognize Systemic Risk. OTS and the FDIC allowed Washington Mutual and Long Beach to reduce their own risk by selling hundreds of billions of dollars of high risk mortgage backed securities that polluted the financial system with poorly performing loans, undermined investor confidence in the secondary mortgage market, and contributed to massive credit rating downgrades, investor losses, disrupted markets, and the U.S. financial crisis. 9. Ineffective and Demoralized Regulatory Culture. The Washington Mutual case history exposes the regulatory culture at OTS in which bank examiners are frustrated and demoralized by their inability to stop unsafe and unsound practices, in which their supervisors are reluctant to use formal enforcement actions even after years of serious bank deficiencies, and in which regulators treat the banks they oversee as constituents rather than arms-length regulated entities. FinancialCrisisReport--120 WCC had over 200 employees and offices in Seattle, New York, Los Angeles, and Chicago. The majority of WCC employees were based in New York. 432 WCC was headed by Tim Maimone, WCC President, who reported to David Beck, Executive Vice President in charge of WaMu’s Capital Markets Division. Mr. Beck reported to the President of WaMu’s Home Loans Division, David Schneider. 433 At the Subcommittee hearing on April 13, 2010, Mr. Beck explained the role of WCC in WaMu and Long Beach securitizations as follows: “WaMu Capital Corp. acted as an underwriter of securitization transactions generally involving Washington Mutual Mortgage Securities Corp. or WaMu Asset Acceptance Corp. Generally, one of the two entities would sell loans into a securitization trust in exchange for securities backed by the loans in question, and WaMu Capital Corp. would then underwrite the securities consistent with industry standards. As an underwriter, WaMu Capital Corp. sold mortgage-backed securities to a wide variety of institutional investors. 434 WCC sold WaMu and Long Beach loans and RMBS securities to insurance companies, pension funds, hedge funds, other banks, and investment banks. 435 It also sold WaMu loans to Fannie Mae and Freddie Mac. WCC personnel marketed WaMu and Long Beach loans both in the United States and abroad. Before WCC was able to act as a sole underwriter, WaMu and Long Beach worked with a variety of investment banks to arrange, underwrite, and sell its RMBS securitizations, including Bank of America, Credit Suisse, Deutsche Bank, Goldman Sachs, Lehman Brothers, Merrill Lynch, Royal Bank of Scotland, and UBS. To securitize its loans, WaMu typically assembled and sold a pool of loans to a qualifying special-purpose entity (QSPE) that it established for that purpose, typically a trust. 436 The QSPE then issued RMBS securities secured by future cash flows from the loan pool. Next, the QSPE – working with WCC and usually an investment bank – sold the RMBS securities to investors, and used the sale proceeds to repay WaMu for the cost 431 Id. 432 Subcommittee interview of David Beck (3/2/2010). 433 Id. 434 April 13, 2010 Subcommittee Hearing at 53. Washington Mutual Mortgage Securities Corp. (WMMSC) and WaMu Asset Acceptance Corp. (WAAC) served as warehouse entities that held WaMu loans intended for later securitization. Mr. Beck explained in his prepared statement: “WMMSC and WAAC purchased loans from WaMu, and from other mortgage originators, and held the loans until they were sold into the secondary market. WCC was a registered broker-dealer and acted as an underwriter of securitization deals for a period of time beginning in 2004 and ending in the middle of 2007. In addition to buying and selling mortgage loans, WMMSC acted as a ‘master servicer’ of securitizations. The master servicer collects and aggregates the payments made on loans in a securitized pool and forwards those payments to the Trustee who, in turn, distributes those payments to the holders of the securities backed by that loan pool.” Id. at 163. 435 See 6/11/2007 chart entitled, “Origination Through Distribution,” JPM_WM03409859, Hearing Exhibit 4/13- 47c; Subcommittee interview of David Beck (3/2/2010). 436 See 3/2007 Washington Mutual Inc. 10-K filing with the SEC, at 45 (describing securitization process). of the loan pool. Washington Mutual Inc. generally retained the right to service the loans. WaMu or Long Beach might also retain a senior, subordinated, residual, or other interest in the loan pool. CHRG-111hhrg54872--254 Mr. Menzies," Pretty simple answer, you don't make any money on a defaulted loan, and you lose a relationship. So when you underwrite a loan, you don't underwrite a loan with the hopes that it will default and you can go collect legal fees and that sort of thing. But, Congressman, let's understand what really caused the crisis. Do we believe that it was community banks and lenders who live with the people that they lend to? They go to Rotary with them. They sit on the hospice board with them. They live with them. Underwriting products and sticking them into SIVs on Wall Street that are then rated by rating agencies that don't know what they are looking at and selling to investors that don't understand what they are buying; do we really believe that the community banking industry was a player in that game? " fcic_final_report_full--180 Clayton Holdings, a Connecticut-based firm, was a major provider of third-party due diligence services.  As Clayton Vice President Vicki Beal explained to the FCIC, firms like hers were “not retained by [their] clients to provide an opinion as to whether a loan is a good loan or a bad loan.” Rather, they were hired to identify, among other things, whether the loans met the originator’s stated underwriting guidelines and, in some measure, to enable clients to negotiate better prices on pools of loans.  The review fell into three general areas: credit, compliance, and valuation. Did the loans meet the underwriting guidelines (generally the originator’s standards, some- times with overlays or additional guidelines provided by the financial institutions purchasing the loans)? Did the loans comply with federal and state laws, notably predatory-lending laws and truth-in-lending requirements? Were the reported prop- erty values accurate?  And, critically: to the degree that a loan was deficient, did it have any “compensating factors” that offset these deficiencies? For example, if a loan had a higher loan-to-value ratio than guidelines called for, did another characteristic such as the borrower’s higher income mitigate that weakness? The due diligence firm would then grade the loan sample and forward the data to its client. Report in hand, the securitizer would negotiate a price for the pool and could “kick out” loans that did not meet the stated guidelines. Because of the volume of loans examined by Clayton during the housing boom, the firm had a unique inside view of the underwriting standards that originators were actually applying—and that securitizers were willing to accept. Loans were classified into three groups: loans that met guidelines (a Grade  Event), those that failed to meet guidelines but were approved because of compensating factors (a Grade  Event), and those that failed to meet guidelines and were not approved (a Grade  Event). Overall, for the  months that ended June , , Clayton rated  of the , loans it analyzed as Grade , and another  as Grade —for a total of  that met the guidelines outright or with compensating factors. The remaining  of the loans were Grade .  In theory, the banks could have refused to buy a loan pool, or, indeed, they could have used the findings of the due diligence firm to probe the loans’ quality more deeply. Over the -month period,  of the loans that Clayton found to be deficient—Grade —were “waived in” by the banks. Thus  of the loans sampled by Clayton were accepted even though the company had found a basis for rejecting them (see figure .). Referring to the data, Keith Johnson, the president of Clayton from May  to May , told the Commission, “That  to me says there [was] a quality control issue in the factory” for mortgage-backed securities.  Johnson concluded that his clients often waived in loans to preserve their business relationship with the loan originator—a high number of rejections might lead the originator to sell the loans to a competitor. Simply put, it was a sellers’ market. “Probably the seller had more power than the Wall Street issuer,” Johnson told the FCIC.  The high rate of waivers following rejections may not itself be evidence of some- thing wrong in the process, Beal testified. She said that as originators’ lending guide- lines were declining, she saw the securitizing firms introduce additional credit CHRG-111shrg56262--44 Mr. Hoeffel," Senator, I don't think you need to regulate underwriting per se. I think you need to make sure that potential investors who might be impacted by the underwriting are fully aware of what they are investing in, so that if the underwriting has been poor, it is not glazed over by a rating or a structure. They have all the information they need to make the proper assessments. " CHRG-111hhrg50289--31 Mr. McGannon," We had a 12 percent increase in loan activity in 2008, and looking back at 2008 just briefly, we got off to a slow start, not unlike 2009 in terms of actual loan growth. We accelerated throughout the year, even through September into the end of the year of 2008, when obviously things started to cycle downward in the economy. In 2009, we have had just moderate growth year to date, but I can tell you that our pipeline is growing in terms of pending loan requests. There was more activity in April in terms of new loans booked than we had since last September. So am encouraged by that. Our loan requests are down. It is a quieter time. Without question I think there are a lot of borrowers that are reassessing whatever their business is. But having said that, we are gaining market share from other financial institutions in the Kansas City marketplace. Our underwriting, I get that question asked a lot. Our underwriting really has not changed. We feel like we have had a strong credit culture in our bank for many years. Certainly we are more concerned about collateral values, and so we may, in fact, when you think about underwriting, we may well, in fact, require more money down on a particular project if it is real estate related, as an example. But by and large, our underwriting remains unchanged. " CHRG-111shrg57322--1127 Mr. Blankfein," I think there are disclosure requirements in connection with underwritings, and we are talking about these are underwritings, what you are talking about. Senator Tester. Yes. " 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. " FOMC20080130meeting--335 333,VICE CHAIRMAN GEITHNER.," Thank you. I agree with President Poole and President Yellen about the need to focus on compensation structures and incentives, but just two observations. One is that, if you look at compensation practices among the guys who actually look as though they did pretty well against those who didn't do so well--I'm not talking about in a mortgage-origination sense but in the major global financial institutions--the structure of compensation doesn't vary that much. What varies a lot is how well people control for the inherent problems in the basic compensation structures. Remember Raghu's presentation was mostly about hedge fund compensation, and I think he is mostly wrong when you think about that and the incentive structure. The difference really is how you design your limits to make sure that your traders' incentives are more aligned with the incentives of the firm as a whole. The biggest errors and differences are in the design of the process of the checks and balances to compensate for the inherent problems in the compensation structure. That's important to know because a lot of these things, if you look at the formal attributes of the risk-management governance structure across these firms, don't look that different. What distinguishes how well the guys did is much more subtle around culture, independence, and the quality of judgment exercised at the senior level, and this is important because, when you think about what you can do through supervision and regulation, to affect that stuff is hard. I have a question for Pat. Pat, not to overdo this, but where do you put in your diagnosis of contributing factors the constellation of financial conditions that prevailed during the boom and what those did to housing prices? You know, there's a tendency for everybody to look at regulation and supervision and the incentives that they have created or failed to mitigate, but there is a reasonable view of the world that you wouldn't have had the pattern of underwriting standards of mortgages without the trajectory of house prices that occurred. Sure, maybe what happened in the late stage of the mortgage-origination process contributed to the upside, but if you look at a chart, the rate of house-price appreciation started to decelerate about the time you had the worst erosion in underwriting practices. Anyway, my basic question is, Where do you put the constellation of financial conditions, not so much just what the Fed was doing but what was happening globally that affected long rates, expectations of future rates, et cetera? " FinancialCrisisReport--211 Again, I’m sorry to communicate this decision by email, but I’m scheduled to be out of the office next week myself and wanted you to have this information. Best regard, Kerry, John” 801 The email does not convey a message from an arms-length regulator concerned about a failing bank. To the contrary, the email conveys a sense of familiarity and discloses that the head of OTS knew his agency had already been providing preferential treatment to the bank by failing to impose an MOU after its downgrade to a 3 rating five months earlier, in February 2008. Mr. Reich stated that others “looking over our shoulders … would probably be surprised” an MOU was not already in place at WaMu. When asked about this email at the Subcommittee hearing, the Treasury and the FDIC Inspectors General both expressed discomfort with its language and tone: Mr. Thorson: Again, he sort of apologizes in the previous document that this could become known. This gets right to the heart of what you were talking about, the culture. … [T]here is not an acceptance of the fact that a strong regulatory control helps them. Senator Levin: This is far too cozy? Mr. Thorson: Absolutely, as far as I am concerned, yes. Senator Levin: Mr. Rymer, do you have any reaction to this? Mr. Rymer: It does indicate a level of familiarity that makes me uncomfortable. 802 Equally telling is the fact that, even after sending the email, OTS delayed imposing the MOU on WaMu for another two months, waiting until September 2008, just three weeks before the bank’s failure. 803 Like the head of the agency, OTS examiners also took a deferential approach to WaMu. In a January 2006 email discussing WaMu’s desire to purchase Long Beach, for example, the OTS Examiner-in-Charge indicated that, rather than insist the bank clean up Long Beach 801 7/3/2008 email from OTS Director John Reich to WaMu CEO Kerry Killinger, OTSWMS08-014 0000912-13, Hearing Exhibit 4/16-44. 802 April 16, 2010 Subcommittee Hearing at 34. 803 See also id. at 46 (When asked why OTS took so long to complete the MOU, former OTS Director John Reich testified: “I don’t know, to tell you the truth. I do not know why it took so long to implement the MOU. … I regret [the] … delay.”). problems before the purchase, OTS would have to rely on its “relationship” with WaMu to get the job done: “The letter [from WaMu] seems okay. They obviously want to leave it a little squishy, of course, on the growth plans, but at least they make a firm commitment to clean up the underwriting issues. At some level, it seems we have to rely on our relationship and their understanding that we are not comfortable with current underwriting practices and don’t want them [Long Beach] to grow significantly without having the practices cleaned up first.” 804 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-111shrg57320--437 Mr. Bowman," Absolutely. Senator Levin. All right. So that fact was repeated in these emails. OTS has principal responsibility. FDIC doesn't. We went through these emails earlier today. OTS wanted to remind the FDIC that OTS was the principal regulator, as though FDIC didn't know it. And that is what is so darn troubling here, is in critical times in terms of this bank and its depositors, its impact on the economy, its investors, and so forth, we didn't see that. We didn't see a cooperative relationship, and I can still not understand what the reluctance was. I don't understand why FDIC was apparently rejected when it sought access to materials and access to joint examinations. [Pause.] Senator Levin. Let me ask both of you about some of the risky practices that we have talked about at these hearings, the stated income loans, the negative amortizing loans, teaser rates. Should these practices be banned, either by a regulator or by Congress? I think, Ms. Bair, you talked about one of them, I believe. Ms. Bair. Yes. We have---- Senator Levin. Go into all of them, the 3 or 4 that we have talked about. Ms. Bair. We have. We are opposed on a policy level. We are opposed to stated income. We are opposed to teaser rate underwriting. You need to underwrite at the fully indexed rate. We think you should document income. You should document the customer's ability to repay, not just the initial introductory rate, but if it is an adjustable product, when it resets, as well. One of the things that complicates the ability to set strong underwriting standards across the board is that we can only reach insured depository institutions and a lot of this--actually, the majority of this--was done by non-banking institutions that would not be subject to prudential standards or consumer standards of bank regulators. The Federal Reserve under HOEPA does have the authority to apply consumer lending standards across the board. In 2008, we filed a strong comment letter urging the Federal Reserve to ban stated income, to require ability to repay, to require underwriting at the fully indexed rate for all higher-risk mortgages, not just subprime or higher-rate mortgages, but also Option ARMs, interest-only loans, any non-traditional mortgage product. The Federal Reserve did finalize rules, but they only apply to the high-rate loans. They don't apply to the negative amortization loans. They are out for comment again on this issue. We filed another comment letter suggesting that these type of standards should apply to at least non-traditional mortgages. I think, frankly, given the deterioration in the prime market, they should consider applying them across the board to all mortgages. The authority is there now and we have strongly encouraged the Federal Reserve to use that and we would be happy to make our comment letters available to the Subcommittee. Senator Levin. And you have the authority, as well? Ms. Bair. The banking regulators have the authority for insured depository institutions under safety and soundness rules, yes. Senator Levin. But you have the authority to act on all of those items that you enumerated? Ms. Bair. We do for insured depository institutions. Senator Levin. Stated income, teaser rates, document---- Ms. Bair. That is right, for insured depository institutions, the primary regulators do. Senator Levin. And you do. And you have made recommendations to your board, have you? Ms. Bair. We have. We joined the Interagency Guidance, which was a negotiated document. It did not completely ban stated income, as our examiners indicated, but it did make clear that we think that should be the exception, not the rule. I personally would be willing to go further and just eliminate stated income. I think if you provide flexibility in terms of the types of documentation that could be provided, whether it is deposit slips or W-2s or tax returns, fine. Any third-party good verification of income can be allowed. But some verification should be made. I, frankly, don't personally think there is any reason for a stated income loan and we would be happy to see rulemaking applied across the board for all insured depository institutions. But again, you are only getting part of the market if you don't apply that to the non-banks as well, and you do get into this regulatory arbitrage problem. The more standards you put on banks, you have the non-banks doing looser underwriting and drawing market share from the banks. Senator Levin. Well, that is exactly the kind of testimony which I think is going to be very helpful to us as we proceed with the legislative response. Mr. Bowman, what would be your answer to my question? " CHRG-111shrg57320--432 Mr. Bowman," I can save you the trouble. Senator Levin. You can? OK. Well, do you want to look at Exhibit 1d in your book.\1\ This is the pattern. ``Underwriting of single-family residential (SFR) loans,'' 2004, ``remains less than satisfactory.'' Level of SFR underwriting exceptions in our samples has been an ongoing examination issue, ``in other words, a problem,'' for several years and one that management has found difficult to address. ``[Residential quality assurance]'s review of the 2003 originations disclosed critical error rates as high as 57 percent of certain loan samples. . . .'' SFR loan underwriting, this has been an area of concern for several exams. Securitizations prior to 2003 have horrible performance.--------------------------------------------------------------------------- \1\ See Exhibit No. 1d, which appears in the Appendix on page 200.--------------------------------------------------------------------------- Year after year after year, these are the findings, and yet no formal action taken by OTS against this bank. That was a problem. I don't know whether--I guess you didn't hear me ask questions about it before, but this is not effective regulation. It is feeble regulation, year after year after year. The Inspector General's report is highly critical. I don't know if you have read that report or not. Did you? " CHRG-111hhrg53240--75 Mr. Bachus," Now it really took until 2007 or 2008 for them to do that; is that correct? Ms. Duke. 2008. " Mr. Bachus," 2008? I think maybe if we had had something where you came up every year and explained your progress. On occasions members did write and say, what are you doing? Let me ask you this. Even on the lending underwriting standards, I think at the same time or around that same period of time, you were given the jurisdiction on all loan underwriting standards; is that correct? Ms. Duke. I believe, and I am not certain on this, so if I get too deep into it, I may have to respond in writing. But I believe that we issued guidance to those institutions that we supervised on underwriting, but then afterwards when we came out with regulations, those regulations would have governed both bank and nonbank lenders. " CHRG-111shrg57319--319 Mr. Beck," I cannot say. Senator Levin. Take a look at Exhibit 22a now,\3\ if you would. This is a November 2005 internal WaMu memo called ``So. CA [Southern California] Emerging Markets Targeted Loan Review Results.'' It describes a year-long internal investigation into suspected fraud affecting loans issued from your two processing centers, Montebello and Downey. You heard in the prior panel that it laid out an extensive level of loan fraud. Forty-two percent of the loans reviewed contained suspect activity or fraud, virtually all of it attributable to some sort of employee malfeasance. And then in Exhibits 22b and 23b,\1\ there is additional detail about the investigation, including the percentage of loans containing fraudulent information at the Montebello office at 83 percent, the percentage in the Downey office 58 percent.--------------------------------------------------------------------------- \3\ See Exhibit No. 22a, which appears in the Appendix on page 509. \1\ See Exhibits No. 22b and 23b, which appear in the Appendix on pages 497 and 511.--------------------------------------------------------------------------- Now, were you aware at the time of those findings? " 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 CHRG-111hhrg53240--136 Mr. Carr," I think we should recognize that it took until the middle of 2008 to actually release final regs on HOEPA to deal with this issue. And even at that time, some of the most egregious predatory practices still weren't purged. For example, yield spread premiums, which are basically kickbacks, were still allowable, as well as weaknesses on issues such as assignee liability, prepayment penalties. And this is knee deep into the crisis. Those issues have now only recently been taken on again. " CHRG-111shrg54789--15 Chairman Dodd," They have very strong underwriting standards with CRA. The Community Reinvestment Act required very strong underwriting standards to be met by the borrowers. Is that true? " CHRG-111shrg57319--346 Mr. Schneider," Yes, I do. Senator Levin. It led to eight separate investigations in that 4-year period, two cases each year with those two people. No one interviewed one of the people involved until January 2008, by the way. And then it says that WaMu--and I am now going back to page 7--WaMu had no record of action taken for performance issues with those loan officers. Now, I do not know how a bank can possibly operate with credibility with this kind of problem, this kind of fraud in its midst. But instead of getting disciplined or fired for fraudulent loans coming out of the offices, those top loan officers from Montebello and Downey during the same period that they were being investigated--that is 2004 to 2007--were rewarded each year with an invitation to the President's Club, which is WaMu's highest honor, including all-expenses-paid trips to places like Hawaii and the Bahamas. You were, I think, very much involved in the President's Club, which made sure those all-expense-paid trips were made. How does that happen? You have loan officers under investigation year after year after year. Instead of being disciplined or fired, they are given rewarding trips to Hawaii and the Bahamas. How does that happen? " FinancialCrisisReport--122 In that particular securitization, Goldman Sachs served as the lead underwriter, WCC served as the securities dealer, Deutsche Bank served as the trustee of the trust set up to hold the securities, and Long Beach served as the mortgage servicer. Another document, prepared by Goldman Sachs, shows the variety of relationships that WaMu engaged in as part of its securitization efforts. 438 That document, which consists of a list of various loan pools and related matters, shows that WaMu worked with Goldman Sachs to make whole loan sales; securitize loans insured by the Federal Home Administration or Veterans Administration; and securitize prime, subprime, Alt A, second lien, and scratch and dent nonperforming loans. It also shows that Goldman Sachs asked WaMu and Long Beach to repurchase more than $19.7 million in loans it had purchased from the bank. 439 Goldman Sachs handled a number of securitizations for Long Beach. At one point in 2006, Goldman Sachs made a pitch to also handle loans issued by WaMu. One Goldman Sachs broker explained to a colleague in an email: “They have possibly the largest subprime portfolio on the planet.” 440 (2) Deficient Securitization Practices Over the years, both Long Beach and Washington Mutual were repeatedly criticized by the bank’s internal auditors and reviewers, as well as its regulators, OTS and the FDIC, for deficient lending and securitization practices. Their mortgage backed securities were among the worst performing in the marketplace due to poor quality loans that incurred early payment defaults, fraud, and high delinquency rates. Long Beach Securitizations. In April 2005, an internal email sent by an OTS regulator recounted eight years of abysmal performance by Long Beach securities, noting that loan delinquencies and losses occurred in pools containing both fixed rate and adjustable rate mortgages: “[Securitizations] prior to 2003 have horrible performance …. For FRM [fixed rate mortgage] losses, LBMC finished in the top 12 worst annual NCLs [net credit losses] in 1997 and 1999 thru 2003. LBMC nailed down the number 1 spot as top loser with an NCL of 14.1% in 2000 and placed 3 rd in 2001 with 10.5% .... For ARM losses, LBMC really outdid themselves with finishes as one of the top 4 worst performers for 1999 thru 2003. For specific ARM deals, LBMC made the top 10 worst deal list from 2000 thru 2002. LBMC had an extraordinary year in 2001 when their securitizations had 4 of the top 6 worst NCLs (range: 11.2% to 13.2%). 438 Undated “List of WaMu-Goldman Loans Sales and Securitizations,” Hearing Exhibit 4/13-47b. 439 Id. 440 3/24/2005 email from Kevin Gasvoda of Goldman Sachs to Christopher Gething, others, Hearing Exhibit 4/27- 167b. “Although underwriting changes were made from 2002 thru 2004, the older issues are still dragging down overall performance. Despite having only 8% of UPB [unpaid balances] in 1st lien FRM pools prior to 2002 and only 14.3% in 2002 jr. lien pools, LBMC still had third worst delinquencies and NCLs for most of [the] period graphed from 11/02 thru 2/05 and was 2nd worst in NCLs in 2005 out of 10 issuers graphed. … At 2/05, LBMC was #1 with a 12% delinquency rate. Industry was around 8.25%. At 3/05, LBMC had a historical NCL rate of 2% smoking their closest competitor by 70bp and tripling the industry average.” 441 CHRG-111shrg57320--240 Mr. Carter," Ultimately, in reducing the exception rates down to levels that we thought would be satisfactory, they were ineffective. Senator Levin. They were ineffective. OK. Mr. Carter, take a look at Exhibit 7,\1\ more a cultural problem. Long Beach, you say in Exhibit 7, ``was working at a deliberate, reasonable pace.'' That is on page 1. And then in Exhibit 7, I believe this is where you said the natural evolution, if I can find those words, would be sufficient. Well, we will come back to that. I do not have the right number exhibit in front of me.--------------------------------------------------------------------------- \1\ See Exhibit No. 7, which appears in the Appendix on page 228.--------------------------------------------------------------------------- Exhibit 7 is right. Take a look in the middle of that. ``Long Beach--natural evolution internally will address a number of issues.'' Well, it did not. So you wrote on Exhibit 32,\2\ Mr. Carter, in reference to WaMu's request to move Long Beach Mortgage under the bank, ``[W]e are not comfortable with current underwriting practices, and you don't want them to grow''--your words--``significantly without having the practices cleaned up first.''--------------------------------------------------------------------------- \2\ See Exhibit No. 32, which appears in the Appendix on page 328.--------------------------------------------------------------------------- Six months later, now Exhibit 36,\3\ in response to findings that Long Beach Mortgage had not improved their practices. OTS wrote it could not ``simply say [to them that] `you made a commitment and haven't kept it.' '' Why couldn't you tell Long Beach, simply, ``You made a commitment and haven't kept it?'' Why do you say that you cannot do that in Exhibit 36? Why can't you tell Long Beach, ``Hey, you guys made a commitment. You haven't kept it?''--------------------------------------------------------------------------- \3\ See Exhibit No. 1i, which appears in the Appendix on page 210.--------------------------------------------------------------------------- " fcic_final_report_full--527 The result of Fannie’s competition with FHA in high LTV lending is shown in the following figure, which compares the respective shares of FHA and Fannie in the category of loans with LTVs equal to or greater than 97 percent, including Fannie loans with a combined LTV equal to or greater than 97 percent. Figure 7. Whether a conscious policy of HUD or not, competition between the GSEs and FHA ensued immediately after the GSEs were given their affordable housing mission in 1992. The fact that FHA, an agency controlled by HUD, substantially increased the LTVs it would accept in 1991 (just before the GSEs were given their affordable housing mission) and again in 1999 (just before the GSEs were required to increase their affordable housing efforts) is further evidence that HUD was coordinating these policies in the interest of creating competition between FHA and the GSEs. The effect was to drive down underwriting standards, which HUD had repeatedly described as its goal. 5. Enlisting Mortgage Bankers and Subprime Lenders in Affordable Housing In 1994, HUD began a program to enlist other members of the mortgage financing community in the effort to reduce underwriting standards. In that year, 143 GAO, “Federal Housing Administration: Decline in Agency’s Market Share Was Associated with Product and Process Developments of Other Mortgage Market Participants,” GAO-07-645, June 2007, pp. 42 and 44. 523 the Mortgage Bankers Association (MBA)—a group of mortgage financing firms not otherwise regulated by the federal government and not subject to HUD’s legal authority—agreed to join a HUD program called the “Best Practices Initiative.” 144 The circumstances surrounding this agreement are somewhat obscure, but at least one contemporary account suggests that the MBA signed up to avoid an effort by HUD to cover mortgage bankers under the Community Reinvestment Act (CRA), which up to that point had only applied only to government-insured banks. In mid-September [1994], the Mortgage Bankers Association of America- whose membership includes many bank-owned mortgage companies, signed a three-year master best-practices agreement with HUD. The agreement consisted of two parts: MBA’s agreement to work on fair-lending issues in consultation with HUD and a model best-practices agreement that individual mortgage banks could use to devise their own agreements with HUD. The first such agreement, signed by Countrywide Funding Corp., the nation’s largest mortgage bank, is summarized [below]. Many have seen the MBA agreement as a preemptive strike against congressional murmurings that mortgage banks should be pulled under the umbrella of the CRA. 145 CHRG-111shrg52966--4 Mr. Long," Chairman Reed, Ranking Member Bunning, my name is Tim Long. I am the Senior Deputy Comptroller for Bank Supervision Policy at the OCC. I appreciate this opportunity to discuss the OCC's views on risk management and the role it plays in banks we supervise, the weaknesses and gaps that we have identified in risk management practices and the steps we are taking to address those issues, and how we supervise risk management at the largest national banks. Recent events have revealed a number of weaknesses in banks' risk management processes that we in the industry must address, and we are taking steps to ensure this happens. More importantly, these events have reinforced that even the best policy manuals and risk models are not a substitute for a strong corporate governance and risk management culture, a tone and approach to business that must be set at the top of the organization and instilled throughout the company. While risk management practices are legitimately the focus of much current attention, risk management is hardest when times are good and problems are scarce. It is in those times when bank management and supervisors have the difficult job of determining when accumulating risks are getting too high and that the foot needs to come off the accelerator. These are never popular calls to make, but in retrospect, we and bankers erred in not being more aggressive in addressing our concerns. However, we must also not lose sight that banks are in the business of managing financial risks. Banks must be allowed to compete and innovate, and this may at times result in a bank incurring losses. The job of risk management is not to eliminate risk, but to ensure that those risks are identified and understood so that bank management can make informed choices. Among the lessons we have learned are: Underwriting standards matter, regardless of whether the loans are held or sold. Risk concentrations can excessively accumulate across products and business lines. Asset-based liquidity is critical. Back-room operations and strong infrastructure matters. And robust capital and capital planning are essential. As described in my written testimony, we are taking steps to address all of these issues. Because the current problems are global in nature, we are working closely with my colleagues here and internationally. Critical areas of focus are on improved liquidity risk management, stronger enterprise-wide risk management, including rigorous stress testing, and further strengthening the Basel II capital framework. Risk management is a key focus of our large bank supervision program. Our program is organized with a national perspective. It is centralized and headquartered in Washington and structured to promote consistent and uniform supervision across the banking organizations. We establish core strategic objectives annually based on emerging risks. These objectives are incorporated into the supervisory strategies for each bank and carried out by our resident onsite staff with assistance from specialists in our Policy and Economics Unit. Examination activities within a bank are often supplemented with horizontal reviews across a set of banks. This allows us to look at trends not only within but across the industry. Throughout our resident staff, we maintain an ongoing program of risk assessment and communication with bank management and the board of directors. Where we find weaknesses, we direct management to take corrective action. For example, we have directed banks to make changes in personnel and organizational structures to ensure that risk managers have sufficient stature and ability to constrain business activities when warranted. Through our examinations and reviews, we have directed banks to be more realistic about recognizing credit risks, to improve their valuation techniques for certain complex transactions, to aggressively build loan loss reserves, to correct various risk management weaknesses, and to raise capital as market opportunities permit. Finally, the Subcommittee requested the OCC's views on the findings that Ms. Williams from the GAO will be discussing with you today. Because we only recently received the GAO's summary statement of findings, we have not had an opportunity to review and assess their full report. We take the findings from GAO very seriously, and we would be happy to provide the Subcommittee with a written response to this report once we receive it. My preliminary assessment based on the summary we were provided is that the GAO raised a number of legitimate issues, some of which I believe we are already addressing; and others, as they pertain to the OCC, may require further action on our part. Thank you, and I will be happy to answer questions you may have. Senator Reed. Thank you. Mr. Polakoff, please. STATEMENT OF SCOTT M. POLAKOFF, ACTING DIRECTOR, OFFICE OF FinancialCrisisReport--151 At Long Beach and WaMu, volume incentives were not limited to the sales people. Back office loan processors and quality control personnel were also compensated for volume. While WaMu executives and senior managers told the Subcommittee that quality control was emphasized and considered as part of employee compensation, the back office staff said otherwise. 562 Diane Kosch worked as a Quality Assurance Controller in a Long Beach Loan Fulfillment Center (LFC) in Dublin, California, east of San Francisco Bay. She told the Subcommittee that the pressure to keep up with the loan volume was enormous. Each month the LFC would set volume goals, measured in dollar value and the number of loans funded. At the end of each month the pressure to meet those goals intensified. Ms. Kosch said that at month’s end, she sometimes worked from 6 a.m. until midnight reviewing loan files. Monthly rallies were held, and prizes were awarded to the underwriters and loan processors who had funded the most loans. 563 Documents obtained by the Subcommittee confirm Ms. Kosch’s recollections. A September 2004 email sent to all Dublin LFC employees with the subject line, “Daily Productivity – Dublin,” by the area manager uses creative formatting to express enthusiasm: “Less than 1 week and we have a long way to go to hit our 440M! including today, we have 4 days of fundings to end the Quarter with a bang ! With all the new UW changes, we will be swamped next month, so don’t hold any back! 4 days…..it’s time for the mad dash to the finish line! Who is in the running…… Loan Set Up – Phuong is pulling away with another 18 files set up yesterday for 275 MTD! 2nd place is held by Jean with 243…can you catch Phuong ? Get ready Set Up – come October, it’s going to get a little crazy! Underwriting – Michelle did it! She broke the 200 mark with 4 days left to go! Nice job Michelle! 2nd place is held by Andre with 176 for the month! Way to go Andre! Four other UW’s had solid performances for the day as well including Mikhail with 15! Jason and Chioke with 11 and June with 10 – The double digit club!” 564 562 Subcommittee interview of Mark Brown (2/19/2010). Mr. Brown, WaMu National Underwriting Director, told the Subcommittee that incentives for loan processors were based on quality standards and monthly volume. 563 Subcommittee interview of Diane Kosch (2/18/2010). 564 9/2004 Long Beach processing center internal email, Hearing Exhibit 4/13-61. In the email, “UW” stands for Underwriting or Underwriter, and “SLC” stands for Senior Loan Coordinator. FinancialCrisisReport--28 Borrowers were able to pay for the increasingly expensive homes, in part, because of the exotic, high risk loans and lax loan underwriting practices that allowed them to buy more house than they could really afford. C. Credit Ratings and Structured Finance Despite the increasing use of high risk loans to support mortgage related securities, mortgage related securities continued to receive AAA and other investment grade ratings from the credit rating agencies, indicating they were judged to be safe investments. Those credit ratings gave a sense of security to investors and enabled investors like pension funds, insurance companies, university endowments, and municipalities, which were often required to hold safe investments, to continue to purchase mortgage related securities. Credit Ratings Generally. A credit rating is an assessment of the likelihood that a particular financial instrument, such as a corporate bond or mortgage backed security, may default or incur losses. 37 A high credit rating indicates that a debt instrument is expected to be repaid and so qualifies as a safe investment. CHRG-111shrg56415--36 Mr. Dugan," Senator, I think that you are onto a very important point that I do not think has gotten the same kind of attention that it deserved and what got us here in the mortgage market, not just in subprime. I think we lost our way as a country in terms of some of our basic underwriting standards on loan-to-value and on stated income, and I think it is worth exploring having a more common set of minimum underwriting standards that apply across the board with more specificity than what we have today, which I think is what you are suggesting. " 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-111shrg57319--252 Mr. Schneider," I think as we looked at the originations and the overall quality coming out, we felt that there was--we were given the right disclosures and that if loans proved to be fraudulent or have a problem, we would be buying them--we would buy them back out. Senator Levin. Dr. Coburn. Senator Coburn. Thank you. Would you put up the percentage chart on WaMu project originations and purchases by percentage.\1\ In fairness to your testimony in terms of the declining nature, however, this pie chart represents, in fact, the percentages of the originations of WaMu as a percentage. Based on your testimony, what we see is something very different, what actually happened versus what you said, because you can see that each year, fixed mortgages go down and non-conforming loans still are increasing, versus your testimony that said that was not the case, that when you came on board, things started to change.--------------------------------------------------------------------------- \1\ See Exhibit No. 1i, which appears in the Appendix on page 223.--------------------------------------------------------------------------- So two questions for that. Did things change because you all made an active process to change, or was the market souring so much that you couldn't market those loans? " FinancialCrisisInquiry--13 I would like to describe some of the regular business practices that we believe protected us leading up to and during the crisis. If we weren’t doing these things right going into the crisis, it would have been too late to start once the crisis began. J.P. Morgan Chase did not unduly leverage our capital or rely on low-quality capital. We’ve always used conservative accounting and vigilant risk management, built up strong loan loss reserves, and maintained a high level of liquidity. We always believed in maintaining a fortress balance sheet. We continually stress test our capital liquidity to ensure that we can withstand a wide range of highly unlikely but still possible negative scenarios. We did not build up our structured finance business. While we were large participants in the asset-backed securities market, we deliberately avoided large risky positions like structured CDOs. We avoided short-term funding of liquid assets and did not rely heavily on wholesale funding. In addition we essentially stayed away from sponsoring SIVs and minimized our financing of them. Even before 2005 we recognized that the credit losses were extremely low, and we decided not to offer higher risk, less tested loan products. In particular, we did not write payment option ARMs. As I said before, we did make mistakes. There are a number of things we could have done better. First, we should have been more diligent when negotiating and structuring commitment letters for leverage to indicate loan transactions. In response we have tightened our lending standards as well as our oversight of loan commitments we make. Second, the underwriting standards of our mortgage business should have been higher. We have substantially enhanced our mortgage underwriting standards, essentially returning to traditional 80 percent loan to value ratios and requiring borrowers to document their income. We’ve also closed down most—almost all of the business originated by mortgage brokers where credit losses have generally been over two times worse than the business we originate ourselves. CHRG-111shrg57320--389 Mr. Corston," At the time when examiners were in these institutions, we knew--and one of the first memos that you brought up, we saw the issues. But it became very hard to influence institutions to change these practices. They certainly were competing against each other, and there were institutions outside the insured environment that were influencing the underwriting also. And it became difficult from an examiner's point of view as a one-off to influence, say, Washington Mutual when there were other non-insured institutions with which they competed. It made it a challenge. And I would say when we were dealing with these institutions at the time, that is what we were facing. Senator Levin. After a while--I do not have the exact--I guess it was October 2006, there is a joint interagency guidance for nontraditional mortgages that is agreed upon. I do not know why it was guidance instead of enforceable regulations. We have talked a little bit about that. There was not a clear effective date, but I understand FDIC, Office of the Comptroller of the Currency (OCC), and the Federal Reserve treated the guidance as effective immediately. Is that correct? " 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." FinancialCrisisReport--213 After urging patience on WaMu reforms, suggesting a limit on the corrective actions listed in the ROE, and recommending fewer meetings with WaMu management, the curious final line in the email is: “My management class this week has made me feel empowered! Can you tell? Please don’t fire me!” Additional evidence of OTS deference is its reliance on WaMu to track its own compliance with OTS findings calling for corrective action. At all other thrifts, OTS tracked the extent to which the thrift implemented OTS findings, using its own systems. But at WaMu, OTS did not keep its own records, but relied on WaMu’s Enterprise Risk Issue Control System (ERICS). The Treasury and the FDIC Inspectors General criticized this arrangement, noting that they were unable to use WaMu’s system to determine the status of multiple OTS findings. 806 In addition, they noted that, in 2006, ERICS discontinued its practice of identifying “repeat findings,” making it difficult to identify and track those findings. 807 Their report explicitly recommends against OTS’ relying on a bank’s systems in the future to track compliance. Finally, the actual language used by OTS in its reports and memoranda that described deficiencies demonstrated a passive approach to dealing with management. Common phrases noted that the bank’s practices were “less than satisfactory,” error rates were at “higher than acceptable levels,” and “management’s actions did not improve underwriting to a satisfactory level.” OTS reports rarely used more assertive language that, for example, called the bank’s efforts unsatisfactory, inadequate, or ineffective. An exchange at the Subcommittee hearing between Senator Levin and the OTS Examiner-in-Charge at WaMu from 2004 to 2006, Lawrence Carter, captured the issue: Mr. Carter: I think that what I said here is that we could not conclude that their progress was wholly inadequate, because they did make some progress. Senator Levin: … Can you use the words, ‘Folks, your progress was inadequate?’ Are you able to tell them that? Mr. Carter: For their progress on this specific action plan, I did not conclude we could tell them that. Senator Levin: That it was inadequate? Mr. Carter: That is right. Senator Levin: You could tell them it was not wholly adequate. Mr. Carter: Yes. Senator Levin: But not inadequate. Mr. Carter: I do not think I could say it was wholly inadequate. 806 See, e.g., IG Report at 30. 807 See Thorson prepared statement, April 16, 2010 Subcommittee Hearing at 12. CHRG-111shrg57319--124 Mr. Vanasek," Yes. FICO scores were the best single indicators we had in terms of predicting default or successful underwriting. We moved more and more to FICO scores over time because of what was happening with conventional underwriting, where we would have in the past looked at either tax returns or pay stubs or other things we would have looked at, we would have had different kinds of appraisals. They wouldn't have been drive-by appraisals. It would have been full appraisals, and so forth. So in the absence of those more detailed forms of underwriting and analysis, we had relied more heavily on FICO. Senator Kaufman. And the barbelling you were talking about, do you think that went on? " FinancialCrisisReport--85 In February 2007, WaMu senior managers discussed “how best to dispose” of $433 million in Long Beach performing second lien loans, due to “disarray” in the securitization market. 249 David Beck, head of WaMu’s Wall Street operation, wrote that securitizing the loans was “not a viable exit strategy” and noted: “Investors are suffering greater than expected losses from subprime in general as well as subprime 2nd lien transactions. As you know, they are challenging our underwriting representations and warrants. Long Beach was able to securitize 2nd liens once in 2006 in May. We sold the BBB- bonds to investors at Libor +260. To date, that transaction has already experienced 7% foreclosures.” 250 WaMu CEO Killinger complained privately to President Steve Rotella: “Is this basically saying that we are going to lose 15 [percent] on over $400 million of this product or 60 million. That is a pretty bad hit that reflects poorly on credit and others responsibility for buying this stuff. Is this showing up in hits to compensation or personnel changes.” 251 WaMu President Rotella responded: “This is second lien product originated 7-10 months ago from Long Beach. … In 2006 Beck’s team started sprinkling seconds in deals as they could. And, we now have the % down to the low single digits, so that we can sell all into our deals (assuming the market doesn’t get even worse).” He continued: “In terms of folks losing their jobs, the people largely responsible for bringing us this stuff are gone, the senior management of LB.” 252 Also in February 2007, early payment defaults again ticked up. A review of the first quarter of 2007 found: “First payment defaults (FPDs) rose to 1.96% in March but are projected to fall back to 1.87% in April based on payments received through May 5th.” 253 It also reported that the findings from a “deep dive into February FPDs revealed” that many of the problems could have been eliminated had existing guidelines been followed: “The root cause of over 70% of FPDs involved operational issues such as missed fraud flags, underwriting errors, and condition clearing errors. This finding indicates there may be opportunities to improve performance without further restricting underwriting guidelines.” 254 249 2/2007 email chain among WaMu personnel, JPM_WM00673101-03, Hearing Exhibit 4/13-17. 250 Id. at JPM_WM00673103. 251 Id. at JPM_WM00673101. 252 Id. 253 “Quarterly Credit Risk Review SubPrime,” prepared by WaMu Home Loans Risk Management (1st Quarter, 2007), Hearing Exhibit 4/13-18. 254 Id. CHRG-111shrg57320--14 Mr. Rymer," I think what you have here is a combination of not only very aggressive loan products, the Option ARMs, the purchase of subprime loans that they did, the home equity line of credit (HELOC) loans that they did, coupled with lax underwriting standards, and then over that very lax enterprise risk management processes. So I think the products themselves were risky. The administration of those products, the underwriting of those products were risky. And then the management and control after those loans were originated was really inadequate. Senator Levin. I think regulators banned negatively amortizing credit card loans about 5 years ago. Should we do the same thing relative to home loans? " FinancialCrisisInquiry--465 SOLOMON: Well, you asked that—if I may—in terms of underwritings, I think, and whether they should hold back—be required to hold a piece of their underwriting. And I don’t know, they didn’t give you—that wasn’t a bad answer they gave, meaning that there is a legitimacy to that, but whether the firm should have more capital is the issue I’m saying, not whether they are required to take a part of their underwriting and hold it back instead of underwriting fees or suffer the loss. Now, one of the things that does happen today is they’re much smarter. They’re, you know, when you talk to these folks, you read about Goldman Sachs, and if none of you January 13, 2010 have read the Charley Ellis book on Goldman Sachs you should all read it, particularly the updated version. I’ll give Charley a plug. You should read it, because it’s very revelatory about the thinking of Goldman Sachs about their business and how they look at markets. And, you know, let the—let their words tell you where they’re going. 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 FinancialCrisisReport--90 Another problem was the weak role played by WaMu’s compliance department. In March 2007, an OTS examiner noted that WaMu had just hired its “ninth compliance leader since 2000,” and that its “compliance management program has suffered from a lack of steady, consistent leadership.” The examiner added: “The Board of Directors should commission an evaluation of why smart, successful, effective managers can’t succeed in this position. … (HINT: It has to do with top management not buying into the importance of compliance and turf warfare and Kerry [Killinger] not liking bad news.)” 280 Still another problem was that WaMu failed to devote sufficient resources to overseeing the many loans it acquired from third party lenders and mortgage brokers. The 2010 Treasury and FDIC IG report found that, from 2003 to 2007, a substantial portion of WaMu’s residential loans – from 48% to 70% – came from third party lenders and brokers. 281 The IG report also found: “The financial incentive to use wholesale loan channels for production was significant. According to an April 2006 internal presentation to the WaMu Board, it cost WaMu about 66 percent less to close a wholesale loan ($1,809 per loan) than it did to close a retail loan ($5,273). Thus, WaMu was able to reduce its cost of operations through the use of third-party originators but had far less oversight over the quality of originations.” 282 During its last five years, WaMu accepted loans from tens of thousands of third party brokers and lenders across the country, not only through its wholesale and correspondent channels, but also through its securitization conduits that bought Alt A and subprime loans in bulk. Evidence gathered by the Subcommittee from OTS examination reports, WaMu internal 276 2/7/2005 OTS Letter to Washington Mutual Board of Directors on Matters Requiring Board Attention, OTSWMEF-0000047591, Hearing Exhibit 4/16-94 [Sealed Exhibit]. See the Regulator Chapter of this Report for more information. 277 6/3/2005 OTS Findings Memorandum, “Single Family Residential Home Loan review,” OTSWME05-004 0000392, Hearing Exhibit 4/16-26. For more information, see Chapter IV, below. 278 3/14/2005 OTS Report of Examination, OTSWMS05-004 0001794, Hearing Exhibit 4/16-94 [Sealed Exhibit]. (Examination findings were issued to WaMu on August 28, 2005.) 279 See, for example, 5/23/2006 OTS Exam Finding Memo, “Home Loan Underwriting, “ OTSWMS06-008 0001299, Hearing Exhibit 4/16-33; and 8/29/2006 OTS Report of Examination, OTSWMS06-008 0001690, Hearing Exhibit 4/16-94 [Sealed Exhibit]. 280 5/31/2007 Draft OTS Findings Memorandum, “Compliance Management Program,” Franklin_Benjamin- 00020408_001, Hearing Exhibit 4/16-9. 281 4/2010 IG Report, at 23, Hearing Exhibit 4/16-82. 282 Id. at 23. documents, and oral testimony shows that WaMu exercised weak oversight over the thousands of brokers submitting loans. For example, a 2003 OTS report concluded that WaMu’s “annual review and monitoring process for wholesale mortgage brokers was inadequate, as management did not consider key performance indicators such as delinquency rates and fraud incidents.” 283 A 2003 WaMu quality assurance review found an “error rate of 29 percent for wholesale mortgage loans, more than triple the acceptable error rate of 8 percent established by WaMu.” 284 A 2004 CHRG-111hhrg53021--80 Secretary Geithner," Well, it is true that, in the consumer credit area, where we have seen just terrible examples of predation and failure of basic underwriting standards, basic protections for consumers, we are proposing to give this new agency comprehensive rule-writing and enforcement authority. And, in this context, we would expect them to proscribe certain types of marketing practices; and, that would be appropriate, given what we have been through. That is an approach that has, sort of, come in lots of other areas before. But I do think it is important to recognize--and if you look at what the Congress of the United States did in the wake of the Great Depression, we put in place this comprehensive set of reforms to help protect consumers and investors and depositors to ensure the integrity of market functioning. What we are proposing to do is in the spirit of that. In many ways, the big mistake we made as a country was we allowed a huge array of activity, financial activity, to build up and exist outside those protections. But---- " CHRG-111hhrg53021Oth--80 Secretary Geithner," Well, it is true that, in the consumer credit area, where we have seen just terrible examples of predation and failure of basic underwriting standards, basic protections for consumers, we are proposing to give this new agency comprehensive rule-writing and enforcement authority. And, in this context, we would expect them to proscribe certain types of marketing practices; and, that would be appropriate, given what we have been through. That is an approach that has, sort of, come in lots of other areas before. But I do think it is important to recognize--and if you look at what the Congress of the United States did in the wake of the Great Depression, we put in place this comprehensive set of reforms to help protect consumers and investors and depositors to ensure the integrity of market functioning. What we are proposing to do is in the spirit of that. In many ways, the big mistake we made as a country was we allowed a huge array of activity, financial activity, to build up and exist outside those protections. But---- " 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. " FinancialCrisisReport--209 Senator Coburn: [To Mr. Thorson] By your statement, it would imply almost that OTS is an enabler of this effort rather than an enabler of making sure that the American people’s taxpayer dollars and the trust in institutions that are supposed to be regulated by an agency of the Federal Government can be trusted. Mr. Thorson: Right. In trying to understand why OTS failed to make use of its enforcement tools to compel WaMu to operate in a safe and sound manner, the Subcommittee investigation has identified factors that have resonance not only in the recent financial crisis, but are critical for regulators and policymakers to address in order to avoid future financial disasters as well. (1) OTS’ Failed Oversight of WaMu During the five-year period of the Subcommittee’s inquiry, from 2004 to 2008, OTS identified over 500 serious operational deficiencies at WaMu and Long Beach. At WaMu, the problems included weak lending standards, high loan exception and error rates, noncompliance with bank loan policy, weak risk management, poor appraisal practices, and poor quality loans. At Long Beach, OTS identified many of the same problems and added on top of those, weak management, poor quality mortgage backed securities, and inadequate repurchase reserves. The problems are described in examination report after examination report, and OTS raised many of the same concerns, in writing and in person, with WaMu’s Board of Directors. But for all those years, OTS did little beyond describing the problems and asking bank executives to make improvements. When the reforms failed to materialize, the problems continued, and the risk increased, OTS stood on the sidelines. Subcommittee interviews found that, until 2008, OTS regulators never even held internal discussions about taking an enforcement action against the bank. In 2008, in the face of mounting losses, OTS took two informal, nonpublic enforcement actions, which contained few mandatory measures or deadlines and were together insufficient to save the bank. In trying to understand the agency’s years of inaction, the Subcommittee’s investigation concluded that the lack of enforcement reflected an OTS culture of deference to bank management, demoralized examiners whose oversight efforts were unsupported by their supervisors, and a narrow regulatory focus that allowed short term profits to excuse high risk activities and disregarded systemic risk. Inflated CAMELS ratings may have further reduced the pressure to act, while conflicts of interest may have also tempered OTS’ willingness to take tough enforcement action against WaMu. (a) Deference to Management Part of the reason that OTS declined to take enforcement action against Washington Mutual was a posture of deference to the management of the institutions it regulated. Ronald Cathcart, WaMu’s chief enterprise risk officer from 2006-2008, described OTS as essentially believing in “self-regulation”: “I … have actually operated in banks under three regulators, in Canada under the Office of the Supervisor of Financial Institutions, at Bank One under the OCC, and then at Washington Mutual under the OTS[.] … [T]he approach that the OTS took was much more light-handed than I was used to. It seemed as if the regulator was prepared to allow the bank to work through its problems and had a higher degree of tolerance that I had … seen with the other two regulators. … I would say that the OTS did believe in self- regulation.” 796 FinancialCrisisReport--58 When Washington Mutual began securitizing its loans, it was dependent upon investment banks to help underwrite and sell its securitizations. In order to have greater control of the securitization process and to keep securitization underwriting fees in house, rather than paying them to investment banks, WaMu acquired a company able to handle securitizations and renamed it Washington Mutual Capital Corporation (WCC), which became a wholly owned subsidiary of the bank. 123 WCC was a registered broker-dealer and began to act as an underwriter of WaMu and Long Beach securitizations. 124 WCC worked with two other bank subsidiaries, Washington Mutual Mortgage Securities Corp. and Washington Mutual Asset Acceptance Corp., that provided warehousing for WaMu loans before they were securitized. WCC helped to assemble RMBS pools and sell the resulting RMBS securities to investors. At first it worked with other investment banks; later it became the sole underwriter of some WaMu securitizations. WCC was initially based in Seattle with 30 to 40 employees. 125 In 2004, it moved its headquarters to Manhattan. 126 At the height of WCC operations, right before the collapse of the securitization market, WCC had over 200 employees and offices in Seattle, New York, Los Angeles, and Chicago, with the majority of its personnel in New York. 127 WCC closed its doors in December 2007, after the securitization markets collapsed. (5) Overview of WaMu’s Rise and Fall Washington Mutual Bank (WaMu) was a wholly owned subsidiary of its parent holding company, Washington Mutual Inc. 128 From 1996 to 2002, WaMu acquired over a dozen other financial institutions, including American Savings Bank, Great Western Bank, Fleet Mortgage Corporation, Dime Bancorp, PNC Mortgage, and Long Beach, expanding to become the nation’s largest thrift and sixth largest bank. WaMu also became one of the largest issuers of home loans in the country. Washington Mutual kept a portion of those loans 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. From 2000 to 2008, Washington Mutual sold over $500 billion in loans to Fannie Mae and Freddie Mac, representing more than a quarter of its loan production during those years. 123 See 6/11/2007 chart entitled, “Capital Markets Division Growth,” JPM_WM03409858, Hearing Exhibit 4/13-47c. 124 Prepared statement of David Beck, April 13, 2010 Subcommittee Hearing at 2. 125 Subcommittee interview of David Beck (3/2/2010). 126 Id. 127 Id. 128 9/25/2008 “OTS Fact Sheet on Washington Mutual Bank,” Dochow_Darrel-00076154_001, at 002. Washington Mutual Inc. also owned a second, much smaller thrift, Washington Mutual Bank, FSB. Id. fcic_final_report_full--492 The deterioration in mortgage standards did not occur—contrary to the Commission majority’s apparent view—because banks and other originators suddenly started to make deficient loans; nor was it because of insuffi cient regulation at the originator level. The record shows unambiguously that government regulations made FHA, Fannie and Freddie, mortgage banks and insured banks of all kinds into competing buyers. All of them needed NTMs in order to meet various government requirements. Fannie and Freddie were subject to increasingly stringent affordable housing requirements; FHA was tasked with insuring loans to low-income borrowers that would not be made unless insured; banks and S&Ls were required by CRA to show that they were also making loans to the same group of borrowers; mortgage bankers who signed up for the HUD Best Practices Initiative and the Clinton administration’s National Homeownership Strategy were required to make the same kind of loans. Profit had nothing to do with the motivations of these firms; they were responding to government direction. Under these circumstances, it should be no surprise that underwriting standards declined, as all of these organizations scrambled to acquire the same low quality mortgages. 1. HUD’s Central Role In testimony before the House Financial Services Committee on April 14, 2010, Shaun Donovan, Secretary of Housing and Urban Development, said in reference to the GSEs: “Seeing their market share decline [between 2004 and 2006] as a result of [a] change of demand, the GSEs made the decision to widen their focus from safer prime loans and begin chasing the non-prime market, loosening long- standing underwriting and risk management standards along the way. This would be a fateful decision that not only proved disastrous for the companies themselves –but ultimately also for the American taxpayer.” Earlier, in a “Report to Congress on the Root Causes of the Foreclosure Crisis,” in January 2010, HUD declared “The serious financial troubles of the GSEs that led to their being placed into conservatorship by the Federal government provides strong testament to the fact that the GSEs were, indeed, overexposed to unduly risky mortgage investments. However, the evidence suggests that the GSEs’ decisions to purchase or guarantee non-prime loans was motivated much more by efforts to chase market share and profits than by the need to satisfy federal regulators .” 61 61 [emphasis supplied] Finger-pointing in Washington is endemic when problems occur, and Report to Congress on the Root Causes of the Foreclosure Crisis , January 2010, p.xii, http://www. huduser.org/portal/publications/hsgfin/foreclosure_09.html. agencies and individuals are constantly trying to find scapegoats for their own bad decisions, but HUD’s effort to blame Fannie and Freddie for the decline in underwriting standards sets a new standard for running from responsibility. Contrast the 2010 statement quoted above with this statement by HUD in 2000, when it was significantly increasing Fannie and Freddie’s affordable housing goals: FinancialCrisisReport--217 Weak Standards. The documents show that the OTS examiners were also frustrated by the agency’s weak standards, which made it difficult to cite WaMu for violations or require the bank to strengthen its operations. In 2007, for example, an examiner critical of WaMu’s compliance procedures wanted to downgrade the bank’s compliance rating from 2 to 3, but told the OTS Examiner-in-Charge that, due to the lack of standards on compliance matters, she didn’t believe she could win a battle with the bank: “I’m not up for the fight or the blood pressure problems. … It doesn’t matter that we are right, what matters is how it is framed. … They [Washington Mutual] aren’t interested in our ‘opinions’ of the [compliance] program. They want black and white, violations or not. … [O]ur training always emphasizes ‘Best Practices’ but when it comes down to it, we don’t have the resources to show the risk.” 820 At another point, when discussing standards for calculating acceptable loan error rates, an OTS examiner wrote: “We will need additional discussion of acceptable error rates and how we view their [WaMu’s] standard. … [A] 2.5 percent error rate would mean that approximate[ly] $600.0 million could be originated and be within acceptable guidelines. A 20.0 percent medium error rate means that $4.8 billion of loans with these types of errors could be originated without a criticism. The latter seem[s] especially high when you consider that their medium criteria includes loans that we don’t think should be made.” 821 The OTS Examiner-in-Charge responded with a lengthy email criticizing outdated, unclear OTS standards on the acceptable loan error rate for a portfolio of subprime loans: “Unfortunately, our sampling standards are 10 years old and we have no standards of acceptance really. It depends on our own comfort levels, which differ. … Moreover, our guidance requires that an exception be SIGNIFICANT, which ... we have over time interpreted as loans that should not have been made. … While we may (and have) questioned the reasonableness of these standards, they are all we have at this time. If our tolerance for some reason is now a lot lower than our handbook standards, it would be nice to have this clarified. I have always used these standards as rough benchmarks and not absolutes myself, upping my expectations for higher risk portfolios. … It would be 819 Subcommittee interview of Benjamin Franklin (2/17/2010). 820 6/3/2007 email from OTS examiner Mary Clark to Examiner-in-Charge Benjamin Franklin, “Compliance Rating,” OTSWMS07-013 0002576, Hearing Exhibit 4/16-39. 821 11/21/2005 email exchange between OTS examiner Benjamin Franklin and Examiner-in-Charge Lawrence Carter and others, OTSEMS05-004 0001911-12, Hearing Exhibit 4/16-30. nice if they [higher risk loan portfolios] could meet even higher expectations, but that would require us to agree on what the standard should be.” 822 CHRG-111hhrg51591--106 Mr. Foster," Well, that is on the underwriting side more, which it is always going to be there. " CHRG-111shrg56262--95 PREPARED STATEMENT OF ANDREW DAVIDSON President, Andrew Davidson and Company October 7, 2009 Mr. Chairman and Members of the Subcommittee, I appreciate the opportunity to testify before you today about securitization. My expertise is primarily in the securitization of residential mortgages and my comments will be primarily directed toward those markets. Securitization has been a force for both good and bad in our economy. A well functioning securitization market expands the availability of credit for economic activity and home ownership. It allows banks and other financial institutions to access capital and reduces risk. On the other hand a poorly functioning securitization market may lead to misallocation of capital and exacerbate risk. \1\--------------------------------------------------------------------------- \1\ Portions of this statement are derived from ``Securitization: After the Fall'', Anthony Sanders and Andrew Davidson, forthcoming.--------------------------------------------------------------------------- Before delving into a discussion of the current crisis, I would like to distinguish three types of capital markets activities that are often discussed together: Securitization, Structuring, and Derivatives. \2\--------------------------------------------------------------------------- \2\ See, Andrew Davidson, Anthony Sanders, Lan-Ling Wolff, and Anne Ching, ``Securitization'', 2003, for a detailed discussion of securitization and valuation of securitized products.--------------------------------------------------------------------------- Securitization is the process of converting individual loans into securities that can be freely transferred. Securitization serves to separate origination and investment functions. Without securitization investors would need to go through a very complex process of transferring the ownership of individual loans. The agency mortgage-backed securities (MBS) from Ginnie Mae, Fannie Mae, and Freddie Mac are one of the most successful financial innovations. However, as the last years have taught us, the so-called, ``originate to sell'' model, especially as reflected in private-label (nonagency) MBS, has serious shortcomings. Structuring is the process of segmenting the cash flows of one set of financial instruments into several bonds which are often called tranches. The collateralized mortgage obligation or CMO is a classic example of structuring. The CMO transforms mortgage cash flows into a variety of bonds that appeal to investors from short-term stable bonds, to long-term investments. Private label MBS use a second form of structuring to allocate credit risk. A typical structure uses subordination, or over-collateralization, to create bonds with different degrees of credit risk. The collateralized debt obligation or CDO is a third form of structuring. In this case, bonds, rather than loans, are the underlying collateral for the CDO bonds which are segmented by credit risk. Structuring allows for the expansion of the investor base for mortgage cash flows, by tailoring the bonds characteristics to investor requirements. Unfortunately, structuring has also been used to design bonds that obfuscate risk and return. Derivatives, or indexed contracts, are used to transfer risk from one party to another. Derivatives are a zero sum game in that one investor's gain is another's loss. While typically people think of swaps markets and futures markets when they mention derivatives, the TBA (to be announced) market for agency pass-through mortgages is a large successful derivative market. The TBA market allows for trading in pass-through MBS without the need to specify which pool of mortgages will be delivered. More recently a large market in mortgage credit risk has developed. The instruments in this market are credit default swaps (CDS) and ABX, an over-the-counter index based on subprime mortgage CDS. Derivatives allow for risk transfer and can be powerful vehicles for risk management. On the other hand, derivatives may lead to the creation of more risk in the economy as derivate volume may exceed the underlying asset by substantial orders of magnitude. For any of these products to be economically useful they should address one or more of the underlying investment risks of mortgages: funding, interest rate risk, prepayment risk, credit risk, and liquidity. More than anything else mortgages represent the funding of home purchases. The twelve trillion of mortgages represents funding for the residential real estate of the country. Interest rate risk arises due to the fixed coupon on mortgages. For adjustable rate mortgages it arises from the caps, floors and other coupon limitations present in residential mortgage products. Interest rate risk is compounded by prepayment risk. Prepayment risk reflects both a systematic component that arises from the option to refinance (creating the option features of MBS) as well as the additional uncertainty created by the difficulty in accurately forecasting the behavior of borrowers. Credit risk represents the possibility that borrowers will be unable or unwilling to make their contractual payments. Credit risk reflects the borrower's financial situation, the terms of the loan and the value of the home. Credit risk has systematic components related to the performance of the economy, idiosyncratic risks related to individual borrowers and operational risks related to underwriting and monitoring. Finally, liquidity represents the ability to transfer the funding obligation and/or the risks of the mortgages. In addition to the financial characteristics of these financial tools, they all have tax, regulatory and accounting features that affect their viability. In some cases tax, regulatory and accounting outcomes rather than financial benefit are the primary purpose of a transaction. In developing policy alternatives each of these activities: securitization, structuring and derivatives, pose distinct but interrelated challenges.Role of Securitization in the Current Financial Crisis The current economic crisis represents a combination of many factors and blame can be laid far and wide. Additional analysis may be required to truly assess the causes of the crisis. Nevertheless I believe that securitization contributed to the crisis in two important ways. It contributed to the excessive rise in home prices and it created instability once the crisis began. First, the process of securitization as implemented during the period leading up to the crisis allowed a decline in underwriting standards and excessive leverage in home ownership. The excess lending likely contributed to the rapid rise in home prices leading up to the crisis. In addition to the well documented growth in subprime and Alt-A lending, we find that the quality of loans declined during the period from 2003 to 2005, even after adjusting for loan to value ratios, FICO scores, documentation type, home prices and other factors reflected in data available to investors. The results of our analysis are shown in Figure 1. It shows that the rate of delinquency for loans originated in 2006 is more than 50 percent higher than loans originated in 2003. The implication is that the quality of underwriting declined significantly during this period, and this decline was not reflected in the data provided to investors. As such it could reflect fraud, misrepresentations and lower standard for verifying borrower and collateral data. The net impact of this is that borrowers were granted credit at greater leverage and at lower cost than in prior years.[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] In concrete terms, the securitization market during 2005 and 2006 was pricing mortgage loans to an expected lifetime loss of about 5 percent. Our view is that even if home prices had remained stable, these losses would have been 10 percent or more. Given the structure of many of these loans, with a 2-year initial coupon and an expected payoff by the borrower at reset, the rate on the loans should have been 200 or 300 basis points higher. That is, initial coupons should have been over 10 percent rather than near 8 percent. Our analysis further indicates that this lower cost of credit inflated home prices. The combination of relaxed underwriting standards and affordability products, such as option-arms, effectively lowered the required payment on mortgages. The lower payment served to increase the price of homes that borrowers could afford. Figure 2 shows the rapid rise in the perceived price that borrowers could afford in the Los Angeles area due to these reduced payment requirements. Actual home prices then followed this pattern. Generally we find that securitization of subprime loans and other affordability products such as option arms were more prevalent in the areas with high amounts of home price appreciation during 2003 to 2006. To be clear, not all of the affordability loans were driven by securitization, as many of the option arms remained on the balance sheet of lending institutions.[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] Figure 3 provides an indication of the magnitude of home price increases that may have resulted from these products on a national basis. Based on our home price model, we estimate that home prices may have risen by 15 percent at the national level due to lower effective interest rates. In the chart, the gap between the solid blue line and the dashed blue line reflects the impact of easy credit on home prices.[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] On the flip side, we believe that the shutting down of these markets and the reduced availability of mortgage credit contributed to the sharp decline in home prices we have seen since 2006 as shown in Figure 4. Without an increase in effective mortgage rates, home prices might have sustained their inflated values as shown by the dashed blue line. \3\--------------------------------------------------------------------------- \3\ See, http://www.ad-co.com/newsletters/2009/Jun2009/Valuation_Jun09.pdf for more details.[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] Thus the reduced focus on underwriting quality lead to an unsustainable level of excess leverage and reduced borrowing costs which helped to inflate home prices. When these ``affordability'' products were no longer sustainable in the market, they contributed to the deflation of the housing bubble. The way securitization was implemented during this period fostered high home prices through poor underwriting, and the end of that era may have led to the sharp decline in home prices and the sharp decline in home prices helped to spread the financial crisis beyond the subprime market. The second way that securitization contributed to the current economic crisis is through the obfuscation of risk. For many structures in the securitization market: especially collateralized debt obligations, structured investment vehicles and other resecuritizations, there is and was insufficient information for investors to formulate an independent judgment of the risks and value of the investment. As markets began to decline in late 2007, investors in all of these instruments and investors in the institutions that held or issued these instruments were unable to assess the level of risk they bore. This lack of information quickly became a lack of confidence and led to a massive deleveraging of our financial system. This deleveraging further depressed the value of these complex securities and led to real declines in economic value as the economy entered a severe recession. In addition, regulators lacked the ability to assess the level of risk in regulated entities, perhaps delaying corrective action or other steps that could have reduced risk levels earlier.Limitations of Securitization Revealed To understand how the current market structure could lead to undisciplined lending and obfuscation of risk it is useful to look at a simplified schematic of the market. \4\--------------------------------------------------------------------------- \4\ Adapted from ``Six Degrees of Separation'', August 2007, by Andrew Davidson http://www.securitization.net/pdf/content/ADC_SixDegrees_1Aug07.pdf.[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] In the simplest terms, what went wrong in the subprime mortgage in particular and the securitization market in general is that the people responsible for making loans had too little financial interest in the performance of those loans and the people with financial interest in the loans had too little involvement in the how the loans were made. The secondary market for nonagency mortgages, including subprime mortgages, has many participants and a great separation of the origination process from the investment process. Each participant has a specialized role. Specialization serves the market well, as it allows each function to be performed efficiently. Specialization, however also means that risk creation and risk taking are separated. In simplified form the process can be described as involving: A borrower--who wants a loan for home purchase or refinance A broker--who works with the borrower and lenders to arrange a loan A mortgage banker--who funds the loan and then sells the loan An aggregator--(often a broker-dealer) who buys loans and then packages the loans into a securitization, whose bonds are sold to investors. A CDO manager--who buys a portfolio of mortgage-backed securities and issues debt An investor--who buys the CDO debt Two additional participants are also involved: A servicer--who keeps the loan documents and collects the payments from the borrower A rating agency--that places a rating on the mortgage securities and on the CDO debt This chart is obviously a simplification of a more complex process. For example, CDOs were not the only purchasers of risk in the subprime market. They were however a dominant player, with some estimating that they bought about 70 percent of the lower rated classes of subprime mortgage securitizations. What is clear even from this simplified process is that contact between the provider of risk capital and the borrower was very attenuated. A central problem with the securitization market, especially for subprime loans was that no one was the gate keeper, shutting the door on uneconomic loans. The ultimate CDO bond investor placed his trust in the first loss investor, the rating agencies, and the CDO manager, and in each case that trust was misplaced. Ideally mortgage transactions are generally structured so that someone close to the origination process would take the first slice of credit risk and thus insure that loans were originated properly. In the subprime market, however it was possible to originate loans and sell them at such a high price, that even if the mortgage banker or aggregator retained a first loss piece (or residual) the transaction could be profitable even if the loans did not perform well. Furthermore, the terms of the residuals were set so that the owner of the residual might receive a substantial portion of their cash flows before the full extent of losses were known. Rating agencies set criteria to establish credit enhancement levels that ultimately led to ratings on bonds. The rating agencies generally rely on historical statistical analysis to set ratings. The rating agencies also depend on numeric descriptions of loans like loan-to-value ratios and debt-to-income ratios to make their determinations. Rating agencies usually do not review loans files or ``re-underwrite'' loans. Rating agencies also do not share in the economic costs of loan defaults. The rating agencies methodology allowed for the inclusion of loans of dubious quality into subprime and Alt-A mortgage pools, including low documentation loans for borrowers with poor payment histories, without the offsetting requirement of high down payments. To help assure investors of the reliability of information about the risks of purchased loans, the mortgage market has developed the practice of requiring ``representations and warranties'' on purchased loans. These reps and warrants as they are called, are designed to insure that the loans sold meet the guidelines of the purchasers. This is because mortgage market participants have long recognized that there is substantial risk in acquiring loans originated by someone else. An essential component in having valuable reps and warrants is that the provider of those promises has sufficient capital to back up their obligations to repurchase loans subsequently determined to be inconsistent with the reps and warrants. A financial guarantee from an insolvent provider has no value. Representations and warranties are the glue that holds the process together; if the glue is weak the system can collapse. The rating agencies also established criteria for Collateralized Debt Obligations that allowed CDO managers to produce very highly leveraged portfolios of subprime mortgage securities. The basic mechanism for this was a model that predicted the performance of subprime mortgage pools were not likely to be highly correlated. That is defaults in one pool were not likely to occur at the same time as defaults in another pool. This assumption was at best optimistic and most likely just wrong. In the CDO market the rating agencies have a unique position. In most of their other ratings business, a company or a transaction exists or is likely to occur and the rating agency reviews that company or transaction and establishes ratings. In the CDO market, the criteria of the rating agency determine whether or not the transaction will occur. A CDO is like a financial institution. It buys assets and issues debt. If the rating agency establishes criteria that allow the institution to borrow money at a low enough rate or at high enough leverage, then the CDO can purchase assets more competitively than other financial institutions. If the CDO has a higher cost of debt or lower leverage, then it will be at a disadvantage to other buyers and will not be brought into existence. If the CDO is created, the rating agency is compensated for its ratings. If the CDO is not created, there is no compensation. My view is that there are very few institutions that can remain objective given such a compensation scheme. CDO bond investors also relied upon the CDO manager to guide them in the dangerous waters of mortgage investing. Here again investors were not well served by the compensation scheme. In many cases CDO managers receive fees that are independent of the performance of the deals they manage. While CDO managers sometimes keep an equity interest in the transactions they manage, the deals are often structured in such a way that that the deal can return the initial equity investment even if some of the bonds have losses. Moreover, many of the CDOs were managed by start-up firms with little or no capital. Nevertheless, much of the responsibility should rest with the investors. CDO bond investors were not blind to the additional risks posed by CDO investing. CDOs generally provided higher yields than similarly rated bonds, and it is an extremely naive, and to my mind, rare, investor who thinks they get higher returns without incremental risk. It is not unusual, however, for investors not to realize the magnitude of additional risk they bear for a modest incremental return. Ultimately it is investors who will bear the losses, and investors must bear the bulk of the burden in evaluating their investments. There were clear warning signs for several years as to the problems and risk of investing in subprime mortgages. Nevertheless, investors continued to participate in this sector as the risks grew and reward decreased. As expressed herein, the primary problem facing securitization is a failure of industrial organization. The key risk allocators in the market, the CDO managers, were too far from the origination process and, at best, they believed the originators and the rating agencies were responsible for limiting risk. At the origination end, without the discipline of a skeptical buyer, abuses grew. The buyer was not sufficiently concerned with the process of loan origination and the broker was not subject to sufficient constraints.Current Conditions of the Mortgage-backed Securities Market More than 2 years after the announcement of the collapse of the Bear Stearns High Grade Structured Credit Enhanced Leverage Fund the mortgage market remains in a distressed state. Little of the mortgage market is functioning without the direct involvement of the U.S. Government, and access to financing for mortgage originators and investors is still limited. Fortunately there are the beginning signs of stabilization of home prices, but rising unemployment threatens the recovery. In the secondary market for mortgage-backed securities there has been considerable recovery in price in some sectors, but overall demand is being propped up by large purchases of MBS by the Federal Reserve Bank. In addition, we find that many of our clients are primarily focused on accounting and regulatory concerns related to legacy positions, and less effort is focused on the economic analysis of current and future opportunities. That situation may be changing as over the past few months we have seen some firms begin to focus on longer term goals.The Effectiveness of Government Action I have not performed an independent analysis of the effectiveness of Government actions, so by comments are limited to my impressions. Government involvement has been beneficial in a number of significant respects. Without Government involvement in Fannie Mae, Freddie Mac, and FHA lending programs, virtually all mortgage lending could have stalled. What lending would have existed would have been for only the absolute highest quality borrowers and at restrictive rates. In addition Government programs to provide liquidity have also been beneficial to the market as private lending was reduced to extremely low levels. Government and Federal Reserve purchases of MBS have kept mortgage rates low. This has probably helped to bolster home prices. On the other hand the start/stop nature of the buying programs under TARP and PPIP has probably been a net negative for the market. Market participants have held back on investments in anticipation of Government programs that either did not materialize or were substantially smaller in scope than expected. Furthermore Government efforts to influence loan modifications, while beneficial for some home owners, and possibly even investors, have created confusion and distrust. Investors are more reluctant to commit capital when the rules are uncertain. In my opinion there has been excessive focus on loan modifications as a solution to the current crisis. Loan modifications make sense for a certain portion of borrowers whose income has been temporarily disrupted or have sufficient income to support a modestly reduce loan amount and the willingness to make those payments. However for many borrowers, loan modifications cannot produce sustainable outcomes. In addition, loan modifications must deal with the complexities of multiple liens and complex ownership structures of mortgage loans. Short sales, short payoffs, and relocation assistance for borrowers are other alternatives that should be given greater weight in policy development. The extensive Government involvement in the mortgage market has likely produced significant positive benefits to the economy. However unwinding the Government role will be quite complex and could be disruptive to the recovery. Government programs need to be reduced and legislative and regulatory uncertainties need to be addressed to attract private capital back into these markets.Legislative and Regulatory Recommendations I believe that the problems in the securitization market were essentially due to a failure of industrial organization. Solutions should address these industrial organization failures. While some may seek to limit the risks in the economy, I believe a better solution is to make sure the risks are borne by parties who have the capacity to manage the risks or the capital to bear those risks. In practical terms, this means that ultimately bond investors, as the creators of leverage, must be responsible for limiting leverage to economically sustainable levels that do not create excessive risk to their stakeholders. Moreover, lenders should not allow equity investors to have tremendous upside with little exposure to downside risk. Equity investors who have sufficient capital at risk are more likely to act prudently. Consequently, all the information needed to assess and manage risks must be adequately disclosed and investors should have assurances that the information they rely upon is accurate and timely. Likewise when the Government acts as a guarantor, whether explicitly or implicitly, it must insure that it is not encouraging excessive risk taking and must have access to critical information on the risks borne by regulated entities. In this light, I would like to comment on the Administration proposals on Securitization in the white paper: ``Financial Regulatory Reform: A New Foundation.'' \5\ Recommendations 1 and 2 cover similar ground:--------------------------------------------------------------------------- \5\ http://www.financialstability.gov/docs/regs/FinalReport_web.pdf pp. 44-46. 1. Federal banking agencies should promulgate regulations that require originators or sponsors to retain an economic interest in a material portion of the credit risk of securitized credit --------------------------------------------------------------------------- exposures. The Federal banking agencies should promulgate regulations that require loan originators or sponsors to retain 5 percent of the credit risk of securitized exposures. 2. Regulators should promulgate additional regulations to align compensation of market participants with longer term performance of the underlying loans. Sponsors of securitizations should be required to provide assurances to investors, in the form of strong, standardized representations and warranties, regarding the risk associated with the origination and underwriting practices for the securitized loans underlying ABS. Clearly excessive leverage and lack of economic discipline was at the heart of the problems with securitization. As described above the market failed to adequately protect investors from weakened underwriting standards. Additional capital requirements certainly should be part of the solution. However, such requirements need to be constructed carefully. Too little capital and it will not have any effect; too much and it will inhibit lending and lead to higher mortgage costs. The current recommendation for retention of 5 percent of the credit risk does not seem to strike that balance appropriately. When a loan is originated there are several kinds of credit related risks that are created. In addition to systematic risks related to future events such as changes in home prices and idiosyncratic risks such as changes in the income of the borrower, there are also operational risks related to the quality of the underwriting and servicing. An example of an underwriting risk is whether or not the borrower's income and current value of their home were verified appropriately. Originators are well positioned to reduce the operational risks associated with underwriting and fight fraud, but they may be less well positioned to bear the long term systematic and idiosyncratic risks associated with mortgage lending. Investors are well positioned to bear systemic risks and diversify idiosyncratic risks, but are not able to assess the risks of poor underwriting and servicing. The securitization process should ensure that there is sufficient motivation and capital for originators to manage and bear the risks of underwriting and sufficient information made available to investors to assess the risks they take on. The current form of representations and warranties is flawed in that it does not provide a direct obligation from the originator to the investor. Instead representations and warranties pass through a chain of ownership and are often limited by ``knowledge'' and capital. In addition current remedies are tied to damages and in a rising home price market calculated damages may be limited. Thus a period of rising home prices can mask declining credit quality and rising violations of representations and warranties. Therefore, incentives and penalties should be established to limit unacceptable behavior such as fraud, misrepresentations, predatory lending. If the goal is to prevent fraud, abuse and misrepresentations rather than to limit risk transfer then there needs to be a better system to enforce the rights of borrowers and investors than simply requiring a originators to retain a set percentage of credit risk. I have proposed \6\ a ``securitization certificate'' which would travel with the loan and would be accompanied by appropriate assurances of financial responsibility. The certificate would replace representations and warranties, which travel through the chain of buyers and sellers and are often unenforced or weakened by the successive loan transfers. The certificate could also serve to protect borrowers from fraudulent origination practices in the place of assignee liability. Furthermore the certificate should be structured so that there are penalties for violations regardless of whether or not the investor or the borrower has experienced financial loss. The record of violations of these origination responsibilities should publically available.--------------------------------------------------------------------------- \6\ http://www.ad-co.com/newsletters/2008/Feb2008/Credit_Feb08.pdf and ``Securitization: After the Fall'', Anthony Sanders and Andrew Davidson, forthcoming.--------------------------------------------------------------------------- I have constructed a simple model of monitoring fraudulent loans. \7\ Some preliminary results are shown in Table 1. These simulations show the impact of increasing the required capital for a seller and of instituting a fine for fraudulent loans beyond the losses incurred. These results show that under the model assumptions, without a fine for fraud, sellers benefit from originating fraudulent loans. The best results are obtained when the seller faces fines for fraud and has sufficient capital to pay those fines. The table below shows the profitability of the seller and buyer for various levels of fraudulent loans. In the example below, the profits of the seller increase from .75 with no fraudulent loans to .77 with 10 percent fraudulent loans, even when the originator retains 5 percent capital against 5 percent of the credit risk. On the other hand, the sellers profit falls from .75 to .44 with 10 percent fraudulent loans even though the retained capital is only 1 percent, but there is a penalty for fraudulent loans. Thus the use of appropriate incentives can reduce capital costs, while increasing loan quality.--------------------------------------------------------------------------- \7\ The IMF has produced a similar analysis and reached similar conclusions. http://www.imf.org/external/pubs/ft/gfsr/2009/02/pdf/chap2.pdf.[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] Under this analysis the Treasury proposals would not have a direct effect on fraud. In fact, there is substantial risk the recommended approach of requiring minimum capital requirements for originators to bear credit risk would lead to either higher mortgage rates or increased risk taking. A better solution is to create new mechanisms to monitor and enforce the representations and warranties of originators. With adequate disclosure of risks and a workable mechanism for enforcing quality controls the securitization market can more effectively price and manage risk. Recommendation 3 addresses the information available to investors: 3. The SEC should continue its efforts to increase the transparency and standardization of securitization markets and be given clear authority to require robust reporting by issuers of asset backed securities (ABS). Increased transparency and standardization of securitization markets would likely to better functioning markets. In this area, Treasury charges the SEC and ``industry'' with these goals. I believe there needs to be consideration of a variety of institutional structures to achieve these goals. Standardization of the market can come from many sources. Possible candidates include the SEC, the American Securitization Forum, the Rating Agencies and the GSEs, Fannie Mae and Freddie Mac. I believe the best institutions to standardize a market are those which have an economic interest in standardization and disclosure. Of all of these entities the GSEs have the best record of standardizing the market; this was especially true before their retained portfolios grew to dominate their income. (As I will discuss below, reform of the GSEs is essential for restoring securitization.) I believe a revived Fannie Mae and Freddie Mac, limited primarily to securitization, structured as member-owned cooperatives, could be an important force for standardization and disclosure. While the other candidates could achieve this goal they each face significant obstacles. The SEC operates primarily through regulation and therefore may not be able to adapt to changing markets. While the ASF has made substantial strides in this direction, the ASF lacks enforcement power for its recommendations and has conflicting constituencies. The rating agencies have not shown the will or the power to force standardization, and such a role may be incompatible with their stated independence. Recommendations 4 and 5 address the role of rating agencies in securitization. 4. The SEC should continue its efforts to strengthen the regulation of credit rating agencies, including measures to require that firms have robust policies and procedures that manage and disclose conflicts of interest, differentiate between structured and other products, and otherwise promote the integrity of the ratings process. 5. Regulators should reduce their use of credit ratings in regulations and supervisory practices, wherever possible. In general I believe that the conflicts of interest facing rating agencies and their rating criteria were well known and easily discovered prior to the financial crisis. Thus I do not believe that greater regulatory authority over rating agencies will offer substantial benefits. In fact, increasing competition in ratings or altering the compensation structure of rating agencies may not serve to increase the accuracy of ratings, since most users of ratings issuers as well as investors are generally motivated to seek higher ratings. (Only if the regulatory reliance on rating agencies is reduced will these structural changes be effective.) To the extent there is reliance on rating agencies in the determination of the capital requirement for financial institutions, a safety and soundness regulators for financial institutions, such the FFIEC or its successor, should have regulatory authority over the rating agencies. Rather than focus on better regulation, I support the second aspect of Treasury's recommendations on rating agencies (recommendation 5) and believe it would be better for safety and soundness regulators to reduce their reliance on ratings and allow the rating agencies to continue their role of providing credit opinions that can be used to supplement credit analysis performed by investors. To reduce reliance on ratings, regulators, and others will need alternative measures of credit and other risks. I believe that the appropriate alternative to ratings is analytical measures of risk. Analytical measures can be adopted, refined, and reviewed by regulators. In addition regulators should insist that regulated entities have sufficient internal capacity to assess the credit and other risks of their investments. In this way regulators would have greater focus on model assumptions and model validation and reduced dependence on the judgment of rating agencies. The use of quantitative risk measures also requires that investors and regulators have access to sufficient information about investments to perform the necessary computations. Opaque investments that depend entirely upon rating agency opinions would be clearly identified. Quantitative measures can also be used to address the concerns raised in the report about concentrations of risk and differentiate structured products and direct corporate obligations. I recently filed a letter with the National Association of Insurance Commissioners on the American Council of Life Insurers' proposal to use an expected loss measure as an alternative to ratings for nonagency MBS in determining risk based capital. Here I would like to present some of the key points in that letter: An analytical measure may be defined as a number, or a value, that is computed based on characteristics of a specific bond, its collateral and a variety of economic factors both historical and prospective. One such analytical measure is the probability of default and another measure is the expected loss of that bond. While an analytical measure is a numeric value that is the result of computations, it should be noted that there may still be some judgmental factors that go into its production. In contrast, a rating is a letter grade, or other scale, assigned to a bond by a rating agency. While ratings have various attributes, generally having both objective and subjective inputs, there is not a particular mathematical definition of a rating. Analytical measures may be useful for use by regulators because they have several characteristics not present in ratings. 1. An analytical measure can be designed for a specific purpose. Specific analytical measures can be designed with particular policy or risk management goals in mind. Ratings may reflect a variety of considerations. For example, there is some uncertainty as to whether ratings represent the first dollar of loss or the expected loss, or how expected loss is reflected in ratings. 2. Analytical measures can be updated at any frequency. Ratings are updated only when the rating agencies believe there has been sufficient change to justify an upgrade, downgrade or watch. Analytical measures can be computed any time new information is available and will show the drift in credit quality even if a bond remains within the same rating range. 3. Analytical measures can take into account price or other investor specific information. Ratings are computed for a bond and generally reflect the risk of nonpayment of contractual cash flows. However, the risk to a particular investor of owning a bond will at least partially depend on the price that the bond is carried in the portfolio or the composition of the portfolio. 4. Regulators may contract directly with vendors to produce analytical results and may choose the timing of the calculations. On the other hand, ratings are generally purchased by the issuer at the time of issuance. Not only may this introduce conflicts of interest, but it also creates a greater focus on initial ratings than on surveillance and updating of ratings. In addition, once a regulator allows the use of a particular rating agency it has no further involvement in the ratings process. 5. Analytical measures based on fundamental data may also be advantageous over purely market-based measures. As market conditions evolve values of bonds may change. These changes reflect economic fundamentals, but may also reflect supply/ demand dynamics, liquidity and risk preferences. Measures fully dependent on market prices may create excessive volatility in regulatory measures, especially for companies with the ability to hold bonds to maturity. Even if regulators use analytical measures of risk, ratings from rating agencies as independent opinions would still be valuable to investors and regulators due to the multifaceted nature of ratings and rating agency analysis can be used to validate the approaches and assumptions used to compute particular analytical measures. Additional measures beyond the credit risk of individual securities such as stress tests, market value sensitivity and measures of illiquidity may also be appropriate in the regulatory structure. The use of analytical measures rather than ratings does not eliminate the potential for mistakes. In general, any rigid system can be gamed as financial innovation can often stay ahead of regulation. To reduce this problem regulation should be based on principles and evolve with the market. Regulators should always seek to build an a margin of safety as there is always a risk that the theory underlying the regulatory regime falls short and that some participants will find mechanisms to take advantage of the regulatory structure. Finally, as discussed by the Administration in the white paper, the future of securitization for mortgages requires the resolution of the status of Fannie/Freddie and role of FHA/GNMA. As stated above, I believe that continuation of Fannie Mae and Freddie Mac as member owned cooperatives would serve to establish standards, and provide a vehicle for the delivery of Government guarantees if so desired. The TBA, or to be announced, market has been an important component in the success of the fixed rate mortgage market in the United States. Careful consideration should be given to the desirability of fixed rate mortgages and the mechanisms for maintaining that market in discussions of the future of the GSEs. ______ CHRG-111hhrg48874--59 Mr. Long," I will take a shot at it, Congressman. And they are concerns that we hear too. There are a couple of things. In terms of, do we think it's going to get worse? I would tell you, from the OCC's standpoint, where we are in the cycle, I believe for many community banks, it is going to get worse. So we are definitely asking our examiners to have good communications with bank management and make sure that they're vigilant, make sure that they have a good handle around the concentrations of credit, the amount of loans that they have to a certain--whether it be industry, developer or whatever. It may be that being told to slow down could be appropriate, but I would need some more information to address it specifically. It may be that the banker or the regulators feel like that concentration level in total on that balance sheet is getting a little heavy and they need to be a little more selective in terms of the risk. It may be in terms of their underwriting, given the credit quality of the borrowers and the stress that the borrowers are under, as you know, Congressman, over the last 3, 4, or 5 years underwriting standards got pretty loose. It was pretty easy to extend credit, and it wasn't that difficult to get a loan. What is happening in the industry right now is a normal occurrence. Bankers tighten up, underwriting standards tighten. Loan demand by good quality borrowers--as I said in my statement, businesses aren't expanding, they don't have capital expenditures--good quality loan demand is harder to come by. But the examiners and the bankers hopefully are having good robust conversations around risk management issues, concentration issues, underwriting issues, whether it be from an individual loan or from a portfolio loan. So the comments along those lines could very well be not: Slow down, we don't want you making good loans. It may be: Make sure you have a good handle around the risk profile of your portfolio, because certain concentration levels, no matter how good they get, when you get into an economic downturn, it doesn't take much to tip a bank over. " CHRG-111shrg57319--240 Mr. Schneider," Yes, I do. Senator Levin. ``Repeat Issue--Underwriting guidelines established to mitigate the risk of unsound underwriting decisions are not always followed. . . .'' Then it says that is high risk. The next one, high risk, ``accurate reporting and tracking of exceptions to policy does not exist. . . .'' So do you see that now? " 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 FOMC20051101meeting--144 142,MS. BIES.," Thank you, Mr. Chairman. What I’d like to do today is to talk a little bit more about some recent trends in consumer borrowing information, which a few people have already mentioned, and then just make some general comments on the economy and on inflation. As a couple of you have already noted, the data on consumer borrowing have shown a lot of noise, as I would call it, in the last couple months. Overall, we’re seeing a slowing in the rapid rate of growth. It’s still growing in general, but the pace of growth is slowing. So it raises the question of what is really happening here. Are consumers saying that they are nearing the point at which they really can’t absorb any more debt? Or are changes in underwriting under way that are slowing the pace of growth? As you know, the Senior Loan Officer Survey, covered in the supplement to the Greenbook, reported only modest changes in demand for credit; it was modestly lower. And to the extent that November 1, 2005 72 of 114 couple of months, as the big incentives came off. Also, we’re beginning to see a moderation in the pace of increase in median housing prices. So that could be consistent with a slowing in demand. On the other hand, if we look at the chart in the Greenbook on bankruptcy filings, there was a huge spike in the week prior to October 17, just before the new bankruptcy law went into effect. And that could have front-loaded anywhere from three to four quarters of bankruptcy filings, as everybody tried to get in before the law changed. We saw a tremendous increase at that point. It doesn’t reflect what the banks are showing in the quality of their credit or in the securitized transactions that are out there in the market where delinquency rates have basically been fairly stable. So this was a blip up ahead of what our normal leading indicators are showing. On home equity lines, I find the numbers really remarkable. Home equity lines grew 31 percent in 2003, 44 percent in 2004, slowed to 17 percent growth in the first half of this year, and now, as Governor Kohn just mentioned, have shown declines in September and October. So the question is: What is happening with these home equity lines? As you know, the banking agencies collectively put out common guidance in May regarding home equity lines. There was really nothing new in this guidance. It just pulled together what was out there to remind everybody what safe and sound lending practices are. We know that the vast majority of banks follow these sound procedures in almost all of their lending. So I felt comforted that in the Senior Loan Officer Survey only a few banks said they had changed their underwriting standards because of the new guidance. That to me says that we did really focus on the outliers, which was our intention. So I don’t believe that this reining in of home equity lines is due to underwriting changes. We know that home equity lines have been used not only to extract equity for spending but also increasingly for downpayments on purchases of homes—more so than in the past. So again, this could reflect something more that November 1, 2005 73 of 114 As you know, the banking agencies later this quarter are going to issue some guidance on mortgages and on loans for commercial real estate. Again, our intention is not to signal alarm that overall credit quality and underwriting are poor, but to call attention to some lending practices at the limit that are raising some concerns. So at the margin it could have some impact on the pace of lending, but we think overall things are in pretty good shape. The other point I want to make is about credit card lending. More than a year ago now, both the OCC [Office of the Comptroller of the Currency] and the Fed started to raise questions about underwriting and credit advances for borrowers who go over their lines of credit and about minimum payments expected on credit card balances. A growing number of customers were not being required to cover late payment fees or fees for going over their credit line and actually were into negative amortization when their outstanding balances exceeded their lines of credit. We’ve given the banks quite a bit of time to figure out how to get into compliance with these guidelines. Some started doing so toward the end of last year and some will be doing it later this year; so they are moving at their own pace. The change in practices will slow credit growth for some clients—the ones who chronically are over their lines and who have paid only the minimum monthly fee. Again, we don’t expect this to be widespread, but it could be a factor in some of these bankruptcy filings. People who have been at the fringe of being overextended are realizing that they’re going to have to get their borrowings down. Now let me shift my focus to the overall economy. I find that the pace of the expansion has been quite resilient, given everything that we’ve been through in the past year. Recently, despite significant difficulties, whether it was hurricanes or the spike in oil prices, growth continued at a November 1, 2005 74 of 114 Inflation has slowed in the last couple of months, but I’ve focused a bit on the nature of the developments there. As you know, some of the slowdown has been in prices of services. And with some of the trends we’re seeing in core elements of inflation, getting a number over 2 percent, as the forecast has, begins to give me some concern. So I look at that and at the forecast for a continued rise in labor compensation costs. A potential slowdown in productivity also suggests that we need to be much more attentive to what’s going on in terms of cost pressures on the labor front that could affect workers’ expectations of compensation increases. So I think it’s even more important for us to watch inflation in the next few months. I support raising the funds rate today. I also support the dialogue, as President Yellen outlined, on the elements of our communication so that we have an orderly transition. We ought to look carefully at every word in our statement. While it will be parsed when we make changes, at least all of us will have had some time to think about the changes. And I would hope that we have that dialogue at our next meeting." CHRG-111shrg57319--486 Mr. Rotella," Well, as I said earlier, Senator, all fraud is bad and there is fraud in all financial products. I have seen that throughout my career. As I said, related to WaMu's operating weaknesses, there were certain tools, at least when I got there and even at the end, we were trying to implement to help us identify fraud. There are automated tools and various techniques you can use. WaMu was behind the curve when I joined and we were making strides to get better at it, but by no means were we perfect. Senator Kaufman. Why did you decide to stop stated income loans, either one of you? Mr. Killinger, why did you stop doing them? " CHRG-111hhrg52261--98 Mr. Robinson," Congresswoman, perhaps there is a parallel in the financial services--noninsurance financial service area you that might consider. I mentioned earlier about underwriting, or identifying the risk, underwriting it and pricing it properly. And you do the best job you can, whether it be a house on a beach or a subprime mortgage or whatever. And then, when the hurricane comes or the collapse happens, management meetings happen that say, We are not going to do that again. And then we have to recast our expectations, and that usually results in underwriting tightening up, which could mean change in credit score or unwillingness to put out lines of credit. Also, a bad result could result in an organization being overleveraged. We have too much out there and so we have to pull back. Ms. Fallin. Thank you, Madam Chairwoman. " 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-111hhrg56767--85 Mr. Neugebauer," What are the credit quality and underwriting standards being used? " 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 " fcic_final_report_full--87 While investors in the lower-rated tranches received higher interest rates because they knew there was a risk of loss, investors in the triple-A tranches did not expect payments from the mortgages to stop. This expectation of safety was important, so the firms structuring securities focused on achieving high ratings. In the structure of this Citigroup deal, which was typical,  million, or , was rated triple-A. GREATER ACCESS TO LENDING: “A BUSINESS WHERE WE CAN MAKE SOME MONEY ” As private-label securitization began to take hold, new computer and modeling tech- nologies were reshaping the mortgage market. In the mid-s, standardized data with loan-level information on mortgage performance became more widely avail- able. Lenders underwrote mortgages using credit scores, such as the FICO score, de- veloped by Fair Isaac Corporation. In , Freddie Mac rolled out Loan Prospector, an automated system for mortgage underwriting for use by lenders, and Fannie Mae released its own system, Desktop Underwriter, two months later. The days of labori- ous, slow, and manual underwriting of individual mortgage applicants were over, lowering cost and broadening access to mortgages. This new process was based on quantitative expectations: Given the borrower, the home, and the mortgage characteristics, what was the probability payments would be on time? What was the probability that borrowers would prepay their loans, either because they sold their homes or refinanced at lower interest rates? In the s, technology also affected implementation of the Community Rein- vestment Act (CRA). Congress enacted the CRA in  to ensure that banks and thrifts served their communities, in response to concerns that banks and thrifts were refusing to lend in certain neighborhoods without regard to the creditworthiness of individuals and businesses in those neighborhoods (a practice known as redlining).  The CRA called on banks and thrifts to invest, lend, and service areas where they took in deposits, so long as these activities didn’t impair their own financial safety and soundness. It directed regulators to consider CRA performance whenever a bank or thrift applied for regulatory approval for mergers, to open new branches, or to en- gage in new businesses.  The CRA encouraged banks to lend to borrowers to whom they may have previ- ously denied credit. While these borrowers often had lower-than-average income, a  study indicated that loans made under the CRA performed consistently with the rest of the banks’ portfolios, suggesting CRA lending was not riskier than the banks’ other lending.  “There is little or no evidence that banks’ safety and sound- ness have been compromised by such lending, and bankers often report sound busi- ness opportunities,” Federal Reserve Chairman Alan Greenspan said of CRA lending in .  CHRG-111shrg57319--324 Mr. Beck," No, I did not. Senator Levin. Purchasers of these securities are relying on you as an underwriter to provide truthful information. You had evidence of the fraud. You knew of it. You had heard of it. And yet you did not check to see whether or not that the fraud-tainted mortgages were removed from the security. Wasn't that your job or part of your job? " CHRG-111shrg57322--108 Mr. Sparks," WaMu, Long Beach is and was a client of Goldman Sachs. Senator Kaufman. And in May 2006, Goldman Sachs acted as co-lead underwriter with WaMu to securitize $532 million in subprime second-lien, fixed-rate mortgages originated at Long Beach? Does that sound reasonable to you? " CHRG-110shrg46629--45 Chairman Bernanke," No, I think the market will find solutions. They already are finding some. For example, even if the individual instruments are not particularly liquid, there are indices that are based on the payments from CDOs or CLOs which are traded and therefore give some sense of the market valuation of these underlying assets. So this is a market innovation. Sometimes there are bumps associated with a market innovation. I think we just have to sit and see how it works out. There are very strong incentives in the market to change the structure of these instruments as needed to make them attractive to investors. Senator Reed. Let me change gears just slightly. You alluded to it, not the CDOs but the CLOs, the collateralized loan obligations, essentially derivatives of corporate debt. There has been a lot of discussion that it is very easy now to go out in this market and to prop up companies that do not have the ability to borrow directly. And that the underwriting standards have slipped a bit because the banks who typically do the underwriting do not hold the product. They move them out very quickly in these complex secondary markets. First, can you comment on the underwriting standards for the corporate borrowing? Are they loosening to a degree that could-- " FinancialCrisisReport--604 Investment Advisers. For investment banks that act, not just as a broker-dealer, underwriter, or placement agent, but also as an investment adviser to their customers, federal securities laws impose still a higher legal duty. When acting as an investment adviser, the law imposes a fiduciary obligation on the investment bank to act in the “best interests of its clients.” 2694 A person qualifies as an “investment adviser” under the Investment Advisers Act if that person: provides advice regarding securities, is in the business of providing such advice, and provides that advice for compensation. 2695 A broker-dealer, however, is excluded from the Investment Advisers Act if the performance of its investment advisory services is “solely” incidental to its business as a broker-dealer, and the broker-dealer does not receive “special compensation” for providing those advisory services. 2696 Because Goldman appears to have acted primarily as an underwriter, placement agent, or broker-dealer in carrying out its securitization activities, this section analyzes Goldman’s conduct in that context and not in the context of an investment adviser. 2697 (b) Analysis One key issue is whether Goldman was acting as a market maker versus an underwriter or placement agent when it recommended that its clients purchase its CDO and RMBS securities, since those roles have different disclosure and suitability obligations under the law. A second key issue is whether Goldman withheld material adverse information when recommending its securities to its clients, including the fact that it was shorting the securities it was selling. A third key issue is whether Goldman violated its obligation to make suitable investment recommendations when urging customers to purchase securities that Goldman knew were designed to lose value. (i) Claiming Market Maker Status Given its active role in the securitization markets, Goldman assumed a variety of roles in the development, marketing, and trade of RMBS and CDO products. At times, it acted as a market maker responding to client orders to buy and sell RMBS and CDO products. In addition, from 2006 to 2007, Goldman originated and served as an underwriter or placement agent for 27 CDOs and 93 RMBS securitizations, and sold the resulting RMBS and CDO securities to a broad range of clients around the world. 2693 6/16/1934 “Stock Exchange Practices,” Report of the Senate Committee on Banking and Currency, S. Rep. 73- 1455, at 88 (quoting “Who Buys Foreign Bonds,” Foreign Affairs (1/1927)). 2694 SEC Study on Investment Advisers and Broker-Dealers at 15-16. 2695 Id. 2696 Id. 2697 The Subcommittee did not examine the extent to which Goldman was acting as an investment adviser within the meaning of the Investment Advisers Act when recommending that various customers buy its RMBS and CDO securities. CHRG-111hhrg53244--228 Mr. Bernanke," On that particular example, the Fed has taken a number of actions about overdraft fees, even though we are also a safety and soundness regulator. I think there are also examples where consumer protection and safety and soundness are complementary. An example would be underwriting standards. Good underwriting standards, well documented, making sure there is enough income, those sorts of things, that is good for safety and soundness and it is also good for the consumer. So there is also situations where there they are complementary. " CHRG-110shrg50416--55 Chairman Dodd," Thank you very much, Senator. Sheila Bair, I just could not resist that idea of that across-the-board regulation, and for those of us who were involved in 1994 with the crafting of the HOEPA legislation, that legislation required all lenders--State-chartered, federally chartered institutions--to apply standards against deceptive and fraudulent practices. Not a single regulation was ever promulgated under that law for 15 years. And more than any other single thing I can think of, had that regulation been promulgated and someone enforcing them on lenders across the board, I think we would be in a very different place today. Senator Crapo. Senator Crapo. Thank you very much, Mr. Chairman. Mr. Kashkari, I want to direct my first question to you, and I want to follow up on the line of questioning that our Chairman and our Ranking Member went into with regard to the $250 billion of liquidity that has been provided to the banks. Their focus there was to make sure that those dollars were not hoarded and that the actual result would be the lending that we would like to see happening. And I understand that, and I appreciate your answers with regard to that part of the program. The question I have goes to the toxic asset purchase issue. It seems to me that the plan to utilize these resources that Congress has provided for the purchase of toxic assets has the opposite impact. In other words, it creates an incentive for investors to stay on the sidelines for a while and watch what the Government is going to do and then maybe step in at some later date and either buy or finance purchases from the Government. And I just wonder what your thoughts are on that aspect of the proposal. " CHRG-111hhrg51592--80 Mr. Joynt," I would think the issuer of the securities and/or their underwriter should be presenting the information that supports the-- " CHRG-111hhrg51592--43 Chairman Kanjorski," Issuers being the underwriters, or the individuals who have mortgages? " CHRG-111shrg57319--602 Mr. Killinger," Yes. Senator Levin. Well, I want to thank you for your testimony. We have a situation here where a bank, a mainstream bank and a Main Street bank began as a prudent, well-run bank, but it over time engaged in some high-risk and shoddy lending practices, early payment defaults, fraudulent information, unreasonable income statements, negatively amortizing loans. And then at the end, it became just a conveyor belt that dropped into the stream of commerce literally hundreds of billions of dollars of mortgages that were substandard and dubious. And it wasn't the only lender doing it. We know that. It was one of many. Together, these toxic mortgages contributed to a financial crisis in 2008. So we are now debating financial reform. We sure as heck need it. We are going to have three additional hearings in the next 2 weeks which will look at other aspects. It came up today about the question of the regulators. Where do they fall short? The credit rating agencies, where did they fall short? And the investment banks and Wall Street directly, what was their involvement? What was their role in this assault on our economy? We have to do some financial reform in the Senate. I hope that we are going to be taking action with respect to stated income loans that have no verification of income or assets. I hope we are going to take some action relative to negatively amortizing loans that hurt borrowers and increase the risk of default to stop that practice from occurring. We have to act on these high-risk loans that are the product of financial engineering, that are turned into these high-paying AAA mortgage-backed securities. The short-term Wall Street profits that have won for too many years over long-term fundamentals have cost this economy dearly. We heard a story today which is an in-depth story, which I think is a sad story, which cost the State of Washington and Seattle a lot of jobs there and around the country. It cost a lot of mortgages being foreclosed, and that resulted in a lot of homes lost, and were part of the problem that this economy faced that came to a head in 2008. So we will look at other parts of this in the 2 weeks ahead, but in the meantime, we want to thank our witnesses today for coming forward. We always appreciate people who are willing to testify, even when we have problems with that testimony. So we are grateful to the two of you. We will stand adjourned. [Whereupon, at 4:31 p.m., the Subcommittee was adjourned.] CHRG-111shrg57319--113 Mr. Cathcart," It depended very much on the business unit and on the individual who was put in that double situation. I would say that in the case of home loans, it was not satisfactory because the Chief Risk Officer of that business favored the reporting relationship to the business rather than to risk. Senator Coburn. And this is a hard question to answer, but I hope you will make an attempt to do it. Was there a point in time when you recognized the writing on the wall in terms of the fraudulent activity? Mr. Vanasek, you saw a bubble coming, and Mr. Cathcart, I am not sure that we have any comments from you. But was there a point in time when you knew that things were going to come unwound? " CHRG-111hhrg67816--48 Mr. Leibowitz," Thank you, Mr. Chairman, Mr. Radanovich, Ms. Schakowsky, members of the subcommittee, I am Jon Leibowitz. I am the chairman of the Federal Trade Commission, and I really do appreciate the opportunity to appear before you today to discuss the FTC's role in protecting consumers from predatory financial practices. This is my first hearing of several you mentioned, and let me just say this. You are an authorizing committee. We want to work with all of you. We will not be successful agency unless we can work together, and I hope that we will be doing that over the coming weeks and months. The Commission's views are set forth in the written testimony which was approved by a vote of the entire Commission, though my answers to your questions represent my own views. Mr. Chairman, during these times of difficulty for so many American consumers, the FTC is working hard. Whether Americans are trying to stave off foreclosure, lower their monthly mortgage payments or deal with abusive debt collectors the FTC is on the job enforcing the law, offering guidance, and in the process of issuing new regulations. The written testimony describes in great detail the Commission's enforcement, education, and policy tools and how we have used those tools to protect and advocate for consumers of financial services. We brought about 70 cases involving financial services since I came to the Commission 4-1/2 years ago, and we have gotten $465 million in redress for consumers over the past 10 years in this area alone. But let me highlight just a few recent cases. In the fall, Bear Stearns and its EMC subsidiary paid $28 million to settle Federal Trade Commission charges of illegal mortgage servicing practices. For example, they misrepresented the amounts consumers owed. They collected unauthorized fees. They made harassing and deceptive collection calls. In January we sent out more than 86,000 redress checks, 86,000, to reimburse consumers who were harmed. And today the FTC announced two more cases against so-called mortgage rescue operations that allegedly charged thousands of dollars in upfront fees but failed to provide any assistance in saving people's homes. Even worse, these scurrilous companies Hope Now and New Hope gave consumers false hope by impersonating the HUD-endorsed Hope Now alliance, which helps borrowers with free debt management and credit counseling services, mostly low income consumers. I am pleased to report that the courts have issued temporary restraining orders stopping these fraudulent claims and freezing the company's assets. We are announcing a third action today against yet another rogue rescue scam. Less than 2 weeks ago, FTC investigators discovered a foreclosure rescue web site that was impersonating the HUD web site itself. The HUD inspector general had the site taken down. Last week, however, we were told that the same site had popped up again on a differed ISP. Within hours, we filed a complaint against the unknown operators of the site, and armed with a court order we shut it down. Let me assure you, particularly in this economic climate the FTC will continue to target fraudulent mortgage rescue operations, but we can do better and we will. Mr. Chairman, you mentioned the lack of statutory authority, the one hand tied behind our back. First, we are going to vigorously enforce new mortgage rules issued by the Federal Reserve Board that go into effect this fall that will prohibit a variety of unfair, deceptive, and abusive mortgage advertising, lending, appraisal, and servicing practices such as banning sub-prime buyer's loans. Second, the 2009 Omnibus Appropriations Act gave us authority to find violators in this area for the first time. And, third, we are going to use the regulatory authority given to use by the Omnibus to issue new regulations that will protect consumers from other predatory mortgage practices. We expect these rules to address foreclosure rescue scams and unfair and deceptive mortgage modification and servicing practices. At the same time, we are going to focus more attention on empirical research about how to make mortgages and other disclosures more effective so that consumers have accurate, easily understandable information about a mortgage's terms. We have put a prototype disclosure form on your desks. It is clearly better, and we have copy tested this, than what people are using under current law. But we could use more help. FTC law enforcement would be a greater deterrent if we were able to obtain civil penalties for all unfair and deceptive acts and practices related to financial services beyond mortgages, for example, in-house debt collection and debt negotiation. The FTC could also do more to assist consumers if it could use streamlined APA rulemaking procedures to promulgate rules for unfair acts and practices related to financial services other than mortgage loans. These steps, of course, would require congressional action. They may perhaps require some more resources. Will all these measures be enough? Well, they could certainly help to ensure that we are never in this kind of economic mess again. Finally, Mr. Chairman, as you know, right now jurisdiction is balkanized between the FTC and the banking agencies about who protects American consumers from deceptive financial practices. Several bills have been introduced that call for an overall federal consumer protection regulator of financial services. As discussions about these proposals continue, we urge you to keep this in mind. The FTC, the Commission, has unparalleled expertise in consumer protection. That is what we do. We are not beholding to any providers of financial services, and we have substantial experience effectively and cooperating working with the states, especially cooperatively working with the states. In short, if your committee and if Congress determines that such an overall federal regulator is needed, if you do, we ask that the FTC be an integral part of the discussion about how to best protect the American public. Thank you, Mr. Chairman, for the opportunity to speak today about what the FTC has done and what we are going to do. We look forward to working with this committee, and I am pleased to answer your questions. Thank you. [The prepared statement of Mr. Leibowitz follows:] [GRAPHIC] [TIFF OMITTED] T7816A.004 CHRG-111shrg57319--162 Mr. Vanasek," Historically, Washington Mutual, in comparison to other banks that I worked for, was administratively weak, and it did not carry the same priority, in other organizations that I worked for. Randy and I both work for Norwest, any suspicion of fraud would have resulted in immediate terminations. Senator Kaufman. Yes, they are administratively weak. Do you think based on the presentation up here of how emphasis was made on subprime loans, how they are more profitable, do you really think that if, in fact, the company had been losing money because of administration that it would have been just as weak administratively? Do you think if they were reporting the fact that we were, not doing enough loans, do you think that would have been administered poorly? I mean, it is one thing to say it is administered poorly, it is another when it is an incredible advantage to you, to your compensation program, to everything you are doing, to continue to administer poorly. How much of that do you think---- " FinancialCrisisReport--83 Again, he expressed hope that the situation would improve: “The good news is David and his team are pros and are all over it.” 238 Two months later, in November 2006, however, the head of WaMu Capital Markets in New York, David Beck, relayed even more bad news to Mr. Schneider, the Home Loans President: “LBMC [Long Beach] paper is among the worst performing in the mkt [market] in 2006.” 239 Despite the additional focus on improving its lending operations throughout 2006, Long Beach was once again flooded with repurchase requests. According to a memorandum later written by an FDIC examination specialist, “[d]uring 2006, more than 5,200 LBMC loans were repurchased, totaling $875.3 million.” 240 Even though, in January 2006, the bank had ceased executing whole loan sales which allowed an automatic repurchase in the event of an EPD, 46% of the repurchase volume was as a result of EPDs. Further, 43% of the repurchase volume resulted from first payment defaults (FPDs) in which the borrower missed making the first payment on the loan after it was sold. 241 Another 10% of the repurchases resulted from violations related to representation and warranties (R&W) not included in the EPD or FPD numbers, meaning the violations were identified only later in the life of the loan. R&W repurchases generally pose a challenge for a bank’s loss reserves, because the potential liability – the repurchase request – continues for the life of the loan. The FDIC memorandum observed: “Management claims that R&W provisions are industry standard and indeed they may be. However, I still found that the Mortgage Loan Purchase Agreement contains some representations and warranties worth noting. For example, not only must the loans be ‘underwritten in accordance with the seller’s underwriting guideline,’ but the ‘origination, underwriting, and collection practices used by the seller with respect to each mortgage loan have been in all material respects legal, proper, prudent, and customary in the subprime mortgage business.’ This provision elevates the potential that investors can put back a problem loan years after origination and not only must the loan have been underwritten in line with bank guidelines but must also have been underwritten in accordance with what is customary with other subprime lenders.” 242 R&W repurchase requests and loss reserves continued to be an issue at Long Beach. The fourth quarter of 2006 saw another spike in R&W repurchase requests, and in December the required amount of R&W loss reserves jumped from $18 million to $76 million. 243 238 Id. 239 11/7/2006 WaMu internal email, Hearing Exhibit 4/13-50. 240 See 6/5/2007 memorandum by Christopher Hovik, Examination Specialist, sent to FDIC Dedicated Examiner Steve Funaro, “WaMu – Long Beach Mortgage Company (LMC) Repurchases,” at 1, FDIC_WAMU_000012348, Hearing Exhibit 4/13-13b. 241 Id. 242 Id. 243 Id. at 3. CHRG-110shrg50410--58 Chairman Dodd," Thank you. This will be a subject of longer discussion, but let's remind ourselves, this began with predatory lenders out there marketing products that borrowers could not afford. GSEs, Fannie and Freddie, were never bottom feeders. They had some Alt-A, they had some subprime, but nothing to the extent these other institutions had. That is where the problem lay, the failure to actually oversee, to regulate, to monitor that effectively, is where the problems began. We had legislation adopted 14 years ago for which a regulation was never promulgated to protect against deceptive and fraudulent practices. Had that been done, had cops been on the beat, going after these people who are marketing these products as they were as aggressively, we would not be here today. This was not a natural disaster. This was malfeasance and misfeasance, in my view, that created this mess that we are in today. Senator Reed. Senator Reed. Thank you, Mr. Chairman. Mr. Secretary, recently the Federal Reserve and the Securities and Exchange Commission entered into a memorandum to coordinate their supervision of the consolidated supervised entities. I do not believe there was a specific legislative requirement that they do that, they consult, or anything else. So why is it necessary to have a legislative requirement that this new super regulator consult with the Federal Reserve? I would think it would happen or could happen in the course of the common interest of both regulators. And the downside I think has been expressed by some of my colleagues, is if we have the super regulator, if he is looking over his shoulder every moment, even for--as your language requires--even for guidelines or directives concerning prudential management operations, that would involve the Federal Reserve I think in the routine decisions on a daily basis. " CHRG-111hhrg48875--252 Secretary Geithner," We can look at it, and I will commit to look at it more carefully and come talk to you and your staff about how best we can do that. Ms. Waters. Okay. All right. One other thing that I would like to ask about is in terms of how the dollars have been put out there. FDIC has a guarantee program, and the banks are doing their own underwriting. Is that unusual? Rather than putting that out there for the firms, all of the small firms, to get a crack at underwriting with this guarantee that comes from FDIC? " FinancialCrisisReport--225 But in the case of Washington Mutual, profits did make a difference. At the Subcommittee hearing, when asked by Senator Kaufman to identify one or two reasons why no regulatory action was taken against WaMu, the FDIC IG Jon Rymer testified as follows: “[L]et me start by saying I think the problem in 2005, 2006, and into 2007, the problem was the bank was profitable. I think there was a great reluctance to [take action], even though problems were there in underwriting, the product mix, the distribution process, the origination process, all in my view extraordinarily risky .… [T]he people in [agency] leadership positions have to be willing to make the tough calls and be experienced enough to know that today’s risky practices may show today profitability, but to explain to management and enforce with regulatory action that risky profitability is going to have a cost. It either has a cost in control processes an institution would have to invest in now, or it is going to have a cost ultimately to the bank’s profitability and perhaps eventually to the Deposit Insurance Fund.” 856 In his prepared statement, the Treasury Inspector General, Eric Thorson, noted that OTS examiners told his staff they did not lower WaMu’s CAMELS ratings because “even though underwriting and risk management practices were less than satisfactory, WaMu was making money and loans were performing.” 857 This problem was not isolated within OTS, however, but applied to other regulatory agencies as well. The FDIC Inspector General noted, for example, that the bank’s profitability also tempered the FDIC views of the bank. He explained that, prior to 2008, the FDIC did not challenge WaMu’s 2 CAMELS ratings, because “the risks in WaMu’s portfolio had not manifested themselves as losses and nonperforming loans, and therefore did not impact WaMu’s financial statements.” 858 At the same time, an internal FDIC analysis of the bank identified a long list of “embedded risk factors” in WaMu’s home loans that, despite the bank’s profitability, exposed the bank to losses in the event of “a widespread decline in housing prices.” 859 In the financial industry, high risk activities are undertaken by financial institutions to earn higher marginal returns. The role of the regulator is to enforce rules that ensure the risks an institution undertakes do not unfairly transfer that risk to others or threaten the safety and soundness of the economy, despite any short term profits. In the case of the FDIC, the judgment 855 11/2004 Office of Thrift Supervision Examination Handbook, at 070.8, OTSWMEF-0000032053; 2/2011 Office of Thrift Supervision Examination Handbook, at 070.9, http://www.ots.treas.gov/_files/422008.pdf (quote is the same in updated version of handbook). See also April 16, 2010 Subcommittee Hearing at 19 (testimony of FDIC and Treasury Inspectors General). 856 April 16, 2010 Subcommittee Hearing at 24-26. 857 Thorson prepared statement at 10, April 16, 2010 Subcommittee Hearing at 110. 858 Rymer prepared statement at 10, April 16, 2010 Subcommittee Hearing at 129. 859 Undated draft memorandum from the WaMu examination team at the FDIC to the FDIC Section Chief for Large Banks, FDIC-EM_00251205-10, Hearing Exhibit 4/16-51a (likely mid-2005). includes whether the risk threatens loss to the Deposit Insurance Fund. Any firm that decides to take a risk should be the only firm, along with its investors, to bear the brunt of the problem if it turns out to have been a mistake. Regulators that, when faced with short term profits, stop evaluating or downplay attendant risks that could produce later losses fail in their obligation to ensure the safety and soundness of the financial institutions they are regulating. In the case of WaMu, both OTS and the FDIC allowed the bank’s success in the short term to paper over its underlying problems. CHRG-111shrg52619--126 Mr. Polakoff," Mr. Chairman, you are right. The private label securitization market, we could have done a better job in looking at the underwriting as those loans passed off the institution's books and into a securitization process. Yes, sir. " fcic_final_report_full--183 SEC: “The elephant in the room is that we didn’t review the prospectus supplements” By the time the financial crisis hit, investors held more than  trillion of non-GSE mortgage-backed securities and close to  billion of CDOs that held mortgage- backed securities.  These securities were issued with practically no SEC oversight. And only a minority were subject to the SEC’s ongoing public reporting require- ments. The SEC’s mandate is to protect investors—generally not by reviewing the quality of securities, but simply by ensuring adequate disclosures so that investors can make up their own minds. In the case of initial public offerings of a company’s shares, the work has historically involved a lengthy review of the issuer’s prospectus and other “offering materials” prior to sale.  However, with the advent of “shelf registration,” a method of registering securities on an ongoing basis, the process became much quicker for mortgage-backed securi- ties ranked in the highest grades by the rating agencies. The process allowed issuers to file a base prospectus with the SEC, giving investors notice that the issuer intended to offer securities in the future. The issuer then filed a supplemental prospectus de- scribing each offering’s terms. “The elephant in the room is that we didn’t review the prospectus supplements,” the SEC’s deputy director for disclosure in corporation fi- nance, Shelley Parratt, told the FCIC.  To improve disclosures pertaining to mort- gage-backed securities and other asset-backed securities, the SEC issued Regulation AB in late . The regulation required that every prospectus include “a description of the solicitation, credit-granting or underwriting criteria used to originate or pur- chase the pool assets, including, to the extent known, any changes in such criteria and the extent to which such policies and criteria are or could be overridden.”  With essentially no review or oversight, how good were disclosures about mort- gage-backed securities? Prospectuses usually included disclaimers to the effect that not all mortgages would comply with the lending policies of the originator: “On a case-by-case basis [the originator] may determine that, based upon compensating factors, a prospective mortgage not strictly qualifying under the underwriting risk category or other guidelines described below warrants an underwriting exception.”  The disclosure typically had a sentence stating that “a substantial number” or perhaps “a substantial portion of the Mortgage Loans will represent these exceptions.”  Citi- group’s Bowen criticized the extent of information provided on loan pools: “There was no disclosure made to the investors with regard to the quality of the files they were purchasing.”  Such disclosures were insufficient for investors to know what criteria the mort- gages they were buying actually did meet. Only a small portion—as little as  to —of the loans in any deal were sampled, and evidence from Clayton shows that a significant number did not meet stated guidelines or have compensating factors.  On the loans in the remainder of the mortgage pool that were not sampled (as much as ), Clayton and the securitizers had no information, but one could reasonably ex- pect them to have many of the same deficiencies, and at the same rate, as the sampled loans. Prospectuses for the ultimate investors in the mortgage-backed securities did not contain this information, or information on how few loans were reviewed, raising the question of whether the disclosures were materially misleading, in violation of the securities laws. CHRG-111hhrg74855--224 Mr. Markey," Thank the gentleman very much. I would just like to ask one final question and then we will move to the next panel. Ask this of Chairman Gensler, if the CFTC is doing an antifraud or anti-manipulation investigation of oil futures trading on the New York Mercantile Exchange and you believe that part of the fraudulent scheme may have involved wrongdoing in the cash market, you have the power under the Commodities Exchange Act to extend your investigation to cover that part of the fraud and you wouldn't want the Congress to deny the CFTC the power to look at transactions in both the NYMEX futures market and the cash market in your own investigation, is that correct? " CHRG-111shrg56262--7 UNIVERSITY OF CONNECTICUT SCHOOL OF LAW Ms. McCoy. Thank you. Chairman Reed, Ranking Member Bunning, and Members of the Subcommittee, thank you for inviting me here today. In the run-up to the crisis, Wall Street financed over half of subprime mortgages through private label securitization. When defaults spiked on those loans and housing prices fell, securitization collapsed in August 2007. It has been on life support ever since. When private label securitization comes back, it is critical to put it on sound footing so that it does not bring down the financial system again. The private label system had basic flaws that fueled the crisis. First, under the originate-to-distribute model, lenders made loans for immediate sale to investors. In addition, lenders made their money on up-front fees. Both features encouraged lenders to ``pass the trash.'' Lenders cared less about underwriting because they knew that investors would bear the brunt if the loans went belly up. In addition, to boost volume and fees, lenders made loans to weaker and weaker borrowers. In fact, when I have examined the internal records of some of the largest nonprime lenders in the United States, I have often found two sets of underwriting standards: lower standards for securitized loans and higher ones for loans held in portfolio. Second, securitizations spread contagion by allowing the same bad loan to serve as collateral for a mortgage-backed security, a collateralized debt obligation, and even the CDO of CDOs. It further spread contagion because investors used tainted subprime bonds as collateral for other types of credit, such as commercial paper and interbank loans. This shook confidence in the entire financial system because investors did not know where the toxic assets were located. Last, securitization resulted in a servicing system that creates thorny barriers to constructive workouts of distressed loans. We have had too many foreclosures as a result. In this, there were three victims: borrowers, who were steered into bafflingly risky mortgages, often at inflated interest rates; investors, who were forced to rely on ratings because securities disclosures were deficient and securitizations were so complex; and, finally, the public, who had to pay to clean up the mess. So how do we fix these problems going forward? There are two aspects: lax underwriting and loan workouts. First, fixing underwriting. One group of proposals seeks to realign incentives indirectly so that mortgage actors do careful underwriting. These include requiring securitizers to retain risk, higher capital requirements, better compensation methods, and stronger representations and warranties along with stiff recourse. I applaud these measures, but they are not enough to ensure good underwriting. I doubt, for example, whether prohibiting issuers from hedging their retained risk is really enforceable. Banks are adept at evading capital standards, and the Basel II standards are badly frayed. And stronger reps and warranties are only as good as the issuer's solvency. Consider the fact that most nonbank subprime lenders are out of business and 128 banks and thrifts have failed since the crisis began. Another group of proposals focuses on better due diligence by investors and rating agency reform. This, too, is badly needed. However, memories of this crisis eventually will grow dim. When that happens, query whether investors will really take the time to do careful due diligence when a high-yield investment is dangled out in front of them. For these reasons, we need to finish the work the Federal Reserve Board began last year and adopt uniform Federal underwriting standards for mortgages that apply to all mortgage actors across the board. A brand-new study by researchers at UNC-Chapel Hill just found that States with similar laws had lower foreclosure rates than States without those laws. And a 2008 study found that State assignee liability laws did not reduce access to credit. Then one last thought: facilitating loan workouts. Here I propose amending Federal tax laws to tax securitized trusts unless they provide ironclad incentives to do loan workouts when cost effective. Thank you, and I welcome any questions. " CHRG-111shrg56415--46 Mr. Tarullo," I think, as Chairman Bair said a little while ago--she didn't say it quite in these words, but what I heard her say was, we have got to worry about problems in the future as well as problems in the past. I do think that the problems with underwriting played a very central, though not the only role, in the financial crisis. I do think we need underwriting standards for residential mortgages and in other areas---- Senator Corker. And each of you can write those, is that correct? " CHRG-111hhrg67816--133 Mr. Leibowitz," I want to get back to you on those cases. We do a lot of work with the postal inspectors. We do some work with the FBI, of course, but when we see something that is criminal we generally refer it to the Justice Department, and if they will take it they have more appropriate sanctions than we do. We generally can only get redress and disgorgement and stop the bad conduct, so sometimes we are sort of the fallback entity for going after fraudulent behavior in this area, but I will get back to you on whether we have worked with the FBI task force specifically. " Mr. Pitts," OK. Thank you. The Commission has conducted research on ways to improve mortgage disclosure. If the disclosure documents were simplified in a manner that provided relevant information similar to the prototype disclosure developed by the Commission, would that have prevented any of the fraud that occurred in the home mortgage loan market in your opinion or might fraudsters simply find a way around that simplified uniform disclosure? " CHRG-111shrg57320--34 Mr. Rymer," I would agree with Mr. Thorson. Senator Coburn. OK. Mr. Thorson, in your testimony you say that WaMu failed because its management pursued a high-risk business strategy that loosened underwriting too much. It is your belief that the high-risk strategy could have been OK with proper controls in place? " CHRG-111shrg57319--242 Mr. Schneider," I think it is fair to say, Mr. Chairman, that the underwriting group and the audit group, as well as myself, were less than satisfied with the progress being made, which is the reason we ultimately decided to shut down the operation. Senator Levin. Yes. When did you finally shut it down and transfer it to WaMu? " CHRG-111shrg57709--248 DESKS ARE NOT THE PROBLEM January 25, 2010 By Christopher Whalen There are certain basic things that the investor must realize today. In the first place, he must recognize the weakness of his individual position . . . [T]he growth of investors from the comparative few of a generation ago to the millions of the present day has made it a practical impossibility for the individual investor to know what is occurring in the affairs of the corporation in which he has an interest. He has been forced to relegate his rights to a controlling class whose interests are often not identical to his own. Even the bondholder who has superior rights finds in many cases that these rights have been taken away from him by some clause buried in a complicated indenture . . . The second fact that the investor must face is that the banker whom tradition has considered the guardian of the investors' interests is first and foremost a dealer in securities; and no matter how prominent the name, the investor must not forget that the banker, like every other merchant, is primarily interested in his own greatest profit. --False Security: The Betrayal of the American Investor, Bernard J. Reis and John T. Flynn, Equinox Cooperative Press, NY (1937). This is an expanded version of a comment we posted last week on ZeroHedge. Watching the President announcing the proposal championed by former Fed Chairman Paul Volcker to forbid commercial banks from engaging in proprietary trading or growing market share beyond a certain size, we are reminded of the reaction by Washington a decade ago in response to the Enron and WorldCom accounting scandals, namely the Sarbanes-Oxley law. The final solution had nothing to do with the actual problem and everything to do with the strange political relationship between the national Congress, the central bank and the Wall Street dealer community. We call it the ``Alliance of Convenience.'' The basic problems illustrated by the Enron/WorldCom scandals were old fashioned financial fraud and the equally old use of off-balance sheet vehicles to commit same. By responding with more stringent corporate governance requirements, the Congress was seen to be responsive--but without harming Wall Street's basic business model, which was described beautifully by Bernard J. Reis and John T. Flynn some eighty years ago in the book False Security. A decade since the Enron-WorldCom scandals, we still have the same basic problems, namely the use of OBS vehicles and OTC structured securities and derivatives to commit securities fraud via deceptive instruments and poor or no disclosure. Author Martin Mayer teaches us that another name for OTC markets is ``bucket shop,'' thus the focus on prop trading today in the Volcker Rule seems entirely off target--and deliberately so. The Volcker Rule, at least as articulated so far, does not solve the problem nor is it intended to. And what is the problem? Not a single major securities firm or bank failed due to prop trading during the past several years. Instead, it was the securities origination and sales process, that is, the customer side of the business of originating and selling securities that was the real source of systemic risk. The Volcker Rule conveniently ignores the securities sales and underwriting side of the business and instead talks about hedge funds and proprietary trading desks operated inside large dealer banks. But this is no surprise. Note that former SEC chairman Bill Donaldson was standing next to President Obama on the dais last week when the President unveiled his reform, along with Paul Volcker and Treasury Secretary Tim Geithner. Donaldson is the latest, greatest guardian of Wall Street and was at the White House to reassure the major Sell Side firms that the Obama reforms would do no harm. But frankly Chairman Volcker poses little more threat to Wall Street's largest banks than does Donaldson. After all, Chairman Volcker made his reputation as an inflation fighter and not in bank supervision. Chairman Volcker was never known as a hawk on bank regulatory matters and, quite the contrary, was always attentive to the needs of the largest banks. Volcker's protege, never forget, was E. Gerald Corrigan, former President of the Federal Reserve Bank of New York and the intellectual author of the ``Too Big To Fail'' (TBTF) doctrine for large banks and the related economist nonsense of ``systemic risk.'' But Corrigan, who now hangs his hat at Goldman Sachs (GS), did not originate these ideas. Corrigan was never anything more than the wizard's apprentice. As members of the Herbert Gold Society wrote in the 1993 paper ``Gone Fishing: E. Gerald Corrigan and the Era of Managed Markets'': Yet a good part of his career was not public and, indeed, was deliberately concealed, along with much of the logic behind many far-reaching decisions. Whether you agreed with him or not, Corrigan was responsible for making difficult choices during a period of increasing instability in the U.S. financial system and the global economy. During the Volcker era, as the Fed Chairman received the headlines, his intimate friend and latter day fishing buddy Corrigan did `all the heavy lifting behind the scenes,' one insider recalls. The lesson to take from the Volcker-Corrigan relationship is don't look for any reform proposals out of Chairman Volcker that will truly inconvenience the large, TBTF dealer banks. The Fed, after all, has for several decades been the chief proponent of unregulated OTC markets and the notion that banks and investors could ever manage the risks from these opaque and unpredictable instruments. Again to quote from the ``Gone Fishing'' paper: Corrigan is a classic interventionist who sees the seemingly random workings of a truly free market as dangerously unpredictable. The intellectual author and sponsor of such uniquely modernist financial terms such as `too big to fail,' which refers to the unwritten government policy to bail out the depositors of big banks, and `systemic risk,' which refers to the potential for market disruption arising from inter-bank claims when a major financial institutions fails. Corrigan's career at the Fed was devoted to thwarting the extreme variations of the marketplace in order to `manage' various financial and political crises, a role that he learned and gradually inherited from former Chairman Volcker. As Wall Street's normally selfish behavior spun completely out of control, Volcker has become an advocate of reform, but only focused on those areas that do not threaten Wall Street's core business, namely creating toxic waste in the form of OTC derivatives such as credit default swaps and unregistered, complex assets such as collateralized debt obligations, and stuffing same down the throats of institutional investors, smaller banks and insurance companies. Securities underwriting and sales is the one area that you will most certainly not hear President Obama or Bill Donaldson or Chairman Volcker or HFS Committee Chairman Barney Frank mention. You can torment prop traders and hedge funds, but please leave the syndicate and sales desks alone. Readers of The IRA will recall a comment we published half a decade ago (``Complex Structured Assets: Feds Propose New House Rules,'' May 24, 2004), wherein we described how the SEC and other regulators knew that a problem existed regarding the underwriting and sale of complex structured assets, but did almost nothing. The major Sell Side firms pushed back and forced regulators to retreat from their original intention of imposing retail standards such as suitability and know your customer on institutional underwriting and sales. Before Enron, don't forget, there had been dozens of instances of OTC derivatives and structured assets causing losses to institutional investors, public pensions and corporations, but Washington's political class and the various regulators did nothing. Ultimately, the ``Interagency Statement on Sound Practices Concerning Complex Structured Finance Activities'' was adopted, but as guidance only; and even then, the guidance was focused mostly on protecting the large dealers from reputational risk as and when they cause losses to one of their less than savvy clients. The proposal read in part: The events associated with Enron Corp. demonstrate the potential for the abusive use of complex structured finance transactions, as well as the substantial legal and reputational risks that financial institutions face when they participate in complex structured finance transactions that are designed or used for improper purposes. The need for focus on the securities underwriting and sales process is illustrated by American International Group (AIG), the latest poster child/victim for this round of rape and pillage by the large Sell Side dealer banks. Do you remember Procter & Gamble (PG)? How about Gibson Greetings? AIG, along with many, many other public and private Buy Side investors, was defrauded by the dealers who executed trades with the giant insurer. The FDIC and the Deposit Insurance Fund is another large, perhaps the largest, victim of the structured finance shell game, but Chairman Volcker and President Obama also are silent on this issue. Proprietary trading was not the problem with AIG nor the cause of the financial crisis, but instead the sales, origination and securities underwriting side of the Sell Side banking business. The major OTC dealers, starting with Merrill Lynch, Citigroup (C), GS and Deutsche Bank (DB) were sucking AIG's blood for years, one reason why the latest ``reform'' proposal by Washington has nothing to do with either OTC derivatives, complex structured assets or OBS financial vehicles. And this is why, IOHO, the continuing inquiry into the AIG mess presents a terrible risk to Merrill, now owned by Bank of America (BCA), GS, C, DB and the other dealers--especially when you recall that the AIG insurance underwriting units were lending collateral to support some of the derivatives trades and were also writing naked credit default swaps with these same dealers. Deliberately causing a loss to a regulated insurance underwriter is a felony in New York and most other states in the United States. Thus the necessity of the bailout--but that was only the obvious reason. Indeed, the dirty little secret that nobody dares to explore in the AIG mess is that the Federal bailout represents the complete failure of state-law regulation of the U.S. insurance industry. One of the great things about the Reis and Flynn book excerpted above is the description of the assorted types of complex structured assets that Wall Street was creating in the 1920s. Many of these fraudulent securities were created and sold by insurance and mortgage title companies. That is why after the Great Depression, insurers were strictly limited to operations in a given state and were prohibited from operating on a national basis and from any involvement in securities underwriting. The arrival of AIG into the high-beta world of Wall Street finance in the 1990s represented a completion of the historical circle and also the evolution of AIG and other U.S. insurers far beyond the reach of state law regulation. Let us say that again. The bailout of AIG was not merely about the counterparty financial exposure of the large dealer banks, but was also about the political exposure of the insurance industry and the state insurance regulators, who literally missed the biggest act of financial fraud in U.S. history. But you won't hear Chairman Volcker or President Obama talking about Federal regulation of the insurance industry. And AIG is hardly the only global insurer that is part of the problem in the insurance industry. In case you missed it, last week the Securities and Exchange Commission charged General Re for its involvement in separate schemes by AIG and Prudential Financial (PRU) to manipulate and falsify their reported financial results. General Re, a subsidiary of Berkshire Hathaway (BRK), is a holding company for global reinsurance and related operations. As we wrote last year (``AIG: Before Credit Default Swaps, There Was Reinsurance,'' April 2, 2009), Warren Buffett's GenRe was actively involved in helping AIG to falsify its financial statements and thereby mislead investors using reinsurance, the functional equivalent of credit default swaps. Yet somehow the insurance industry has been almost untouched by official inquiries into the crisis. Notice that in settling the SEC action, General Re agreed to pay $92.2 million and dissolve a Dublin subsidiary to resolve Federal charges relating to sham finite reinsurance contracts with AIG and PRU's former property/casualty division. Now why do you suppose a U.S. insurance entity would run a finite insurance scheme through an affiliate located in Dublin? Perhaps for the same reason that AIG located a thrift subsidiary in the EU, namely to escape disclosure and regulation. If you accept that situations such as AIG and other cases where Buy Side investors (and, indirectly, the U.S. taxpayer) were defrauded through the use of OTC derivatives and/or structured assets as the archetype ``problems'' that require a public policy response, then the Volcker Rule does not address the problem. The basic issue that still has not been addressed by Congress and most Federal regulators (other than the FDIC with its proposed rule on bank securitizations) is how to fix the markets for OTC derivatives and structured finance vehicles that caused losses to AIG and other investors. Neither prop trading nor the size of the largest banks are the causes of the financial crisis. Instead, opaque OTC markets, deliberately deceptive structured financial instruments and a general lack of disclosure are the real problems. Bring the closed, bilateral world of OTC markets into the sunlight of multilateral, public price discovery and require SEC registration for all securitizations, and you start down the path to a practical solution. But don't hold your breath waiting for President Obama or the Congress or former Fed chairmen to start that conversation. ______ CHRG-111hhrg48868--735 Mr. Liddy," They were retention payments, yes, commonly referred to as bonuses. Ms. Moore of Wisconsin. Okay. Good. Okay. Because here is what we don't understand. I guess I think we understand that bonuses are for good performance. And earlier we had the Office of Thrift Supervision in here, Mr. Polakoff, and he testified that as early as December 2005, the Financial Products group, on their general observation, knew that the underwriting standards for mortgage-backed securities were declining, that by March of 2006, that the Office of Thrift Supervision was talking to the AIG board about this weakness and certainly by June 2007, they had taken supervisory action against them. So I am trying to get a timeline of when these bonuses were put in place in these contracts because I did read your letter, the very difficult situation that you feel that you are in having to honor these contracts. What I understand a contract to be is kind of a meeting of the minds. I mean, I offer my employees a bonus because they are going to produce a good result, but clearly, it seems to me, if I have the timeline right, that it was--according to your letter, it was the first quarter of 2008 when you put these bonuses in place. And so I guess what I would like for you to help me to understand is how you knew that this particular division of AIG was failing, that you would offer bonuses as a sort of a perverse thing in terms of what we all understand? " CHRG-111hhrg58044--122 Mr. Marchant," You give the report to them, but it is up to the underwriting department to make its own decision based on your report, how much they weigh each of those things? " FinancialCrisisInquiry--56 That’s the change. CHAIRMAN ANGELIDES: All right. Thank you very much. All right. Let’s go—thank you. Mr. Holtz-Eakin? HOLTZ-EAKIN: I want to pick up on that and ask a question a little more broadly of the whole panel. Each of you, in your testimony, talked about problems of managing risk and excessive risk. Mr. Blankfein talked about under pricing of risk that led to massive leverage across wide swaths of the economy. A discussion from Mr. Dimon about compensation practices and misjudgments about aggressive underwriting standards. Mr. Mack talks about not having sufficient resources to manage those risks. And so each of the institutions you represent are publicly traded. They have audit committees. They have boards. They have internal auditors. And so my question is what is it about this traditional structure that failed us? Why is it that the risks that you have identified weren’t uncovered in the moment? And what specifically has each of you done, in addition to what you’ve discussed, to change your risk management practices since the crisis? We’ll just start with Mr. Blankfein. BLANKFEIN: I think if I had to say one thing in specific—and a lot of—we focus a lot, a lot of efforts and always have on risk management and our senior risk managers rise to the highest levels, including our named executive -- one of our named executive officers is our risk manager. So it’s the highest level of the firm. I’d say the one thing that we constantly learn from every crisis—‘98, tech, this one, of course, which is a different level—is the need for more stress tests. Very often in our business, we go through the analytical process of what could go wrong versus what is the probability of that going wrong. And, therefore, tend to discount the consequences too much. FinancialCrisisReport--323 If a security is not offered to the general public, it can still be offered to investors through a “private placement.” Investment banks often act as the “placement agent,” performing intermediary services between those seeking to raise money and investors. Placement agents often help issuers design the securities, produce the offering materials, and market the new securities to investors. Offering documents in connection with private placements are exempt from SEC registration and are not filed with the SEC. In the years leading up to the financial crisis, RMBS securities were registered with the SEC, while CDOs were sold to investors through private placements. Both of these securities were also traded in a secondary market by market makers. Investment banks sold both types of securities primarily to large institutional investors, such as other banks, pension funds, insurance companies, municipalities, university endowments, and hedge funds. Whether acting as an underwriter or placement agent, a major part of the investment bank’s responsibility is to solicit customers to buy the new securities being offered. Under the securities laws, investment banks that act as an underwriter or placement agent for new securities are liable for any material misrepresentation or omission of a material fact made in connection with a solicitation or sale of those securities to investors. 1246 The obligation of an underwriter and placement agent to disclose material facts to every investor it solicits comes from two sources: the duties as an underwriter specifically, and the duties as a broker-dealer generally. With respect to duties relating to being an underwriter, the U.S. Court of Appeals for the First Circuit observed that underwriters have a “unique position” in the securities industry: 1246 See Sections 11 and 12 of Securities Act of 1933. See also Rule 10b-5 of the Securities Exchange Act of 1934. See also, e.g., SEC v. Capital Gains Research Bureau, Inc. , 375 U.S. 180, 201 (1963) ( “Experience has shown that disclosure in such situations, while not onerous to the advisor, is needed to preserve the climate of fair dealing which is so essential to maintain public confidence in the securities industry and to preserve the economic health of the country.”). See also SEC Study on Investment Advisers and Broker-Dealers at 51 (citations omitted) ( “Under the so- called ‘shingle ’ theory … , a broker-dealer makes an implicit representation to those persons with whom it transacts business that it will deal fairly with them, consistent with the standards of the profession. … Actions taken by the broker-dealer that are not fair to the customer must be disclosed in order to make this implied representation of fairness not misleading. ”). “[T]he relationship between the underwriter and its customer implicitly involves a favorable recommendation of the issued security. … Although the underwriter cannot be a guarantor of the soundness of any issue, he may not give it his implied stamp of approval without having a reasonable basis for concluding that the issue is sound.” 1247 fcic_final_report_full--185 In the spring of , the FOMC would again discuss risks in the housing and mortgage markets and express nervousness about the growing “ingenuity” of the mortgage sector. One participant noted that negative amortization loans had the per- nicious effect of stripping equity and wealth from homeowners and raised concerns about nontraditional lending practices that seemed based on the presumption of continued increases in home prices. John Snow, then treasury secretary, told the FCIC that he called a meeting in late  or early  to urge regulators to address the proliferation of poor lending practices. He said he was struck that regulators tended not to see a problem at their own institutions. “Nobody had a full -degree view. The basic reaction from finan- cial regulators was, ‘Well, there may be a problem. But it’s not in my field of view,’” Snow told the FCIC. Regulators responded to Snow’s questions by saying, “Our de- fault rates are very low. Our institutions are very well capitalized. Our institutions [have] very low delinquencies. So we don’t see any real big problem.”  In May , the banking agencies did issue guidance on the risks of home equity lines of credit and home equity loans. It cautioned financial institutions about credit risk management practices, pointing to interest-only features, low- or no-documentation loans, high loan-to-value and debt-to-income ratios, lower credit scores, greater use of automated valuation models, and the increase in transactions generated through a loan broker or other third party. While this guidance identified many of the problematic lending practices engaged in by bank lenders, it was limited to home equity loans. It did not apply to first mortgages.  In , examiners from the Fed and other agencies conducted a confidential “peer group” study of mortgage practices at six companies that together had origi- nated . trillion in mortgages in , almost half the national total. In the group were five banks whose holding companies were under the Fed’s supervisory purview—Bank of America, Citigroup, Countrywide, National City, and Wells Fargo—as well as the largest thrift, Washington Mutual.  The study “showed a very rapid increase in the volume of these irresponsible loans, very risky loans,” Sabeth Siddique, then head of credit risk at the Federal Reserve Board’s Division of Banking Supervision and Regulation, told the FCIC.  A large percentage of their loans issued were subprime and Alt-A mortgages, and the underwriting standards for these prod- ucts had deteriorated.  Once the Fed and other supervisors had identified the mortgage problems, they agreed to express those concerns to the industry in the form of nonbinding guidance. “There was among the Board of Governors folks, you know, some who felt that if we just put out guidance, the banks would get the message,” Bies said.  The federal agencies therefore drafted guidance on nontraditional mortgages such as option ARMs, issuing it for public comment in late . The draft guidance directed lenders to consider a borrower’s ability to make the loan payment when rates adjusted, rather than just the lower starting rate. It warned lenders that low- documentation loans should be “used with caution.”  CHRG-111shrg57319--238 Mr. Schneider," Yes, it does. Senator Levin. All right. Eight months later, in an August 20, 2007 audit report--that is Exhibit 19--here is what you said.\3\ ``Repeat Issue--Underwriting guidelines established to mitigate the risk of unsound underwriting decisions are not always followed . . . accurate reporting and tracking of exceptions to policy does not exist. . . .'' Do you see that?--------------------------------------------------------------------------- \3\ See Exhibit No. 19, which appears in the Appendix on page 462.--------------------------------------------------------------------------- " CHRG-111shrg56262--10 Mr. Miller," Chairman Reed, Ranking Member Bunning, Members of the Subcommittee, on behalf of the American Securitization Forum, I appreciate the opportunity to testify today. Securitization plays an essential role in the financial system and the broader U.S. economy. It is a mainstream source of credit and financing for individuals and businesses and finances a substantial portion of all consumer credit. Currently there is over $12 trillion of outstanding securitized assets, including mortgage-backed securities, asset-backed securities, and asset-backed commercial paper. The size and scope of securitization activities reflects the benefits and value it has historically delivered to the financial system and economy. Restoration of greater function and confidence to this market is a particularly urgent need today, in light of capital and liquidity constraints currently confronting financial institutions and markets. With the process of bank de-leveraging and balance sheet reduction still underway, and with increased bank capital requirements on the horizon, it is clear that the credit and funding capacity provided by securitization cannot be replaced by deposit-based financing or other alternatives. Simply put, the recovery and restoration of confidence in securitization is a necessary ingredient for economic growth to resume and for that growth to continue on a sustained basis into the future. The U.S. securitization markets experienced substantial dislocation during the ongoing financial market turmoil. While there are signs of recovery in certain market sectors, others--most notably, private residential mortgage-backed securities--remain dormant, with other asset classes remaining significantly challenged. Although tightened lending standards are one important reason for a broader constriction in the supply of credit, the impairment and reduction in securitization activity plays an equal, if not more important role. Certain Government programs, including direct support for Government-guaranteed mortgage securitization and the TALF program for certain asset-backed securities, have been successful in supporting financing and the liquidity needs in part of this market. However, these programs are temporary, and a larger challenge remains to create a stable and sustainable private capital market platform for future securitization activity. To accomplish this essential goal, a number of weaknesses and deficiencies of securitization revealed by the financial market crisis must be addressed. ASF and the broader industry are working actively to pursue and implement certain critical reforms, and we will continue to work constructively with policymakers on others. I would like to offer several overriding perspectives on these reform measures. First, many of the problems that have been identified are not inherent in securitization per se. Instead, they relate to the manner in which securitization was used. As a general rule, the amount of risk inherent in a securitization transaction is equal to the risk that is embedded in the securitized assets themselves. However, ancillary practices and strategies, such as the excessive use of leverage and undue reliance on short-term funding for long-term liabilities, poor credit underwriting, or the absence of effective risk management controls, can amplify and concentrate these risks. This does not, however, mean that securitization itself is inherently flawed. Second, any reform measures should be targeted carefully to address specific and clearly identified deficiencies. Equal care should be taken to consider the individual and combined effects of various policy reforms to ensure that they do not inadvertently stifle otherwise sound and desirable securitization activity. We are very concerned that some reform measures currently being pursued or under consideration--most particularly, the combined effect of accounting standards changes and proposed regulatory capital rules--are counterproductive policy responses that are not reasonably targeted to address identified problems. Such reforms may render it prohibitively expensive to securitize a wide range of consumer and business assets. In turn, this could blunt the ability of the financial system to originate and fund consumer and business credit demand that finances jobs and investments, just as the broader economy begins to recover. We believe that this is an important matter that would benefit from Congress's further attention. Finally, from an industry perspective, ASF is focused primarily on devising and implementing concrete steps to improve the basic securitization market infrastructure in response to specific deficiencies identified in preexisting practices. Grouped broadly under the heading of ``Project Restart,'' these reforms will substantially improve and standardize information and data that is captured and reported to investors in securitized products, including, in the case of residential mortgage-backed securities, extensive and detailed loan level data. With these data enhancements broadly in place, securitization risks will be more transparent and capable of evaluation by investors and other market participants. At the same time, these data and standardization improvements will support higher-quality rating agency, due diligence, quality assurance, valuation, and other processes that depend on accurate and reliable underlying data. And, finally, and briefly, another important goal of Project Restart is to enhance and standardize representations and warranties that originators of mortgage loans typically provide. Much like a defective product is returned to a store from which it was sold, a mortgage loan that does not meet specified underwriting criteria should be returned to the originator through its removal from a securitization trust for cash. We believe that more effective representations and warranties will result in a full retention of economic risk by originators of defective loans consistent with the policy goal of requiring those who originate assets for securitization to retain a meaningful and continuing economic stake in the quality of those loans. I thank the Subcommittee for the opportunity to testify today. " CHRG-111hhrg52261--63 Mr. Anderson," Well, the way the National Association of Mortgage Brokers operates, we have a very strong code of ethics. We do not have a fiduciary responsibility to the borrowers. We counsel the borrowers. We do not underwrite the loans. And I will give a prime example where the mortgage broker got blamed, and that was with Fannie Mae and Freddie Mac. And we know what happened there. I can tell you, I have done a lot of loans, and Fannie Mae and Freddie Mac had an automated underwriting system and they would approve borrowers at 100 percent financing with a 65 percent debt-to-income ratio before taxes. Now, can the mortgage broker turn that borrower down when it was approved by Fannie Mae and Freddie Mac? If we did take that approach, if I would turn somebody down for that, I could be sued because--for discrimination or what have you. And those are the mistakes that happened. " CHRG-111shrg57320--233 Mr. Dochow," Yes. Senator Levin. OTS, on Exhibit 17,\2\ in May 2004 issued a findings memo on excessive errors in the underwriting process, concluded that some of the reasons were sales culture focused heavily on market share via loan production and extremely high lending volumes. OTS recommended to WaMu that it should compensate loan processors based on the quality of the loans that they made. And on page 5, WaMu laid out a set of corrective actions that it planned to take. But as is happening regularly, as we have seen, WaMu did not carry out the plan that it designed. And so next year, Exhibit 27,\3\ OTS asked WaMu to address ``continuing high levels of errors in loan origination process.'' That is OTS' words. OTS had to revisit the problem of paying loan staff for quantity over quality. Again, it asked WaMu to reward loan processors based on the quality of the loans that they made.--------------------------------------------------------------------------- \2\ See Exhibit No. 17, which appears in the Appendix on page 269. \3\ See Exhibit No. 27, which appears in the Appendix on page 311.--------------------------------------------------------------------------- So how about Mr. Carter? Do you know whether OTS was more successful the second time around in pressuring WaMu to reward its loan processors for loan quality instead of quantity? Do you know? " fcic_final_report_full--103 New Century and Ameriquest were especially aggressive. New Century’s “Focus ” plan concentrated on “originating loans with characteristics for which whole loan buyers will pay a high premium.”  Those “whole loan buyers” were the firms on Wall Street that purchased loans and, most often, bundled them into mortgage- backed securities. They were eager customers. In , New Century sold . bil- lion in whole loans, up from . billion three years before,  launching the firm from tenth to second place among subprime originators. Three-quarters went to two secu- ritizing firms—Morgan Stanley and Credit Suisse—but New Century reassured its investors that there were “many more prospective buyers.”  Ameriquest, in particular, pursued volume. According to the company’s public statements, it paid its account executives less per mortgage than the competition, but it encouraged them to make up the difference by underwriting more loans. “Our people make more volume per employee than the rest of the industry,” Aseem Mital, CEO of Ameriquest, said in . The company cut costs elsewhere in the origina- tion process, too. The back office for the firm’s retail division operated in assembly- line fashion, Mital told a reporter for American Banker; the work was divided into specialized tasks, including data entry, underwriting, customer service, account management, and funding. Ameriquest used its savings to undercut by as much as . what competing originators charged securitizing firms, according to an indus- try analyst’s estimate. Between  and , Ameriquest loan origination rose from an estimated  billion to  billion annually. That vaulted the firm from eleventh to first place among subprime originators. “They are clearly the aggressor,” Countrywide CEO Angelo Mozilo told his investors in .  By , Countrywide was third on the list. The subprime players followed diverse strategies. Lehman and Countrywide pur- sued a “vertically integrated” model, involving them in every link of the mortgage chain: originating and funding the loans, packaging them into securities, and finally selling the securities to investors. Others concentrated on niches: New Century, for example, mainly originated mortgages for immediate sale to other firms in the chain. When originators made loans to hold through maturity—an approach known as originate-to-hold —they had a clear incentive to underwrite carefully and consider the risks. However, when they originated mortgages to sell, for securitization or other- wise—known as originate-to-distribute —they no longer risked losses if the loan de- faulted. As long as they made accurate representations and warranties, the only risk was to their reputations if a lot of their loans went bad—but during the boom, loans were not going bad. In total, this originate-to-distribute pipeline carried more than half of all mortgages before the crisis, and a much larger piece of subprime mortgages. For decades, a version of the originate-to-distribute model produced safe mort- gages. Fannie and Freddie had been buying prime, conforming mortgages since the s, protected by strict underwriting standards. But some saw that the model now had problems. “If you look at how many people are playing, from the real estate agent all the way through to the guy who is issuing the security and the underwriter and the underwriting group and blah, blah, blah, then nobody in this entire chain is re- sponsible to anybody,” Lewis Ranieri, an early leader in securitization, told the FCIC, not the outcome he and other investment bankers had expected. “None of us wrote and said, ‘Oh, by the way, you have to be responsible for your actions,’” Ranieri said. “It was pretty self-evident.”  CHRG-110hhrg44900--47 The Chairman," The gentlewoman from California. Ms. Waters. Thank you very much, Mr. Chairman. I would like to thank you first for holding this very important hearing today, and I would like to thank both Secretary Paulson and Chairman Bernanke for being here today. Let me start by saying that which you have probably heard too often, how disappointed I am with all of us, Members of Congress, for what appears to have been weak oversight of our regulatory agencies, and our regulatory agencies for what appears to have been weak oversight of our financial institutions. I have to tell you, I have been holding hearings throughout the country on the subprime meltdown, and I'm absolutely stunned by the extent of the devastation to some of our families and communities caused by this subprime meltdown. I'm stunned when I hear about these exotic products and how they could ever have come into being without any oversight. I'm really stunned about some of the ARMs and the way that they reset, and the fact that there's something called a margin that I never knew about before, and that margin can be whatever the financial institution decides it should be, above and beyond the going interest rate. I came on this committee right after the S&L scandal, and I heard a lot about reform. And so while I suppose I should be impressed with the fact that there's a President's Working Group on Financial Markets and the reports that have been issued, I'm skeptical about what is being proposed. As it said in March, the President's Working Group on Financial Markets issued a report and recommendations for addressing the weaknesses revealed by recent events, both at the international level--between the two reports--and at the domestic level, between the two reports, focused on a number of specific problems, including mortgage lending practices and their oversight, risk management and management at large financial institutions. And then there was, Mr. Bernanke, the Blueprint that you talked about for a modernized financial regulatory structure, and you proposed a new regulatory architecture, and the third regulatory agency would be focused on protecting consumers and investors. I have to tell you, I'm surprised, because I thought that our regulatory agencies, no matter how they were organized, whether it was by financial institution category or not, had as its prime objective, all of those things that you talk about doing now. So what I really want to know is not so much what you plan that may not be instituted for some time, because it takes some time to get this into practice, I want to know what you're doing now. I want to know what you know about servicers. We have found that there's little if any regulation of mortgage servicers. And I want to know if you have anything in your plans to deal with them, because after we get finished with all of the President's HOPE NOW program and the money that we are giving to NeighborWorks and other organizations to do counseling, they can't do very much good, because the servicers are the ones who make the decisions. They're the ones that are in charge of these accounts. They decide to collect--well, they have to collect the fees, they have to collect the mortgage payment. They increase fees. They agree to extend or modify arrangement, but they can do practically whatever they want. I want to know what you know about them, what you're doing about them. And secondly, I want to know and understand Mr. Bernanke, what you know about the sale of Countrywide to Bank of America. I understand that Bank of America bought these mortgages at quite a reduced rate. And I want to know what that rate was and whether or not these properties could go back on the market appraised at a higher rate than the bank purchased them for, and who gets the profit and the difference, and why can't that go back to the homeowners who are losing their homes through foreclosure. First, I would like to hear from Secretary Paulson. " CHRG-111shrg56262--20 Chairman Reed," Thank you very much, Dr. Irving. In fact, I wanted to thank all the witnesses for their not only very insightful, but very concise testimony. I appreciate it very much. All of your written statements will be made a part of the record and any of the statements that my colleagues wish to be submitted will be made part of the record. Let me pose a question to all of you, which in some cases will allow you to elaborate on your initial comments. We have seen a--I am getting to the point now where I can say lifetime, and that is a long time--shift from a very small secondary market for loans to a well-functioning market, now to one that has basically seized up. I think some rough numbers that I have seen, that loans on bank balance sheets, roughly $3.5 trillion, compared to securitization products, about $7.1 trillion, and that market has sort of collapsed. So the issue is how do we--or what are the key factors that are stalling this market and that have to be addressed by us? And again, I think you have alluded to some of them, but let me start with Professor McCoy and go down the row. Ms. McCoy. Thank you. The problem right now on the investor end is lack of investor trust. Investors were not getting useful disclosures up front. They simply weren't. They weren't given information on the individual loans in the loan package so they could figure out whether the underwriting was good or bad. The due diligence done on those deals by investment banks left a lot to be desired, and in some cases, I fear, was tantamount to fraud to the investors. When I have looked at securitization prospectuses for mortgage-backed securities, often they would say, here are our underwriting standards. But many of the loans in the loan pool were exceptions to these standards, and there is no further description of the exception loans or how many of the loans in the loan pools are exception loans. In some cases, it was more than half, and I guarantee you they did not exceed the underwriting standards. They fell far below. So this is a pig in the poke, and for starters, that needs to be fixed. My additional concern is that investors' interests are not always protective of borrowers. We also need to rebuild securitization so that it does not saddle borrowers unknowingly with products that they cannot afford to repay, and that is a separate issue. " FinancialCrisisReport--598 These practices raise a wide range of ethical and legal concerns. This section examines the key issues of whether Goldman had a legal obligation to disclose to clients the existence of material adverse information, including conflicts of interest, when selling them RMBS and CDO securities; whether Goldman had material adverse interests that should have been disclosed to investors; and whether Goldman had an obligation not to recommend securities that were designed to lose value. Many of these issues hinge upon the proper treatment of financial instruments, such as credit default swaps and CDOs, which enable an investment bank to bet against the very same securities it is selling to clients. (a) Securities Laws To protect fair, open, and efficient markets for investors, federal securities laws impose a range of specific disclosure and fair dealing obligations on market participants, depending upon the securities activities they undertake. In the matters examined by the Subcommittee, the key roles under the securities laws include market maker, underwriter, placement agent, broker- dealer, and investment adviser. CHRG-111shrg57320--245 Mr. Carter," I think that overall when you look at single family underwriting, we told them that. Senator Levin. You said here you cannot tell---- " CHRG-111shrg50814--181 Chairman Dodd," But the underwriting standards in institutions dealing with community reinvestment are very tough. Do you agree with that? Well, not tough---- " 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. CHRG-111shrg61513--101 Mr. Bernanke," I will start with one point, which is that Canada's monetary policy was very similar to that of the United States, and they had very different outcomes. So those who blame this on monetary policy should address that issue. I think the differences between Canada and the United States had to do with their regulatory structure, and there were two primary advantages that they had. First, they simply had a much more conservative bank supervisory structure in terms of what they allowed banks to do, in terms of the amount of capital that banks had. You know, in the go-go days, they would be considered staid and unexciting. But, of course, that turned out to be the right way to go, and they are looked at as models around the world as we look at banks supervision. The other thing that they did, which we did not avoid, was they avoided the deterioration in underwriting standards in mortgages and the proliferation of very low downpayments and bad underwriting and other problems that came back to bite us in the crisis. So they took a very conservative approach, and it really paid off for them, although given that they are the biggest trading partner of the United States, they still have had a significant recession, of course. Senator Merkley. Well, if I can follow up on your point about the underwriting standards, some have argued that the reason that Canada proceeded to maintain solid underwriting standards was that they had an independent consumer financial protection agency and that that vision of defending consumers from tricks and traps in lending was never subverted, if you will, to other goals, be they safety and soundness, monetary policy, and so forth. Any insights on the role that institution plays in Canada? " FinancialCrisisReport--234 In July 2007, after the credit rating agencies downgraded the ratings on most subprime mortgage backed securities and the subprime secondary market collapsed, IndyMac – like WaMu – was left holding a large inventory of poor quality mortgage loans it could not sell. As delinquencies increased and the value of the mortgages fell, IndyMac incurred substantial losses, and its depositors began withdrawing funds. The withdrawals continued throughout 2007 and into 2008, eventually reaching $1.55 billion and triggering a liquidity crisis at the bank. 900 In July 2008, IndyMac collapsed and was seized by the FDIC, which had to pay more than $10 billion from the Deposit Insurance Fund to protect insured deposits and pay related expenses. 901 As it did with WaMu, OTS gave IndyMac high CAMELS ratings until shortly before the thrift’s failure, despite the fact that OTS had identified numerous problems with IndyMac’s subprime mortgage business practices. 902 Those problems included adopting an overly narrow definition of “subprime,” so that IndyMac could maintain a lower level of capital reserves; 903 poor underwriting and sloppy property appraisal practices; 904 and improper risk mitigation. 905 Neither OTS nor the FDIC ever took a public enforcement action against the bank. After IndyMac’s failure, the Treasury Inspector General conducted a review and issued a report evaluating OTS’ oversight efforts. 906 The report attributed IndyMac’s collapse to its strategy of rapid growth; originating and securitizing nontraditional, high risk loans; lack of verification of borrowers’ income or assets; lax underwriting; and reliance on high interest loans for its own operations. 907 The Treasury IG found that OTS was aware of IndyMac’s problems, but did not take sufficient enforcement action to correct them. 908 According to the Inspector 899 Id. at 7. 900 Id. at 3. 901 Id. at 1. 902 Id. at 8. 903 Id. at 18. 904 Id. at 21-31. 905 Id. 906 Id. In addition to the Material Loss Review, the Treasury Inspector General investigated OTS’ conduct in permitting thrifts, including IndyMac to backdate certain capital infusions. See 12/22/2008 Office of the Inspector General, Dept. of the Treasury, Letter to Ranking Member Charles Grassley, Senate Committee on Finance, http://media.washingtonpost.com/wp- srv/business/documents/Indymac_Thorson_122308pdf.pdf?sid=ST2008122202386. Darrel Dochow was removed from his position as Director of the OTS West Division for having allowed IndyMac to backdate a capital contribution of $18 million, which made it appear stronger than it really was in the relevant financial statement. Then Acting OTS Director Scott Polakoff was also placed on leave during the backdating investigation, but he disputed that he directed anyone to allow backdated capital injections and asserted that the real impetus for his being placed on leave was his Congressional testimony critical of the agency’s conduct related to AIG. Subcommittee interview of Scott Polakoff (3/16/10). 907 3/31/2009 Office of the Inspector General, Dept. of the Treasury, “Semiannual Report to Congress,” at 15, http://www.treasury.gov/about/organizational-structure/ig/Documents/sar042009.pdf. 908 Id. at 31. CHRG-109hhrg31539--171 Mr. Bernanke," There might be some risks in some of those situations. The Federal Reserve and the other banking agencies have issued proposed guidance for comment about nontraditional mortgages and how they should be managed. About nontraditional mortgages and how they should be managed, and among other things, we are asking banks to underwrite not just the initial payment, but to underwrite the ability of the borrower to pay even as interest rates rise, as we go to a maximum payment, and we are also asking banks and other lenders to make sure that the consumer understands fully the implications of these sometimes complicated mortgages. So we are trying to address it from a guidance perspective. " FinancialCrisisInquiry--618 CHAIRMAN ANGELIDES: OK. Mr. Rosen, you were talking about the development of bad products, bad underwriting and fraud in the marketplace. And obviously it was—went all the way up the chain. And in terms of those products then moving throughout the system. I guess my question is, to what extent were those products available historically as predatory loan products? In a sense, to what extent did what used to be considered predatory loans, focused perhaps on certain neighborhoods, essentially get transported to the larger economy? Because there were lenders who offered some of these products on a narrow basis, correct? 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-111hhrg58044--126 Mr. Marchant," Mr. Snyder, in your particular instance, would a driving record be a significant factor in your information that you gave to an underwriter that bought your service? " CHRG-111hhrg58044--108 Mr. Marchant," Thank you. Mr. Wilson, talk to us about the relationship you have with your customer. Your customer is an insurance underwriter, salesman, company? " CHRG-111shrg50564--177 Mr. Hillman," When you go back a decade or more, the process that depository institutions typically followed in funding mortgages is they would have their own underwriters review the competency of individuals to pay those loans and they would go through a detailed process before making a decision to provide a loan to an individual. Once that decision was made, they would hold that risk or hold that loan on their books themselves. Today, most oftentimes that is not the case. The case is a model of originate to distribute, where institutions are making decisions and receiving a fee for that service and passing that risk on to others. This originate to distribute model is one of the reasons why we have resulted in the crisis that we are in today and some say that additional attention is going to be needed in the future to help to ensure that at least some responsibilities are being held by each of the individual parties along the way to ensure the appropriateness of decisionmaking at each of those levels. Senator Johanns. Can I often one last piece to this? That piece would be the thought of rating the risk. Is that an appropriate governmental function? For example, if my bank wants to go out and originate junk in the hopes of marketing it, we should call it that. If, on the other hand, they are following a model of caution and due diligence and doing the very best they can to make sure that those loans are going to be repaid, that should be viewed differently. But the important thing is, how do we let the consumer know that? How do I, Mike Johanns, going in to make my deposit, how do I know that those practices have been employed, so if I buy their stock or invest my money in that stock or whatever, I am an informed consumer? These are complicated issues, but I think that is what we are trying to get to here, is to protect the consumer. " fcic_final_report_full--200 Looking back at how the targeted affordable portfolio performed in comparison with overall losses, the  presentation at Freddie Mac took the analysis of the goals’ costs one step further. While the outstanding  billion of these targeted af- fordable loans was only  of the total portfolio, these were relatively high-risk loans and were expected to account for  of total projected losses. In fact, as of late , they had accounted for only  of losses—meaning that they had performed better than expected in relation to the whole portfolio. The company’s major losses came from loans acquired in the normal course of business. The presentation noted that many of these defaulted loans were Alt-A.  COMMISSION CONCLUSIONS ON CHAPTER 9 The Commission concludes that firms securitizing mortgages failed to perform adequate due diligence on the mortgages they purchased and at times knowingly waived compliance with underwriting standards. Potential investors were not fully informed or were misled about the poor quality of the mortgages contained in some mortgage-related securities. These problems appear to have been signifi- cant. The Securities and Exchange Commission failed to adequately enforce its disclosure requirements governing mortgage securities, exempted some sales of such securities from its review, and preempted states from applying state law to them, thereby failing in its core mission to protect investors. The Federal Reserve failed to recognize the cataclysmic danger posed by the housing bubble to the financial system and refused to take timely action to con- strain its growth, believing that it could contain the damage from the bubble’s collapse. Lax mortgage regulation and collapsing mortgage-lending standards and practices created conditions that were ripe for mortgage fraud. FinancialCrisisReport--104 The second example involves 25 Home Equity Lines of Credit (HELOCs) totaling $8.5 million that were originated in 2008 by a WaMu loan officer at the Sunnyvale loan office in California. Before all of the loans were funded, they were referred to the Risk Mitigation Team because of fraud indicators. On May 1, 2008, the loan files were sent on to the CFI group for further inquiry. An internal document summarizing the CFI investigation stated: “The review found that the borrowers indicated they owned the property free and clear when in fact existing liens were noted on the properties. The properties are located in California, Arizona and Washington. … WaMu used … Abbreviated Title reports [that] … do not provide existing lien information on the subject property.” 355 Of the 25 loan applications, 22 were ultimately terminated or declined. The employee involved in originating the loans was terminated as part of the April 30, 2008 reorganization. The third example involves a review of 2006 and 2007 WaMu loans conducted by Radian Guaranty Inc., a company which provided mortgage insurance for those loans. 356 Radian’s objectives were to test WaMu’s “compliance with Radian’s underwriting guidelines and eligible loan criteria,” assess the quality of WaMu’s underwriting decisions, “rate the risk of the individual loans insured,” and identify any errors in the loan data transmitted to Radian. 357 The review looked at a random selection of 133 loans and found enough problems to give WaMu an overall rating of “unacceptable.” 358 The Radian review identified a number of problems in the loan files it deemed ineligible for insurance. In one, WaMu issued a $484,500 loan to a “Sign Designer” who claimed to be making $34,000 in income every month. 359 The Radian review observed: “Borrower’s stated monthly income of $34,000 does not appear reasonable for a ‘Sign Designer.’” The review also noted several high risk elements in the loan, which was an 85% LTV loan given to a borrower with a 689 credit score who used the loan to refinance an existing loan and “cash-out” the equity in the house. The review noted that the borrower received $203,000 at the loan closing. In addition, the review stated that WaMu had appraised the house at $575,000, but an automated appraisal verification program assigned the house a probable value of only $321,000, less than the amount of the loan. 354 Subcommittee interview of Brian Minkow (2/16/2010). 355 5/15/2008 “WaMu Significant Incident Notification (SIN),” JPM_WM05452389, Hearing Exhibit 4/13-32b. 356 2/7/2008 Radian Guaranty Inc. review of Washington Mutual Bank loans, JPM_WM02057526, Hearing Exhibit 4/13-33. 357 Id. at 1. 358 Id. 359 Id. at 5. 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. CHRG-111hhrg58044--109 Mr. Wilson," Right. Our primary customer is the underwriting department and/or the actuarial department in the personal lines property casualty industries. " CHRG-111shrg57319--330 Mr. Beck," I had a separate responsibility to conduct underwriters' due diligence, which we did. Senator Levin. All right. And you never asked to see if they were removed? " CHRG-111shrg57322--1131 Mr. Blankfein," The disclosure requirements in an underwrite, again, are very well evolved. Senator Tester. OK. So is it you? Do you have to disclose to both sides what is in so that both sides know? " 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. CHRG-111hhrg52406--125 Mr. Gutierrez," Sure. Mr. Miller of California. I want to make myself clear so you don't misunderstand me. I think that the problem we faced in recent years was we failed to define predatory versus subprime. And lenders went out and acted, and some individuals acted as if there were no underwriting standards necessary that should apply to a loan. " CHRG-111hhrg67816--10 Mr. Waxman," Thank you very much, Mr. Chairman. I want to commend you for holding this hearing, and the fact that your subcommittee is taking a close look at consumer protection in the area of credit and debt. This committee has an important role in ensuring that consumers are protected from unfair, abusive, and deceptive practices throughout the marketplace, including the credit market, and I am pleased to join you in welcoming the chairman, the new chairman, of the Federal Trade Commission, Jon Leibowitz. Congratulations on your appointment. I look forward to working with you on this and other issues before our committee. The current financial crisis has brought to light a host of schemes that have hurt both individual consumers and the economy as a whole, mortgages have required no money down and no proof of income or assets, pay-day lenders who charge 500 percent interest for a short-term loan, companies that take money from individuals based on false offers or they offer to fix a credit report or save a home from foreclosure. These are schemes, and they are allowed to happen because of a fierce anti-regulatory ideology that was prevailing at least in the last 8 years. The philosophy was the government was the source of the problem, that it posed obstacles to success and that it should be slashed wherever feasible. This was the ideology that led to FEMA's failure during Hurricane Katrina, billons of dollars of contracting abuse at the Defense Department, and a food safety system that could not keep unsafe peanuts and spinach off the grocery shelves. The agencies of government responsible for protecting our financial system and Americans' hard-earned assets also suffered under this ideology. There was a feeling that government should step aside and markets should be allowed to work with little or no regulatory intervention. Now we have an opportunity to move beyond the flawed system of the previous 8 years and strengthen consumer protections across the financial system. Today's hearing focuses on the Federal Trade Commission which plays an essential role in overseeing consumer credit. An aggressive and rejuvenated FTC could prevent unfair and deceptive practices before they become commonplace, and it could use its enforcement authority to deter fraudulent schemes. I look forward to working with you, Mr. Chairman, and the members of this committee to making sure that the FTC has the authority, the resources, and the will to be an aggressive consumer protection agency. I yield back the balance of my time. " fcic_final_report_full--211 Citi did have “clawback” provisions: under narrowly specified circumstances, compensation would have to be returned to the firm. But despite Citigroup’s eventual large losses, no compensation was ever clawed back under this policy. The Corporate Library, which rates firms’ corporate governance, gave Citigroup a C. In early , the Corporate Library would downgrade Citigroup to a D, “reflecting a high degree of governance risk.” Among the issues cited: executive compensation practices that were poorly aligned with shareholder interests.  Where were Citigroup’s regulators while the company piled up tens of billions of dollars of risk in the CDO business? Citigroup had a complex corporate structure and, as a result, faced an array of supervisors. The Federal Reserve supervised the holding company but, as the Gramm-Leach-Bliley legislation directed, relied on oth- ers to monitor the most important subsidiaries: the Office of the Comptroller of the Currency (OCC) supervised the largest bank subsidiary, Citibank, and the SEC su- pervised the securities firm, Citigroup Global Markets. Moreover, Citigroup did not really align its various businesses with the legal entities. An individual working on the CDO desk on an intricate transaction could interact with various components of the firm in complicated ways. The SEC regularly examined the securities arm on a three-year examination cycle, although it would also sometimes conduct other examinations to target specific con- cerns. Unlike the Fed and OCC, which had risk management and safety and sound- ness rules, the SEC used these exams to look for general weaknesses in risk management. Unlike safety and soundness regulators, who concentrated on prevent- ing firms from failing, the SEC always kept its focus on protecting investors. Its most recent review of Citigroup’s securities arm preceding the crisis was in , and the examiners completed their report in June . In that exam, they told the FCIC, they saw nothing “earth shattering,” but they did note key weaknesses in risk man- agement practices that would prove relevant—weaknesses in internal pricing and valuation controls, for example, and a willingness to allow traders to exceed their risk limits.  Unlike the SEC, the Fed and OCC did maintain a continuous on-site presence. During the years that CDOs boomed, the OCC team regularly criticized the com- pany for its weaknesses in risk management, including specific problems in the CDO business. “Earnings and profitability growth have taken precedence over risk man- agement and internal control,” the OCC told the company in January .  An- other document from that year stated, “The findings of this examination are disappointing, in that the business grew far in excess of management’s underlying in- frastructure and control processes.”  In May , a review undertaken by peers at the other Federal Reserve banks was critical of the New York Fed—then headed by the current treasury secretary, Timothy Geithner—for its oversight of Citigroup. The review concluded that the Fed’s on-site Citigroup team appeared to have “insufficient resources to conduct continuous supervisory activities in a consistent manner. At Citi, much of the limited team’s energy is absorbed by topical supervisory issues that detract from the team’s continuous supervision objectives . . . the level of the staffing within the Citi team has not kept pace with the magnitude of supervisory issues that the institution has realized.”  That the Fed’s  examination of Citigroup did not raise the concerns expressed that same year by the OCC may illustrate these prob- lems. Four years later, the next peer review would again find substantial weaknesses in the New York Fed’s oversight of Citigroup.  CHRG-111shrg57319--481 Mr. Killinger," Again, that product or that feature has been around for many years. I think what we are all dealing with is the housing crisis, or the housing boom grew and as competition grew, the use of limited documentation and no documentation kind of loans certainly expanded. And as we were commenting earlier, as we became more concerned that the housing market had increased in risk, I think that is one of the elements we all started to take a look at. So in our case, we started to cut back on our originations. We eliminated some of the product offerings. We tightened underwriting. As I heard from David Schneider earlier this morning, at one point, we also decided that limited documentation loans were not appropriate. Senator Kaufman. And what size mortgages were stated income loans used for at WaMu? " CHRG-111shrg57320--206 Mr. Dochow," You fill out your paperwork, you put down what your income is---- Senator Kaufman. Right. Mr. Dochow [continuing]. And the bank pulls your FICO scores, your credit reports, the loan gets approved or disapproved. Those programs lend themselves more to that type of underwriting. Senator Kaufman. Right. " CHRG-111shrg50815--108 Mr. Clayton," There is a significant difference between credit card securitizations and mortgage securitizations. Mortgage securitizations involve, as I understand it, a great deal of pooled loans from a lot of different issuers and underwriters. Credit card loans, they come from one company and that company's reputation and cost of future issuances is dictated by the performance of that underlying securitization. " CHRG-111shrg51395--65 Mr. Turner," I think, without a doubt, Senator Shelby, they are a problem here. You know, if you make a loan at $100 and you are only going to get $70 back, that is OK once or twice, but we did it millions and millions of times. The bottom line is they just aren't worth what they were, and to report to the public, to investors, regulators that you have got a balance sheet that is substantially different than what it is really worth is just flat out misleading, if not straightforward fraudulent. Senator Shelby. Mr. Ryan, your testimony recommends a Financial Market Stability Regulator that, among other things, would have a direct role in supervising, quote, your words, ``systemically important financial organizations.'' What are the criteria, Mr. Ryan, that you would recommend for identifying systemically important entities, and do you believe that there would be any competitive implications for firms that are not so designated? " CHRG-111hhrg56776--241 Mr. Foster," Thank you. And, let's see, countercyclical mortgage underwriting standards are being implemented at various levels in different countries around the world. And, simply put, what this means, when a housing bubble begins to develop, you turn up the downpayment that's required. And I guess my first question to Chairman Bernanke is that had these type of policies been in place in the previous decade, how effect would they have been at damping down the housing bubble, even in the presence of very loose monetary policy? And more--and secondly, in respect to the subject of this hearing, would countercyclical underwriting requirements be easier to implement in the context of consolidated Fed supervision? " FinancialCrisisInquiry--149 John Mack certainly made that point; others did. But you’re not going to catch up with innovation, and unless you change the structure—and I’m not sure it’s advisable; I would like it, but I’m not sure it’s going to happen—I think you’ve just got to have very strong and constant and non-patchwork regulation. GEORGIOU: But does that mean—are you suggesting that really that regulation means enforcing significantly higher capital requirements? SOLOMON: Well, that’s certainly one thing. I don’t think anybody doubts that. Nobody—again, the folks today testified that they thought their capital was too low. So definitely higher capital requirements. That’s a sine qua non. That’s a starting point. But that’s just a starting point. GEORGIOU: Right. But the criticism when I—when we suggested that in the course of the questioning I did, the banker suggested, well, that, you know, that limits the amount of business that they can do, which of course is... SOLOMON: Well, you asked that—if I may—in terms of underwritings, I think, and whether they should hold back—be required to hold a piece of their underwriting. And I don’t know, they didn’t give you—that wasn’t a bad answer they gave, meaning that there is a legitimacy to that, but whether the firm should have more capital is the issue I’m saying, not whether they are required to take a part of their underwriting and hold it back instead of underwriting fees or suffer the loss. Now, one of the things that does happen today is they’re much smarter. They’re, you know, when you talk to these folks, you read about Goldman Sachs, and if none of you have read the Charley Ellis book on Goldman Sachs you should all read it, particularly the updated version. I’ll give Charley a plug. You should read it, because it’s very revelatory about the thinking of Goldman Sachs about their business and how they look at markets. And, you know, let the—let their words tell you where they’re going. CHRG-111hhrg52261--62 Mrs. Dahlkemper," Let me ask you then a question that goes along with that, because it has been reported that mortgage brokers who processed the subprime loans are now counseling individuals who are indebted by those loans regarding their restructuring. So does your association promote standards by which brokers evaluate the financial suitability of loan products by prospective borrowers? Or do you just rely upon the lenders, underwriters for that? " CHRG-111shrg57319--267 Mr. Beck," I knew that we had underwriting problems, yes. Senator Coburn. Who were the most common customers for Washington Mutual's mortgage-backed securities? " CHRG-111shrg57320--237 Mr. Carter," The overall outcome of improving single family underwriting was something they struggled with from exam to exam. Senator Levin. And ``struggled with'' being a bureaucratic euphemism for they did not do much. " FinancialCrisisInquiry--69 GEORGIOU: Right. But you’re customarily paid as a percentage of the issue when you—when you engage in underwriting. And so why couldn’t that percentage of the issue simply be in significant part in the securities themselves, which would permit you to benefit substantially were it to rise, but would also permit you to lose substantially if it went down, just like the investors do? MACK: Again, I would welcome that. I think you would have to give us some leeway because markets are volatile—if markets are to go down, some way of hedging that. Other than that, I wouldn’t mind being paid in equity or in fixed instruments. GEORGIOU: Well, but the problem is that the hedge itself undermines the whole notion of the concept, which is to place responsibility on you, the underwriting, the originator, the party that has the greatest access to the information, for the success or failure ultimately of the security, just like the investor. MACK: But if you are a very large underwriter of either new issues or fixed income, and we’ve just gone through a week of record issuance in the corporate bond market, you very quickly would fill up our balance sheets and you would have us in a situation that we’d have to curtail our business. So there has to be some way to adjust it. It could be a shorter period of holding the securities. That may work. GEORGIOU: Yes. MACK: But again, I’m not opposed to it. fcic_final_report_full--475 Indeed, the Commission’s entire investigation seemed to be directed at minimizing the role of NTMs and the role of government housing policy. In this telling, the NTMs were a “trigger” for the financial crisis, but once the collapse of the bubble had occurred the “weaknesses and vulnerabilities” of the financial system— which had been there all along—caused the crisis. These alleged deficiencies included a lack of adequate regulation of the so-called “shadow banking system” and over-the-counter derivatives, the overly generous compensation arrangements on Wall Street, and securitization (characterized as “the originate to distribute model”). Coincidentally, all these purported weaknesses and vulnerabilities then required more government regulation, although their baleful presence hadn’t been noted until the unprecedented number of subprime and Alt-A loans, created largely to comply with government housing policies, defaulted. 6. Conclusion What is surprising about the many views of the causes of the financial crisis that have been published since the Lehman bankruptcy, including the Commission’s own inquiry, is the juxtaposition of two facts: (i) a general agreement that the bubble and the mortgage meltdown that followed its deflation were the precipitating causes—sometimes characterized as the “trigger”—of the financial crisis, and (ii) a seemingly studious effort to avoid examining how it came to be that mortgage underwriting standards declined to the point that the bubble contained so many NTMs that were ready to fail as soon as the bubble began to deflate. Instead of thinking through what would almost certainly happen when these assets virtually disappeared from balance sheets, many observers—including the Commission majority in their report—pivoted immediately to blame the “weaknesses and vulnerabilities” of the free market or the financial or regulatory system, without considering whether any system could have survived such a blow. One of the most striking examples of this approach was presented by Larry Summers, the head of the White House economic council and one of the President’s key advisers. In a private interview with a few of the members of the Commission (I was not informed of the interview), Summers was asked whether the mortgage meltdown was the cause of the financial crisis. His response was that the financial crisis was like a forest fire and the mortgage meltdown like a “cigarette butt” thrown into a very dry forest. Was the cigarette butt, he asked, the cause of the forest fire, or was it the tinder dry condition of the forest? 44 The Commission majority adopted the idea that it was the tinder-dry forest. Their central argument is that the mortgage meltdown as the bubble deflated triggered the financial crisis because of the “vulnerabilities” inherent in the U.S. financial system at the time—the absence 44 FCIC, Summers interview, p.77. of regulation, lax regulation, predatory lending, greed on Wall Street and among participants in the securitization system, ineffective risk management, and excessive leverage, among other factors. One of the majority’s singular notions is that “30 years of deregulation” had “stripped away key safeguards” against a crisis; this ignores completely that in 1991, in the wake of the S&L crisis, Congress adopted the FDIC Improvement Act, which was by far the toughest bank regulatory law since the advent of deposit insurance and was celebrated at the time of its enactment as finally giving the regulators the power to put an end to bank crises. CHRG-111shrg56262--73 Chairman Reed," Just a follow-up. Would one of aspect of this might be that those investors would be much more careful about what they are buying and what they are investing in? Because they would like to make sure that the originator was doing their job in underwriting and that would be a market solution to this problem. " CHRG-111shrg57319--533 Mr. Killinger," Yes. Senator Coburn. And who represented the other side of that transaction? Who was the broker-dealer or the underwriter? Who was the lead placement firm? " CHRG-111shrg57319--250 Mr. Schneider," That is my understanding. I wasn't---- Senator Levin. Why weren't securitizations halted in 2005, 2006, and 2007 when similar underwriting problems were uncovered? That is my question. " CHRG-111shrg56262--45 Mr. Miller," I would agree. I don't think it is desirable to legislate or regulate underwriting standards per se. I do think it is important, though, for those involved in credit underwriting functions, and I am thinking specifically in the residential mortgage market, for those involved in those activities--mortgage lenders, brokers, and others--to be subject to the same type of regulation so that you have a level playing field and consistent standards that apply to all who are engaged in those functions. Ms. McCoy. I am forced to disagree. We saw a situation in which the residential mortgage lending industry was unable to organize self-regulation, and, in fact, engaged in a race to the bottom in lending standards, which was aided and abetted by our fragmented regulatory system which, as Senator Bunning noted, refused to impose strong standards. That is how we got in this mess, and I think the only way that we prevent that from happening is to have some basic common sense standards that apply to all lenders in all States from the Federal Government. To my mind, the most important one is require borrowers to produce documentation that they have the ability to repay the loan at inception. That is common sense. We don't have to obsess about down payment requirements. But that, to me, is essential. Senator Gregg. I don't want to--doesn't that go to recourse? I mean, should there be recourse? Ms. McCoy. Against the borrower? Senator Gregg. Right. Should that be a standard that we subscribe to in this country, which we don't now? Ms. McCoy. Well, some States do subscribe to it. It depends on the State. Senator Gregg. Well, is it a good idea or bad idea? Ms. McCoy. I think right now, it is causing people who have already lost their houses to be pushed further into crisis and it is not helping the situation right now. Senator Gregg. And didn't this push to the bottom--wasn't the shove given by the Congress with the CRA and the way it set up Fannie Mae and Freddie Mac as basically guaranteed entities? Ms. McCoy. Actually, CRA loans have turned out to perform pretty well, and one of the reasons is that banks held them in portfolios so that those higher underwriting standards actually applied to CRA loans. They have been a success story among different classes of loans. Fannie Mae and Freddie Mac, I agree, they cut their underwriting standards, but they joined the bandwagon late. The private label nonconforming loans created a strong competitive threat that they felt necessary to meet, and so they were not the cause of the problem, although they did join the bandwagon. Senator Gregg. Thank you. " CHRG-110hhrg46591--370 Mr. Klein," Thank you, Mr. Chairman. And thank you, gentlemen, for being here today. When speaking to people at home, large sophisticated borrowers, real estate, and large businesses as well as small businesses, we continue to hear, as you know, that it is difficult to get credit. And I appreciate the fact that community bankers have been very astute in their lending practices over the years. But generally speaking, we are not hearing that there is a lot of capital available. And when we are hearing it is available, it is available under very difficult terms to borrow. So I want to just--if people are listening at home, watching this today, some would think, based on some of the comments, that some lending is really free flowing out there. Maybe it is in different parts of the country. I am from Florida, South Florida, and it has been very very difficult. So just as a thought, one of the things we were talking about back home with small business, SBA loans for example, is maybe expanding the underwriting capacity a little bit. Those are high-quality loans for the most part; the default rate is fairly low, and we already have an institution in place. And that is something that, to the extent we can maybe get SBA loans out there quicker, that may be something to consider. I know there has already been an effort to do that, but if we can really push hard, it is a faster way of getting capital in businesses hands. So if you have some thoughts on that. And then just in general, also to the extent that we know that this is an immediate problem--and there are no silver bullets--whether it is the large, sophisticated borrowers or the smaller borrowers, is there anything that we can or should be doing other than maybe the SBA loans, Treasury, Fed, Congress, that can try to advance the small business side of this thing a little quicker? And if you could direct that to Mr. Yingling and Mr. Washburn. " CHRG-111shrg57319--220 Mr. Beck," Chairman Levin, Dr. Coburn, and Members of the Subcommittee, my name is David Beck. From April 2003 through September 2008, I worked at Washington Mutual Bank. In early 2005, I received responsibility for the capital markets organization in Washington Mutual's Home Loans Group. In the second half of 2006, as part of Mr. Schneider's changes to the management at Long Beach Mortgage, I was given responsibility for Long Beach's capital markets organization. I will use these brief remarks to highlight a few aspects of WaMu's capital markets organizations.--------------------------------------------------------------------------- \1\ The prepared statement of Mr. Beck appears in the Appendix on page 163.--------------------------------------------------------------------------- WaMu Capital Corp. acted as an underwriter of securitization transactions generally involving Washington Mutual Mortgage Securities Corp or WaMu Asset Acceptance Corp. Generally, one of these two entities would sell loans into a securitization trust in exchange for securities backed by the loans in question, and WaMu Capital Corp. would then underwrite the securities consistent with industry standards. As an underwriter, WaMu Capital Corp. sold mortgage-backed securities to a wide variety of institutional investors. The portfolio managers making the investment decision for these institutional investors typically had long-term hands-on experience creating, selling, or buying mortgage-backed securities. In addition, purchasers had extensive information regarding the loans WaMu sold, including the data on the performance of similar loans and the conditions in the housing market. WaMu also bought and sold home loans. WaMu Capital Corp. negotiated the terms and helped to close the whole loan sales undertaken by whichever WaMu entity owned the loans. Typically, these were sales of WaMu-originated loans, although on occasion WaMu Capital Corp. did sell loans originated by third parties. Washington Mutual Mortgage Securities Corp. also operated a bulk loan conduit through which it purchased loans that were then pooled into securitization transactions. WaMu Capital Corp. would underwrite securitization transactions in the same manner, regardless of whether the loans were originated by WaMu or a third party. 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. Your invitation asked specifically about the Repurchase and Recovery Team. In general, purchasers of loans can, under certain circumstances, demand that the seller repurchase a loan. While the circumstances in which a repurchase may be required are dictated by contractual and legal considerations, the repurchase process itself usually involves a give-and-take between buyer and seller. Buyers often take an expansive view when the seller is obligated to repurchase a loan and sellers often disagree. Perhaps not surprisingly, these negotiations lead to outcomes that vary from loan to loan and transaction to transaction. Occasionally, it is the seller that identifies problems with a loan in the first instance and initiates the repurchase process without demand from the buyer. Toward the end of 2007, the WaMu group responsible for evaluating and responding to repurchase requests was placed under my direction. That group reviewed repurchase requests to determine if they presented valid grounds for repurchase of a loan at issue. When appropriate, the group also made repurchase demands to those financial institutions from which WaMu had acquired loans. The group, which came to be called the Repurchase and Recovery Team, also created a computer modeling process to identify loans which WaMu had sold that might present a repurchase obligation. When this process identified loans that presented a repurchase obligation, the repurchase team would affirmatively approach buyers to notify them of that conclusion. In this way, WaMu took proactive action to address potential repurchase obligations. I hope that this very brief introduction has been helpful to the Subcommittee and I would be happy to answer any questions that you may have. Thank you. Senator Levin. Thank you very much, Mr. Beck. We will have rounds of 10 minutes this time, and we will have more than one round. Mr. Schneider, the gain on sale numbers for the various kinds of loans were based on WaMu's own data. If you look at Exhibit 3,\1\ which is an April 18, 2006, presentation that you put together for the WaMu Board of Directors about the high-risk lending strategy, you will see that on page 5 is a chart entitled, ``Shift to High Margin Products.'' On the left of that chart is information about the gain on sale which is produced by the higher-risk loans. We have enlarged that part of the chart so that you can see it better. It shows that WaMu earned about 19 basis points for a fixed loan, a traditional loan, while Option ARMs earned 109, home equity loans earned 113 basis points, and subprime loans earned 150 basis points, about eight times more than the fixed loans.--------------------------------------------------------------------------- \1\ See Exhibit No. 3, which appears in the Appendix on page 278.--------------------------------------------------------------------------- Is it fair to say that the gain on sale for the subprime loans was much higher than fixed loans because the bank was able to charge higher fees and interest rates? Is that basically the case? Mr. Schneider. " 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 CHRG-111hhrg63105--59 Mr. Schrader," Thank you Mr. Chairman. Following up on the line of questions so far, it seems like we are getting hung up on terminology, terminology that has a pejorative context to it like speculation. I would assume that in the 20th century the Commission's primary rule is to root out actual fraud, fraudulent actors that were doing things on purpose. I guess I have to ask the question given the 21st century where you have these hyper-computer trades and massive investments and things flowing unbeknownst, with no mal-intention necessarily intended but mal--bad results coming out of it. I think no one could, while we may disagree about whether or not they are actually speculators causing this problem in 2008, everybody agrees there was a huge distortion in the market. I guess the question for both of you from me would be: Is it the CFTC's responsibility to protect American consumers, American farmers, American industries, by dealing with any distortion of the market, regardless of whether it was intentional or not? " fcic_final_report_full--507 Up to this point, we have seen that HUD’s policy was to reduce underwriting standards in order to make mortgage credit more readily available to low-income borrowers, and that Fannie and Freddie not only took the AH goals seriously but were willing to go to extraordinary lengths to make sure that they met them. Nevertheless, it seems to have become an accepted idea in some quarters— including in the Commission majority’s report—that Fannie and Freddie bought large numbers of subprime and Alt-A loans between 2004 and 2007 in order to recover the market share they had lost to subprime lenders such as Countrywide or Wall Street, or to make profits. Although there is no evidence whatever for this belief—and a great deal of evidence to the contrary—it has become another urban myth, repeated so often in books, blogs and other media that it has attained a kind of reality. 103 The formulations of the idea vary a bit. As noted earlier, HUD has claimed— absurdly, in light of its earlier efforts to reduce mortgage underwriting standards— that the GSEs were “chasing the nonprime market” or “chasing market share and profits,” principally between 2004 and 2007. The inference, all too easily accepted, is that this is another example of private greed doing harm, but it is clear that HUD was simply trying to evade its own culpability for using the AH goals to degrade the GSEs’ mortgage underwriting standards over the 15 year period between 1992 and 2007. The Commission majority also adopted a version of this idea in its report, blaming the GSEs’ loosening of their underwriting standards on a desire to please stock market analysts and investors, as well as to increase management compensation. None of HUD’s statements about its efforts to reduce underwriting standards managed to make it into the Commission majority’s report, which relied entirely on the idea that the GSEs’ underwriting standards were reduced by their desire to “follow Wall Street and other lenders in [the] rush for fool’s gold.” These claims place the blame for Fannie and Freddie’s insolvency—and the huge number of low quality mortgages in the U.S. financial system immediately prior to the financial crisis—on the firms’ managements. They absolve the government, particularly HUD, from responsibility. The GSEs’ managements made plenty of mistakes—and won’t be defended here—but taking risks to compete for market share was not something they actually did. Because of the AH goals, Fannie and 103 See, e.g., Barry Ritholtz, “Get Me ReWrite!” in Bailout Nation, Bailouts, Credit, Real Estate, Really, Really Bad Calls , May 13, 2010, http://www.ritholtz.com/blog/2010/05/rewriting-the-causes-of-the- credit-crisis/print/ ; Dean Baker, “NPR Tells Us that Republicans Believe that Fannie and Freddie Caused the Crash” Beat the Press Blog, Center for Economic and Policy Research http://www.cepr.net/index.php/ blogs/beat-the-press/npr-tells-us-that-republicans-believe-that-fannie-and-freddie-caused-the-crash ; Charles Duhigg, “Roots of the Crisis,” Frontline , Feb 17, 2009, http://www.pbs.org/wgbh/pages/frontline/ meltdown/themes/howwegothere.html . 503 CHRG-111shrg57320--324 Mr. Doerr," No. There is definitely a problem there. What we would expect is strong underwriting to take place, to take into account the ability of a borrower to handle a payment shock. If you are going to give them a teaser rate to attract them into the institution, that is fine, but you have to qualify them to be able to pay the loan as it resets. Senator Levin. Mr. Corston. " CHRG-111shrg50814--54 Mr. Bernanke," I think you do need to make sure there is adequate capital in financial institutions, and when they extend loans--for example, mortgages--they need to do a good job of underwriting. And that would involve adequate downpayments and verification of income, for example. Senator Schumer. But, again, I am saying there are institutions that use this leverage that you did not have any capital standards for because you were not statutorily required to do it. " CHRG-111hhrg53238--227 Mr. Menzies," Yes, sir. We believe that risk retention is an important part of the whole system. And at the same time, we hope those transactions that are clearly underwriting, like a conforming mortgage loan, don't get buried or weighted down in that process. But we think risk retention is an important part of the whole system. " 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). FinancialCrisisReport--229 The FDIC Inspector General also noted that, from 2004 to 2008, the FDIC had assigned LIDI ratings to WaMu that indicated a higher degree of risk at the bank than portrayed by the bank’s CAMELS ratings. He observed that LIDI ratings, which are intended to convey the degree of risk that a bank might cause loss to the Deposit Insurance Fund, are designed to be more forward-looking and incorporate consideration of future risks to a bank, as compared to CAMELS ratings, which are designed to convey the state of an institution at a particular point in time. 874 WaMu kept its 2 rating despite the five-year litany of lending, risk management, appraisal, and Long Beach deficiencies identified by OTS examiners from 2004 to 2008. It was only in February 2008, after the bank began to incur substantial losses, that OTS downgraded the bank to a 3. When the FDIC urged a further downgrade to a 4 rating in the summer of 2008, OTS disagreed. In September 2008, however, while still resisting the ratings downgrade, OTS acknowledged internally that WaMu’s poor quality loans and poor risk management were the source of its problems: “The bank’s overall unsatisfactory condition is primarily the result of the poor asset quality and operating performance in the bank’s major Home Loans Group area of business. … The deteriorating asset quality in the Home Loans Group is accompanied by inadequacies in risk management, internal controls, and oversight that made more vulnerable to the current housing and economic downturn. The examination criticized past liberal home loan underwriting practices and concentrated delivery of nontraditional mortgage products to higher risk geographic markets.” 875 It was only on September 18, 2008, after the bank began to run out of the cash needed to conduct its affairs and the FDIC independently downgraded the bank to a 4, that OTS finally agreed to the downgrade. One week later, OTS placed the bank into receivership. 872 See Thorson prepared statement at 11, April 16, 2010 Subcommittee Hearing at 111. 873 April 16, 2010 Subcommittee Hearing at 24-26. 874 See, e.g., Rymer prepared statement at 5. 875 9/11/2008 OTS document, “WaMu Ratings of 3/343432,” Polakoff_Scott-00065325, Hearing Exhibit 4/16-48. fcic_final_report_full--11 Unfortunately—as has been the case in past speculative booms and busts—we witnessed an erosion of standards of responsibility and ethics that exacerbated the fi- nancial crisis. This was not universal, but these breaches stretched from the ground level to the corporate suites. They resulted not only in significant financial conse- quences but also in damage to the trust of investors, businesses, and the public in the financial system. For example, our examination found, according to one measure, that the percent- age of borrowers who defaulted on their mortgages within just a matter of months after taking a loan nearly doubled from the summer of  to late . This data indicates they likely took out mortgages that they never had the capacity or intention to pay. You will read about mortgage brokers who were paid “yield spread premiums” by lenders to put borrowers into higher-cost loans so they would get bigger fees, of- ten never disclosed to borrowers. The report catalogues the rising incidence of mort- gage fraud, which flourished in an environment of collapsing lending standards and lax regulation. The number of suspicious activity reports—reports of possible finan- cial crimes filed by depository banks and their affiliates—related to mortgage fraud grew -fold between  and  and then more than doubled again between  and . One study places the losses resulting from fraud on mortgage loans made between  and  at  billion. Lenders made loans that they knew borrowers could not afford and that could cause massive losses to investors in mortgage securities. As early as September , Countrywide executives recognized that many of the loans they were originating could result in “catastrophic consequences.” Less than a year later, they noted that certain high-risk loans they were making could result not only in foreclosures but also in “financial and reputational catastrophe” for the firm. But they did not stop. And the report documents that major financial institutions ineffectively sampled loans they were purchasing to package and sell to investors. They knew a significant percentage of the sampled loans did not meet their own underwriting standards or those of the originators. Nonetheless, they sold those securities to investors. The Commission’s review of many prospectuses provided to investors found that this crit- ical information was not disclosed. T HESE CONCLUSIONS must be viewed in the context of human nature and individual and societal responsibility. First, to pin this crisis on mortal flaws like greed and hubris would be simplistic. It was the failure to account for human weakness that is relevant to this crisis. CHRG-111hhrg51591--93 Mr. Royce," I think she made my point. It was the investment side of the business that put at risk the underwriting side of the business. And that is why I think you need a Federal regulator to prevent that and to look at that. " CHRG-111hhrg58044--115 Mr. Wilson," Right. The credit factors or the score in conjunction with driving record, in conjunction with coverage amounts, in conjunction with prior losses, it all goes into the underwriting or rating of the policy. " 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? " FinancialCrisisInquiry--705 ROSEN: They take the riskiest piece of a security, they’ve underwritten it, and they feel confident of that underwriting and they keep that, and they’ve got a premium on the marketplace for their securities because they do that, the securitizations they do in the commercial mortgage area. FinancialCrisisReport--113 So we come down to the basic question, is this the time to expand beyond the ’05 Plan and/or to expand into new categories of higher risk assets? For my part I think not. We still need to complete EDE [Enterprise Decision Engine, an automated underwriting system], reduce policy exception levels, improve the pricing models, build our sub-prime collection capability, improve our modeling etc. We need to listen to our instincts about the overheated housing market and the likely outcome in our primary markets. We need to build further credibility with the regulators about the control exercised over our SFR underwriting and sub-prime underwriting particularly in LBMC.” 393 Mr. Vanasek retired in December 2005, in part, because the management support for his risk policies and culture was lacking. 394 When Mr. Vanasek left WaMu, the company lost one of the few senior officers urging caution regarding the high risk lending that came to dominate the bank. After his departure, many of his risk management policies were ignored or discarded. For example, by the end of 2007, stated income loans represented 73% of WaMu’s Option ARMs, 50% of its subprime loans, and 90% of its home equity loans. 395 Ronald Cathcart was hired in December 2005 to replace Mr. Vanasek, and became the Chief Enterprise Risk Officer. He had most recently been the Chief Risk Officer for Canadian Imperial Bank of Commerce’s retail bank. 396 Although the High Risk Lending Strategy was well underway, after Mr. Vanasek’s departure, risk management was in turmoil. Mr. Cathcart testified at the Subcommittee hearing: “When I arrived at WaMu, I inherited a Risk Department that was isolated from the rest of the bank and was struggling to be effective at a time when the mortgage industry was experiencing unprecedented demand for residential mortgage assets.” In early 2006, the bank reorganized WaMu’s risk management. 397 Under the new system, much of the risk management was subordinated to the WaMu business divisions, with each business division’s Chief Risk Officer reporting to two bosses, Mr. Cathcart and the head of the business unit to which the division’s Chief Risk Officer was assigned. WaMu referred to this system of reporting as a “Double-Double.” 398 393 2/24/2005 Washington Mutual memorandum from Jim Vanasek to the Executive Committee, “Critical Pending Decisions,” JPM_WM01265462-64. 394 Subcommittee interview of Jim Vanasek (12/18/2009 and 1/19/2010). 395 4/2010 IG Report, at 10, Hearing Exhibit 4/16-82. 396 Subcommittee interview of Ronald Cathcart (2/23/2010). 397 Id. 398 Id.; Subcommittee interviews of David Schneider (2/17/2010) and Cheryl Feltgen (2/6/2010). CHRG-111shrg51395--93 Mr. Coffee," I am glad you asked that question because it is a good question, but there are two major limitations on Rule 10b-5. As you have heard from others on this panel, it does not apply to aiders and abetters, even those who are conscious co-conspirators in a fraud. That is one limitation that Congress can address. And, two, when you try to apply Rule 10b-5 to the gatekeepers, whether it is the accountants or the credit rating agencies, you run up against the need to prove scienter. It is possible to have been stupid and dumb rather than stupid and fraudulent, and that is basically the defense of accountants and credit rating agencies. I think you need to look to a standard of scienter that will at least create some threat of liability when you write an incredibly dumb AAA credit report on securities that you have not even investigated, because you do not do investigations as a credit rating agency. You just assume with the facts that you are given by management. So I do think there is some need for updating the anti-fraud rules for the reasons I just specified. Senator Reed. Thank you. " FinancialCrisisInquiry--223 ROSEN: Yes, I would. I think that’s—the data seems to show that. THOMPSON: Yes, OK. Ms. Gordon, you talked about predatory practices, and you specifically said it seemed as though some of that might have been targeted at minorities, African- Americans and Hispanics. Do you have evidence to support that statement? And are there lawsuits or activities underway that would suggest that this is not just predatory, but perhaps illegal? GORDON: Well it’s well documented that African American and Latino families disproportionately received the expensive and dangerous subprime loans that we’ve been talking about. You—you know, there—there are Federal Reserve papers on this. The HUMDA data will show that to you, because it collects the demographic data that you need to get this. I think—in one—one data point I have in my testimony is that in 2006 among consumers who received conventional mortgages for single family homes, about half of African Americans and Hispanic borrowers received a higher rate mortgage compared to about one fifth of White borrowers. You know, our—our research has shown that African Americans and Latinos were much more likely to receive higher rate subprime loans. Another study has shown that minority communities were more likely to get loans with prepayment penalties even after controlling for other factors. You know, and like I said while it’s hard right now to get really good demographic data on foreclosures, you know, given that we know which loans have the highest rates of default, it’s not that hard to connect the dots. THOMPSON: Dr. Rosen, in your written testimony you gave a number of very thoughtful things that people should do as they thought about originating mortgages. And these seem to be quite simple. Better underwriting standards, better mechanisms that discourage speculation, so on and so forth. And since these seem so simple yet so necessary, in your opinion, why weren’t they done? CHRG-111shrg52966--62 Mr. Long," Well, I agree with what Scott said. I am not going to repeat it. I think we have ample authority to take whatever action we need. I think it is an oversimplification to say that this was a modeling problem. If you go back to the last time we went through this and you talk to the CEOs that went through this back in the late 1980s and early 1990s, they are going to tell you there are two things that got them: one was the concentrations, and number two, mitigating the policy overrides on the underwriting. Quite frankly, I think that is really the center of this thing. This was not that we missed a bunch of models. Clearly, the banks were not modeling in their tail risk that there would be a complete shutdown of the liquidity across the system. And that was a problem with their models. But this goes to basic underwriting, and it goes to basic concentration risk. They had too much of a bad deal, and that has compounding effects on liquidity, and on capital. And when the global liquidity market shut down, they had a real problem. So, yes, we look at all of it. We look at corporate governance. We look at underwriting. We look at all of the risk areas. And, clearly, we look at modeling, too. We have rigorous stress testing around those models. And, quite frankly, a lot of people missed it--they would stress tail risk in the company. They did not stress tail risk across the world. Senator Reed. Mr. Cole, briefly, if you could, please. I have additional questions. " CHRG-111hhrg48874--87 Mr. Long," I don't have a lot to add. It is a natural tendency for banks during downturns, particularly coming out of a period of very loose credit, where they pull back, they protect the balance sheet, they protect liquidity, and they protect capital and they tighten the underwriting standards. And Scott is absolutely right. I mean the fact that somebody lost a job and they want to get a loan but the don't have the repayment ability, most bankers probably are not going to make that loan. " 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--601 Unlike when a broker-dealer is acting as a market maker, a broker-dealer acting as an underwriter or placement agent has an obligation to disclose material information to every investor it solicits, including the existence of any material conflict of interest or adverse interest. This duty arises from two sources: the duties of an underwriter specifically, and the duties of a broker-dealer generally, when making an investment recommendation to a customer. With respect to the duties of an underwriter, the First Circuit has observed that underwriters have a “unique position” in the securities industry: “[T]he relationship between the underwriter and its customer implicitly involves a favorable recommendation of the issued security. … Although the underwriter cannot be a guarantor of the soundness of any issue, he may not give it his implied stamp of approval without having a reasonable basis for concluding that the issue is sound.” 2680 With respect to a broker-dealer, the SEC has held: “[W]hen a securities dealer recommends a stock to a customer, it is not only obligated to avoid affirmative misstatements, but also must disclose material adverse facts to which it is aware. That includes disclosure of ‘adverse interests’ such as ‘economic self interest’ that could have influenced its recommendation.” 2681 The SEC has also stated that, if a broker intends to sell a security from its own inventory and recommends it to a customer, “the broker dealer must disclose all material facts.” 2682 To help broker-dealers understand when they are obligated to disclose to investors material information, including any material adverse interest, FINRA has further defined the term “recommendation”: 2679 In the Matter of David Henry Disraeli and Lifeplan Associates , Securities Exchange Act Rel. No. 34-2686 (December 21, 2007) at 10-11 [citations omitted]. 2680 SEC v. Tambone , 550 F.3d 106, 135 (1st Cir. 2008) [citations omitted]. 2681 In the Matter of Richmark Capital Corporation , Securities Exchange Act Rel. No. 48757 (Nov. 7, 2003) (citing Chasins v. Smith Barney & Co., Inc ., 438 F.3d 1167, 1172 (2d. Cir. 1970) (“The investor … must be permitted to evaluate overlapping motivations through appropriate disclosures, especially where one motivation is economic self-interest”). See also SEC Study on Investment Advisers and Broker-Dealers at 55. In this recent study examining the disclosure obligations of broker-dealers and investment advisers, the SEC has explained: “Generally, under the anti-fraud provisions, a broker-dealer’s duty to disclose material information to its customer is based upon the scope of the relationship with the customer, which is fact intensive.” According to the SEC, when a broker-dealer acts as an order taker or market maker in effecting a transaction for a customer, the broker- dealer generally does not have a duty to disclose information regarding the security or the broker-dealer’s economic interest. The duty to disclose this information is triggered, however, when the broker-dealer recommends a security. Id. 2682 SEC Study on Investment Advisers and Broker-Dealers at 56, n.252. “[A] broad range of circumstances may cause a transaction to be considered recommended, and this determination does not depend on the classification of the transaction by a particular member as ‘solicited’ or ‘unsolicited.’ In particular a transaction will be considered to be recommended when the member or its associated person brings a specific security to the attention of the customer through any means, including, but not limited to, direct telephone communication, the delivery of promotional material through the mail, or the transmission of electronic messages.” 2683 CHRG-111shrg56415--43 Mr. Tarullo," This is on the consumer protection side. One of the needs to underwrite is to make sure that you are going to make an assessment based on the ability of the borrower to pay, not just on the rising value of the real estate, for example. " CHRG-111shrg57319--323 Mr. Beck," What we did subsequent to that, Mr. Chairman, is to do a due diligence review separate and distinct by the underwriter, WCC, or---- Senator Levin. Did you check to see whether they were removed before you put those securities on the market? " CHRG-111shrg50814--182 Mr. Bernanke," I would not want to make a complete blanket statement, but certainly the banks which are more directly regulated, and Federal regulators, did a better job on average of underwriting mortgages than did the non-federally regulated lenders. " CHRG-111shrg61651--53 Mr. Scott," And I could see a situation in which a customer's interest was adverse to the interest of a proprietary trader. The customer would have a position that the trader was taking the opposite side of. It could hurt the customer's position. Now, my understanding is, of course, that these activities are walled off and that the proprietary trading desk is totally separate from the people who would be dealing with the customers and that that really handles the situation. I should say that commercial banking is full of potential conflicts. This is not the only conflict. And indeed, in the debate over Glass-Steagall, the emphasis was not on this. It was actually on underwriting, which nobody is attacking here, and the thought was that banks who took positions in underwriting, were potentially exposed to risk on underwriting, would not act in the interest of their customers and force them to buy something in order to protect the bank from risk. Again, we handled that situation by trying to isolate activities within the organization. So I don't think--if you are really worried about conflicts, this is a much bigger issue, and I wouldn't start with proprietary trading if I were worried about it. Senator Johnson. Mr. Zubrow, at Tuesday's hearing with Chairman Volcker and Secretary Wolin, there was much discussion about how to define proprietary trading. In your testimony, you echo those concerns. If you were trying to prevent or stop the riskiest types of proprietary trading activities at commercial banks, how would you define proprietary trading? " CHRG-111shrg53085--55 Mr. Whalen," No, not at the moment. No. Absolutely not. Senator Shelby. Credit rating agencies--while many banks did not engage, as you said, in substandard underwriting for the loans they originated, many of these institutions bought and held so-called AAA-rated securities that were backed by the poorly underwritten mortgages. Mr. Patterson, I want to ask you this question. Why was it inappropriate for these institutions to originate these loans, but it was acceptable for them to hold the securities collateralized by them. " CHRG-111shrg57322--1051 Mr. Blankfein," I am sorry. I apologize. Senator McCaskill. She goes on to say, approximately 10 percent of the pool is flagged as potential REO or potential unsecured or second lien. Another 5 percent of the pool was originally fraudulently based on the DD results. Main findings, possible ID theft, broker misrepresentation, straw buyer, falsification of information origination documents. And then she says, there is a reputation headline risk, as well. Now, I am not sure if these--you did issue a bunch of New Century mortgages at or around that time in a CDO, in one of these instruments. I can't say that these are the ones that you issued, but what it tells me is you had internal analysis on these mortgages. " CHRG-111hhrg58044--80 Mr. Snyder," Congress continued the ability of insurers to use credit information for insurance underwriting, and that has long been the case. Congress continued that through the recent amendments. The recent amendments also made the whole credit scoring system better. Frankly, we have a major interest in making sure that scores are accurate and that people have access to their credit history and the ability to correct any issues that may exist. I think the Congress improved all of that through the most recent amendments, but did maintain the long-standing ability on the part of insurers to use credit for underwriting subject to Federal law under the Fair Credit Reporting Act, and all that implies as well as being currently State regulated, all the State regulation that applies as well. " CHRG-111hhrg48874--78 Mr. Long," And Congressman, we hear that too, and I think it's a good point, and I think it's a good purpose of this hearing, and of the outreach that we do with the bankers. I know that there is a fine line of when underwriting standards get too loose and banks are taking on too much risk, and the line of-- " 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? " FinancialCrisisReport--189 These problems continued without resolution or enforcement action from OTS throughout 2007. In an April 2007 memorandum, OTS detailed its concerns, both old and new, with WaMu’s appraisal operations. OTS found that WaMu had failed to update and revise its appraisal manual after outsourcing, which put the bank at risk of regulatory violations. In addition, an OTS review of 54 WaMu appraisals identified a number of concerns: “Primary appraisal issues (red flags requiring attention by the underwriter or review appraiser) included seller paid closing costs and concession, misstatements/ contradictions, inadequate/incomplete explanations and support for the value conclusion, reconciliation of the sales comparison approach, and weakness in the appraisal review process.” 704 Despite the extent of these concerns, OTS issued a “recommendation” to the bank that it address the identified problems, rather than the stronger “criticism” which would have elevated the issue to the bank’s senior management or Board of Directors. 705 Attorney General Complaint. On November 1, 2007, the New York Attorney General issued a complaint against WaMu’s appraisal vendors, LSI and eAppraiseIT, alleging fraud and collusion with WaMu to systematically inflate real estate values. 706 The complaint stated in part: “[F]irst American and eAppraiseIT have abdicated their role in providing ‘third-party, unbiased valuations’ for eAppraiseIT’s largest client, WaMu. Instead, eAppraiseIT improperly allows WaMu’s loan production staff to hand-pick appraisers who bring in appraisal values high enough to permit WaMu’s loans to close, and improperly permits WaMu to pressure eAppraiseIT appraisers to change appraisal values that are too low to permit loans to close.” 707 Though OTS had been aware of the Attorney General’s investigation in May 2007, it took no action until after the Attorney General issued the complaint. Even then, OTS did not initiate its own investigation until after an internal WaMu investigation was already underway. The OTS Western Region Director advised: “I believe OTS needs to open up its own special investigation. WaMu started their own special investigation a few days ago when this broke.” 708 703 2/21/2007 draft internal WaMu report, “Residential Appraisal Department Review,” OTSWMEN-0000000274 (drafted by Mark Swift). 704 4/5/2007 OTS Asset Quality Memo 2, OTSWME07-067 0001082. 705 Id. 706 11/1/2007 New York Attorney General press release, http://www.ag.ny.gov/media_center/2007/nov/nov1a_07.html. Both companies appraised property in New York, which provided jurisdiction for the complaint. 707 New York v. First American Corporation , et al., (N.Y. Sup.), Complaint (November 1, 2007), at 3. 708 11/7/2007 email from Darrel Dochow to Benjamin Franklin, Randy Thomas, others, OTSWMS07-011 0001294. 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. 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. CHRG-111hhrg54872--162 Mr. Marchant," But many of those loans were made and insured by Fannie Mae and Freddie Mac. Ms. Bowdler. They have multiple--all these institutions have within them a wide range of products. So they will have a product that I--again just speaking for the clientele that we work with--that could have worked for Latino families, but maybe it required manual underwriting or didn't pay as high of a commission and so it wasn't put out there in a big way. " CHRG-111hhrg56778--127 Mr. Dilweg," So in a different scenario, Congressman, where you're simply paying for IT or services, administrative services. You can't have the holding company overcharging the insurance company just to make money as far as business operations, underwriting, things like that. " CHRG-111shrg53085--185 Chairman Dodd," Ms. Hillebrand, how do you respond to this? You are already involved in consumer protection, and know about these functions that are required of our community banks and regional banks and the like. In fact, I remember the CRA debate. During the largest debate, which was over Gramm-Leach-Bliley, I was not sitting in this chair. I was sitting several chairs down from here in that debate. We stayed up all night on Gramm-Leach-Bliley. People were going back and forth and talking about the whole notion of commerce and banking, and that is a legitimate question to have raised with that legislation. But the debate all night was, as we resolved those matters, was over CRA. That is how we came to the conclusion as to whether or not we could have a Community Reinvestment Act and how it would work, and ultimately resolved in favor of one. I love to point out to people, because I know there is an argument to the contrary, that if you look at institutions that follow CRA guidelines on mortgage lending and underwriting standards, only about 6 percent ended up in foreclosure. Where CRA was being followed and where the underwriting standards were adhered to, poorer people were actually getting into homes on terms they could afford. It is when you stepped out of that process with the no-doc loans, the liar loans, and the like, that this whole system fell apart. That, to me, is always going to be the root cause of all of this, in a sense. That was not a community banking issue, that was a different matter. But I wonder if you might respond to this point that Mr. Attridge and my community bankers raised. We are already doing this. We are working our heads off every single day at this stuff. You are going to overload us with some additional burdens here we can't possibly comply with. Ms. Hillebrand. Mr. Chairman, thank you for your earlier remarks about the Financial Product Safety Commission. We don't believe we will overload anyone who is treating their customer fairly and responsibly. This would create rules that apply across the board to make the products simple enough for the customer to use without those ``gotchas'' and tricks. Credit unions and community banks came very late to some of those tricks and traps, but when everyone else is doing it, it does create a pressure and it is a profit center for your competitors if they are doing it and you are not. That can be a problem. In addition, the bank regulatory model of supervision will still exist. There will still be safety and soundness regulation. Of course, consumer protection will still be a piece of safety and soundness. But what bank regulators look at is compliance. Was a current law broken? What the Financial Product Safety Commission would do is be an ``unfairness practices regulator'' where no current law has been broken. As the Wall Street Journal said recently about some hedge fund conduct, ``it was perfectly legal when it occurred.'' It would be those things the Financial Product Safety Commission would make rules about, not all of them, but the ones that go too far. " CHRG-111shrg57319--61 Mr. Vanasek," Yes, that is correct. Senator Levin. And the memo discusses a year-long internal investigation that WaMu's own employees conducted into suspected fraud affecting loans issued by the Montebello and Downey offices, which are referred to as Community Fulfillment Centers (CFCs). Among the findings, here is what the memo says, in the middle of the page there: `` . . . an extensive level of loan fraud exists in the Emerging Markets CFCs, virtually all of it stemming from employees in these areas circumventing bank policy surrounding loan verification and review . . . 42% of the loans reviewed''--and this, again, is in the middle of the page--``42% of the loans reviewed contained suspect activity or fraud, virtually all of it attributable to some sort of employee malfeasance or failure to execute company policy.'' Behind Exhibit 22a is that PowerPoint presentation, Exhibit 22b,\1\ called ``Retail Fraud Risk Overview,'' and that provides a lot of detail about this 2005 investigation, as well as Exhibit 23b,\2\ which is an email with data showing that the percentage of loans containing fraudulent information at the Montebello office was 83 percent and the percentage at the Downey office was 58 percent.--------------------------------------------------------------------------- \1\ See Exhibit No. 22b, which appears in the Appendix on page 497. \2\ See Exhibit No. 23b, which appears in the Appendix on page 511.--------------------------------------------------------------------------- So now back to Exhibit 22b. It gives some examples of the fraud found. Here is one on page 10 of that memo, ``Fraud Loan Samples.'' Here is what that sample says. This is page 10, Exhibit 22b, loan number, and it gives the number. ``Misrepresentation [of] the borrower's identification and qualifying information were confirmed in every aspect of this file''--misrepresentation, every aspect of this file--``including Income . . . Possible Strawbuyer or Fictitious borrower. The credit package was found to be completely fabricated. Throughout the process, red flags were over-looked, process requirements were waived. . . .'' Mr. Vanasek, those fraud percentages, 83 percent, 58 percent, those are truly eye-popping numbers, are they not? " fcic_final_report_full--495 However, there is no diffi culty finding the source of the reductions in mortgage underwriting standards for Fannie and Freddie, or for the originators for whom they were the buyers. HUD made clear in numerous statements that its policy—in order to make credit available to low-income borrowers—was specifically intended to reduce underwriting standards. The GSE Act enabled HUD to put Fannie and Freddie into competition with FHA, and vice versa, creating what became a contest to lower mortgage standards. As the Fannie Mae Foundation noted in a 2000 report, “FHA loans constituted the largest share of Countrywide’s [subprime lending] activity, until Fannie Mae and Freddie Mac began accepting loans with higher LTVs [loan-to-value ratios] and greater underwriting flexibilities.” 70 Under the GSE Act, the HUD Secretary was authorized to establish affordable housing goals for Fannie and Freddie. Congress required that these goals include a low and moderate income goal and a special affordable goal (discussed below), both of which could be adjusted in the future. Among the factors the secretary was to consider in establishing the goals were national housing needs and “the ability of the enterprises [Fannie and Freddie] to lead the industry in making mortgage credit available for low-and moderate-income families.” The Act also established an interim affordable housing goal of 30 percent for the two-year period beginning January 1, 1993. Under this requirement, 30 percent of the GSEs’ mortgage purchases had to be affordable housing loans, defined as loans to borrowers at or below the AMI. 71 Further, the Act established a “special affordable” goal to meet the “unaddressed needs of, and affordable to, low-income families in low-income areas and very low-income families.” This category was defined as follows: “(i) 45 percent shall be mortgages of low-income families who live in census tracts in which the median income does not exceed 80 percent of the area median income; and (ii) 55 percent shall be mortgages of very low income families,” which were later defined as 60 percent of AMI. 72 Although the GSE Act initially required that the GSEs spend on special affordable mortgages “not less than 1 percent of the dollar amount of the mortgage purchases by the [GSEs] for the previous year,” HUD raised this requirement substantially in later years. Ultimately, it became the most diffi cult affordable housing AH burden for Fannie and Freddie to meet. Finally, the GSEs were directed to: “(A) assist primary lenders to make housing credit available in areas with low-income and minority families; and (B) assist insured depository institutions to meet their obligations under the Community Reinvestment Act of 1977.” 73 There will be more on the CRA and its effect on the quality of mortgages later in this section. Congress also made clear in the act that its intention was to call into question the high quality underwriting guidelines of the time. It did so by directing Fannie and Freddie to “examine— 70 Fannie Mae Foundation, “Making New Markets: Case Study of Countrywide Home Loans,” 2000, http://content.knowledgeplex.org/kp2/programs/pdf/rep_newmortmkts_countrywide.pdf . 71 72 73 GSE Act, Section 1332. Id., Section 1333. Id., Section 1335. 491 (1) The extent to which the underwriting guidelines prevent or inhibit the purchase or securitization of mortgages for houses in mixed-use, urban center, and predominantly minority neighborhoods and for housing for low-and moderate- income families; (2) The standards employed by private mortgage insurers and the extent to which such standards inhibit the purchase and securitization by the enterprises of mortgages described in paragraph (1); and (3) The implications of implementing underwriting standards that— (A) establish a downpayment requirement for mortgagors of 5 percent or less; (B) allow the use of cash on hand as a source of downpayments; and (C) approve borrowers who have a credit history of delinquencies if the borrower can demonstrate a satisfactory credit history for at least the 12-month period ending on the date of the application for the mortgage.” 74 CHRG-111shrg57320--12 Mr. Rymer," Yes, sir, I do. I really can see no practical reason from a banker's perspective or lender's perspective to encourage that. That is just, to me, an opportunity to essentially encourage fraud. Senator Levin. Now, on the Option ARMs issue, OTS allowed Washington Mutual to originate hundreds of billions of dollars in these Option Adjustable Rate Mortgages, these Option ARMs. OTS was also allowing the bank to engage in a set of high-risk lending practices in connection with the Option ARMs. Some of these high-risk lending practices included low teaser rates as low as 1 percent in effect for as little as a month to entice borrowers; qualifying borrowers using lower loan payments than they would have to pay if the loan were recast; allowing borrowers to make minimum payments, resulting in negatively amortizing loans; approving loans presuming that rising housing prices and refinancing would enable borrowers to avoid payment shock and loan defaults. Now, it was the Option ARM loans in 2008 that was one of the major reasons that investors and depositors pulled their money from the bank, and did those Option ARMs, particularly when connected with those other factors, raise a real safety and soundness problem at WaMu? Mr. Thorson. " CHRG-111hhrg51698--323 Mr. Morelle," Well, presumably, we would have the underwriters of those bonds. The sellers of protection would be treated in a manner similar to the way that we treat monoline insurers, those who write bond insurance and are required to reserve on the contracts that they write. " CHRG-109shrg24852--50 Chairman Greenspan," We do not need any legislative remedy. It is wholly under the regulatory authorities of the banking agencies. Senator Allard. Do you think the banks are utilizing proper underwriting standards for these type of products, and are we having more of a problem in certain States than in other States? " CHRG-111shrg50815--88 Mr. Clayton," Let me jump in for a second in terms of answering that first question. Interest rates are not just determined by how much it costs, the Fed prices its loans. Interest rates are determined by lots of other things, including delinquencies in the marketplace, which have gone up, as well as the cost of securitization, where spreads have increased significantly. What that means is investors are demanding more return in order to underwrite or fund card loans. Senator Tester. Real quickly, Doctor. " 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: CHRG-111shrg57319--487 Mr. Killinger," Well, again, market conditions changed very dramatically with housing prices coming down and there are a number of things that we changed. As you heard this morning, we tightened underwriting. We changed loan products. We ceased offering some of the subprime products. We ceased offering Option ARMs. We started to go back to more documentation on the loans. And there were just a number of things that became more appropriate because the housing conditions changed so dramatically. Senator Kaufman. So it was just right then when you really found out how bad stated loans were? " CHRG-111hhrg54867--181 Mr. Manzullo," A lot of people believe that if the Fed had done its role, statutory role, which is to govern instruments and underwriting standards with regard to those mortgages, that we wouldn't have had this meltdown. In other words, the basic product that gave rise to the derivatives and the CDOs would have been sound. " CHRG-111shrg57320--239 Mr. Carter," They were not fully effective in addressing all the underwriting issues. Senator Levin. How about saying, instead of ``not fully effective,'' use more direct language like ``they were ineffective?'' I got that not fully effective throughout your ratings here. They were not fully effective. How about saying ``ineffective?'' " 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-109shrg26643--106 Chairman Bernanke," We have put out guidance for comment on nontraditional mortgages and I think that it is good guidance. It addresses what I think are the main issues. First, are banks underwriting nontraditional mortgages in an appropriate way? In particular, are they selling these mortgages to people who are able to manage them effectively? " CHRG-111shrg57319--95 Mr. Vanasek," I really couldn't answer that. They did bridge into Option ARMs and other products over time, but I can't speak to their interest in purchasing fixed rate versus adjustable rate. Senator Coburn. During your time, underwriting standards across the industry declined. " CHRG-111hhrg58044--153 Mr. McRaith," Insurance companies typically will contract with a vendor that will provide or develop the insurance score on which the underwriting decisions and pricing are determined by that insurance company. Some of the larger companies have their own independent proprietary insurance scoring formula. " CHRG-111hhrg58044--127 Mr. Snyder," Absolutely. Auto insurance rating generally involves not only credit information but the age of the driver, the prior driving experience, the make and model of the vehicle, and on and on. The ultimate underwriting and rating decision is based upon many factors, only one of which is credit. " FinancialCrisisInquiry--723 THOMPSON: Dr. Rosen, in your written testimony you gave a number of very thoughtful things that people should do as they thought about originating mortgages. And these seem to be January 13, 2010 quite simple. Better underwriting standards, better mechanisms that discourage speculation, so on and so forth. And since these seem so simple yet so necessary, in your opinion, why weren’t they done? CHRG-111shrg57319--23 Mr. Vanasek," They had not performed well as time went on. There had always been questions about the underwriting of Long Beach mortgages. The company went through, during my tenure, three changes in executive management in order to more effectively manage the company. Senator Levin. At least that was the goal. " CHRG-111shrg50564--561 VOLCKER Q.1. There is pressure to move quickly and reform our financial regulatory structure. What areas should we address in the near future and which areas should we set aside until we realize the full cost of the economic fallout we are currently experiencing? A.1. I recognize the desire to move quickly to reform the financial regulators structure, but more important is to get it right. Speed should not become the enemy of the good, and a piece-meal approach may inadvertently prejudice the thoroughgoing comprehensive measures we need. There may be a few measures--such as the proposed new crisis resolution procedure--that may be usefully enacted promptly, but we still have much to learn from unfolding experience and about the need to achieve international consistency. Q.2. The largest individual corporate bailout to date has not been a commercial bank, but an insurance company. Given the critical role of insurers in enabling credit transactions and insuring against every kind of potential loss, and the size and complexity of many insurance companies, do you believe that we can undertake serious market reform without establishing Federal regulation of the insurance industry? A.2. Consideration of Federal regulation of insurance companies and their holding companies is an example of the need for a comprehensive approach. A feasible starting point should be the availability of a Federal charter, at least for large institutions operating inter-state and internationally, with the implication of Federal supervision. Q.3. As Chairman of the G-30, can you go into greater detail about the report's recommended reestablishment of a framework for supervision over large international insurers? Particularly, cm you provide some further details or thoughts on how this recommendation could be developed here in the United States? Can you comment on the advantages of creating a Federal insurance regulator in the United States? A.3. As indicated, the absence of a Federal charter and supervision for insurance companies is a gap in our current regulatory framework. I am not prepared now to opine whether the Federal regulator should be separate from other supervisory agencies but some means of encouraging alignment is necessary. Again, I'd prefer to see the issue resolved in the context of a more comprehensive approach; in this case including consideration of appropriate and feasible international standards. Q.4. How should the Government and regulators look to mitigate the systemic risks posed by large interconnected financial companies? Do we risk distorting the market by identifying certain institutions as systemically important? How do foreign countries identify and regulate systemically critical institutions? A.4. The question of mitigating systemic risks is a key issue in financial reform, and can be approached in different ways. Specifically identifying particular institutions as systemically important, with the implication of special supervisory attention and support, has important adverse implications in terms of competitive balance and moral hazard. I am not aware of any foreign country that explicitly identifies and regulates particular systemically critical institutions, but in practice sizable banking institutions have been protected. An alternative approach toward systemic risk would be to provide a designated regulatory agency with authority to oversee banks and other institutions, with a mandate to identify financial practices (e.g., weak credit practices, speculative trading excesses, emerging ``bubbles'', capital weaknesses) that create systemic risk and need regulatory supervision. Particular institutions need not be identified for special attention. Q.5. In your testimony you say that you support continuing past U.S. practice of prohibiting ownership or control of Government-insured, deposit-taking institutions by non-financial firms. What are your thoughts on the commercial industrial loan company (ILC) charter? Should this continue to exist? A.5. I do believe recent experience only reinforces long-standing American aversion to mixtures of banking and commerce. The commercial industrial loan companies and other devices to blur the distinction should be guarded against, severely limited if not prohibited. ------ RESPONSE TO WRITTEN QUESTIONS OF SENATOR JOHNSON FROM GENE L. fcic_final_report_full--170 ALL IN CONTENTS The bubble: “A credit-induced boom” ................................................................  Mortgage fraud: “Crime-facilitative environments” ..........................................  Disclosure and due diligence: “A quality control issue in the factory” ................  Regulators: “Markets will always self-correct” ...................................................  Leveraged loans and commercial real estate: “You’ve got to get up and dance” ...................................................................  Lehman: From “moving” to “storage” ................................................................  Fannie Mae and Freddie Mac: “Two stark choices” ...........................................  In , the Bakersfield, California, homebuilder Warren Peterson was paying as lit- tle as , for a ,-square-foot lot, about the size of three tennis courts. The next year the cost more than tripled to ,, as real estate boomed. Over the pre- vious quarter century, Peterson had built between  and  custom and semi-custom homes a year. For a while, he was building as many as . And then came the crash. “I have built exactly one new home since late ,” he told the FCIC five years later.  In , the average price was , for a new house in Bakersfield, at the southern end of California’s agricultural center, the San Joaquin Valley. That jumped to almost , by June .  “By , money seemed to be coming in very fast and from everywhere,” said Lloyd Plank, a Bakersfield real estate broker. “They would purchase a house in Bakersfield, keep it for a short period and resell it. Some- times they would flip the house while it was still in escrow, and would still make  to .”  Nationally, housing prices jumped  between  and their peak in ,  more than in any decade since at least .  It would be catastrophically downhill from there—yet the mortgage machine kept churning well into , apparently in- different to the fact that housing prices were starting to fall and lending standards to deteriorate. Newspaper stories highlighted the weakness in the housing market— even suggesting this was a bubble that could burst anytime. Checks were in place, but  they were failing. Loan purchasers and securitizers ignored their own due diligence on what they were buying. The Federal Reserve and the other regulators increasingly recognized the impending troubles in housing but thought their impact would be contained. Increased securitization, lower underwriting standards, and easier access to credit were common in other markets, too. For example, credit was flowing into commercial real estate and corporate loans. How to react to what increasingly ap- peared to be a credit bubble? Many enterprises, such as Lehman Brothers and Fannie Mae, pushed deeper. CHRG-111shrg56262--42 Chairman Reed," Senator Gregg. Senator Gregg. That is very kind of you, Senator. First off, I thought your testimony was exceptional and very, very helpful and constructive, everyone's, and the fact that you were concise and had specific thoughts and ideas as to what we should do is extremely useful. My opening thought, though, however, as I listened to all of you, was does any of this need to be legislated? It sounds to me like almost every specific proposal you have suggested should fall to a regulatory agency to do, and most of it went to underwriting and better underwriting standards, it seemed like. So I would ask anybody on the panel, is there anything here that needs legislation to accomplish it versus just having the proper regulatory agencies noticed that this is the way we should approach these issues? Ms. McCoy. Senator, if I may, I have jotted down eight different things, and we can divide them between the private market and Government intervention. I think representations and warranties, recourse clauses, standardizing products, and having a functioning resale market for mortgage-backed securities is probably a private sector function, although the Government might convene discussions along those lines. But for Government action---- Senator Gregg. I am talking about Congressional action, not---- Ms. McCoy. Yes. Yes. I believe that better disclosures to investors can be handled by the SEC directly and Congress does not need to intervene there. Better underwriting standards, I think, do need Congressional action because the Fed is still not sufficiently aggressive and there is very strong legislation in both chambers along those lines. Higher capital standards, I believe banking regulators will address. Rating agency reform may very well need Congressional attention. Senator Gregg. I would just note that I think if you are going to have a uniform underwriting standard, you don't want that written into law if you want to have flexibility on how---- Ms. McCoy. Yes, but I believe---- Senator Gregg. That is going to require some mutation. Ms. McCoy. The authorization needs to come from Congress and then delegated, I have proposed, to the new agency. Senator Gregg. You don't think that power already exists within the Fed or---- Ms. McCoy. Well, the power may exist within the Fed, but the Fed is not exercising it effectively. Senator Gregg. OK. So does anybody else have Congressional action that is required? " CHRG-111hhrg48873--426 Secretary Geithner," No concern about that particular issue. But, of course, we knew where he was coming from and what his experience was, but that broad mix of experience made him an exceptionally qualified person to take this job. Mr. Miller of North Carolina. Okay. I have been assuming all along that we had smart, aggressive, mean lawyers looking at possible personal liability claims against people who have been involved personally in these decisions; that, yes, these companies are now unable to pay their bills, unable to pay their debts, but a couple of years ago were doing fabulously well. That money is now gone. In the words of the country music song, it is in a bank in someone else's name. And we have showed very little interest, Mr. Liddy showed no interest, in pursuing personal liability claims against officers or directors or employees based upon breach of fiduciary duty, or other fraud, fraudulent conveyance, negligence, any other theory. Are we looking at personal liability claims against the people who are involved in these decisions and have profited fabulously from them? " FOMC20061212meeting--161 159,VICE CHAIRMAN GEITHNER., The other difference between exhibits 4 and 5 is “weaker” versus “subdued.” Does “subdued” sound weaker than “weak”? [Laughter] Or is “weak” weaker than “subdued”? CHRG-111hhrg58044--165 Mr. Neugebauer," I think one of my colleagues asked the question and I want to rephrase it just a little bit, is it fair to say that because of the underwriting tools, credit report being one of them, and other information, that people can actually effectively lower their insurance costs by good behavior? " CHRG-111shrg50564--109 Chairman Dodd," I won't ask you to comment on this, but since your knowledge and background in accounting, the FASB model, and I realize they are very different functions we are talking about here, but a FASB model has worked fairly well in accounting standards, particularly when we got away from the industry supporting it and financially underwriting it. " CHRG-111shrg53085--144 Mr. Attridge," We haven't changed our underwriting criteria. What has changed is the economic environment we are lending in. Senator Schumer. So if a credit union would want to lend to this small business and the local community banker for whatever reason wouldn't, why not let them? Mr. Whalen. " CHRG-111hhrg51592--103 Mr. Dobilas," They do not have the same basic philosophy when it comes to surveillance. Their major emphasis has always been on the pre-issue, the new issue marketplace. That's where they make most of their money. The surveillance model wouldn't be in existence today if the rating agencies were doing a good job on the surveillance side. Monthly surveillance, we listen to investors, investors are our clients. I started in the rating agency business about 15 years ago, and I can tell you, there has been really no major changes with regards to clarity and transparency to investors until Realpoint came along on the CMBS side. We are offering a different business model to investors, which investors are very supportive of. We don't want to tell them what the right answer is, but we want them to understand fully what our analysis is and how we got to that analysis. By underwriting all of the underlying commercial properties, showing them our underwriting, you know, they're seeing something that they have never seen before, and it proves to be a more reliable rating than the reactive ratings of our counterparts. " CHRG-111shrg55739--123 Mr. Coffee," I think they are going to be sued directly because they made fraudulent misstatements, and that is how they are being sued. I do not think--I think the plaintiffs' bar regards the rating agencies as a possible additional party to throw in, but they have very modest expectations of what they can get from them, and they have not gotten any significant settlements. Senator Bunning. Well, the question--I am over time. Thank you. Senator Reed. If you want to take some more time? Senator Bunning. Well, the only thing I wanted to ask is if here we have a situation where they were not given enough information or they did not investigate far enough with the mortgage-backed securities, and they accepted the fact that these were legitimate mortgage-backed securities by the banks, then I see where they would not be held responsible. But if they did not go into the details of what kind of mortgages they were selling or were being sold, then I think they should be held responsible. " fcic_final_report_full--171 All along the assembly line, from the origination of the mortgages to the creation and marketing of the mortgage-backed securities and collateralized debt obligations (CDOs), many understood and the regulators at least suspected that every cog was reliant on the mortgages themselves, which would not perform as advertised. THE BUBBLE: “A CREDITINDUCED BOOM ” Irvine, California–based New Century—once the nation’s second-largest subprime lender—ignored early warnings that its own loan quality was deteriorating and stripped power from two risk-control departments that had noted the evidence. In a June  presentation, the Quality Assurance staff reported they had found severe underwriting errors, including evidence of predatory lending, legal and state viola- tions, and credit issues, in  of the loans they audited in November and December . In , Chief Operating Officer and later CEO Brad Morrice recommended these results be removed from the statistical tools used to track loan performance, and in , the department was dissolved and its personnel terminated. The same year, the Internal Audit department identified numerous deficiencies in loan files; out of nine reviews it conducted in , it gave the company’s loan production depart- ment “unsatisfactory” ratings seven times. Patrick Flanagan, president of New Cen- tury’s mortgage-originating subsidiary, cut the department’s budget, saying in a memo that the “group was out of control and tries to dictate business practices in- stead of audit.”  This happened as the company struggled with increasing requests that it buy back soured loans from investors. By December , almost  of its loans were going into default within the first three months after origination. “New Century had a brazen obsession with increasing loan originations, without due regard to the risks associated with that business strategy,” New Century’s bankruptcy examiner reported.  In September —seven months before the housing market peaked—thou- sands of originators, securitizers, and investors met at the ABS East  conference in Boca Raton, Florida, to play golf, do deals, and talk about the market. The asset- backed security business was still good, but even the most optimistic could read the signs. Panelists had three concerns: Were housing prices overheated, or just driven by “fundamentals” such as increased demand? Would rising interest rates halt the market? And was the CDO, because of its ratings-driven investors, distorting the mortgage market?  CHRG-111shrg57319--29 Mr. Melby," That is a fair assessment. Senator Levin. And did it find that Long Beach had weak controls over the loan approval process? " CHRG-111shrg57322--187 Mr. Sparks," Dr. Coburn, yes, and--well, I do not know exactly what they knew. It would have been determined under the diligence they did. But I will tell you, Goldman Sachs also many times invested in the equity of those deals. Senator Coburn. I understand. Everything can be invested in if the price is right compared to the risk. I am not disputing that. But I am going back to the question that you have AAA rating on stated income loans, on packages you put together to underwrite. Correct? " CHRG-111shrg57320--47 Mr. Thorson," We talked about asset quality, and we talked about underwriting and also management, all three of those. It is not any one thing. I mean, it was really something pervasive, and it really comes down to following a greater desire to do whatever you could do to increase profits. When you really get down to it, that is what this was all about. We are going to increase the risk in order to increase our profitability, and it does not matter what---- Senator Coburn. Yes, but I am talking about OTS. I am not talking about WaMu. By your statement, it would imply almost that OTS is an enabler of this effort rather than an enabler of making sure that the American people's taxpayer dollars and the trust in institutions that are supposed to be regulated by an agency of the Federal Government can be trusted. " CHRG-111shrg57319--178 Mr. Vanasek," Well, it is very difficult, obviously. If you will permit me, Senator, a short story. Earlier on in my career at the bank, I conducted three meetings with groups of underwriters in the mortgage area at three different locations, and I asked them one simple question: Can you make the decisions that you arrive at hold? And the answer was universally no, because the loans were always escalated up, so if they declined a loan, it was escalated to a higher level, a marketing manager who would ultimately approve. That was part of the environment. Senator Levin. Basically they did not want to slow down loan production. " FinancialCrisisInquiry--368 BLANKFEIN: Good product that does—that creates the exposure that these professional investors are seeking. Right now you could buy—we would underwrite distressed product as long as we disclose it, help somebody move that distressed product off their balance sheet, and give it to somebody, a sophisticated investor, knowing what the product did would give them that exposure. CHRG-109shrg26643--108 Chairman Bernanke," Mr. Chairman, as I was saying, the guidance includes several components, including both underwriting and consumer disclosure to protect consumers, but also safety and soundness. The banks should manage the risks associated with nontraditional mortgages in a way that maintains their capital at a safe and sound level. " 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. " CHRG-111hhrg67816--97 Mr. Leibowitz," Sure. I mean when we bring these cases, and, by the way, the Hope Now case is a case that involved an advance fee of $1,000 to $1,500. My understanding is that when consumers--consumers got no help whatsoever or very little assistance. When they asked for their money back, it was done. So when we bring these cases, we try to ask for a disgorgement of profits. We try to get redress to consumers. In the case we brought against Bear Stearns as a subsidiary, EMC we got 86,000 redress checks issued. But it is tough because sometimes these assets dissipate and sometimes it is hard to determine, you know, not in these cases but in other cases which ones were fraudulently made or which advertisements were deceptive and which ones weren't and that is why a penalty authority will be very helpful to us if we can get it. Ms. Matsui. Well, do you think Congress should ban these advance fees? " CHRG-111hhrg56778--84 Mr. Garrett," Okay. You also mentioned in your testimony that the Federal Reserve supervisory approach also recognizes the additional risk arising from the underwriting of life insurance policies and property and casualty insurance policies. I guess, in a nutshell, since time is limited here, can you explain for us some of what you mean by that? " CHRG-110hhrg34673--101 Mr. Bernanke," I share your concern. As I was discussing earlier, our nontraditional mortgage guidance is very clear that lenders should, first of all, make sure people understand what it is they are signing, what they are getting involved in, and secondly should underwrite in such a way that if the borrower stays in that mortgage and rates go up, then the borrower will be able to make the payments and not be foreclosed. " CHRG-111shrg56262--46 Chairman Reed," Senator Corker. Senator Corker. Thank you, Mr. Chairman, and I am sorry I missed part of the end of the testimony going to another hearing, but I got the general idea. Focusing on commercial real estate right now, I know there has been a lot of discussion. We were just in New York, lots of people concerned about this huge amount of indebtedness that is coming due, huge amounts of loans done 10 years ago. You had 10-year term, 30-year ARM. In essence, you kind of sold the project at that time because it was almost--you almost got full value because underwriting was so loose, so you kind of wondered, what is the problem? These have got to roll over, and the developer kind of sold the deal on the front end. But I guess as we--and I know that is not the case in every case. But what is the key? Some organization that wants to begin originating commercial real estate loans again and securitizing them from just doing those things and market needs to make those be sold by keeping recourse or doing other kinds of things? I just don't get it, really. The real estate values are dropping. You are underwriting at lower levels. The bond holders today are going to take a haircut to get financed out. The developer is going to have a little bit different deal or lose his property, but what is to keep the private market from just functioning right now? I really don't get it, and I don't understand why the focus is on us. " CHRG-111shrg57322--908 Mr. Blankfein," Senator, we could do a public issue of an oil company tomorrow, an IPO of an oil company that goes out and searches for oil. It is not--when we sell that company, and as an underwriter, we make sure there is due diligence because our obligations of an underwriter are disclosure and due diligence and that is very well established. But we can tell our investors, if they want an exposure to an oil company and they understand the risks and we do a good job in diligence and we do all the disclosures that are required by ourselves and all the regulators, we can sell that security and we will not necessarily disclose and won't even know--and the buyer won't care--we could be negative on the equity market and negative on the oil market. It still won't matter---- Senator Levin. Speaking about that security---- Mr. Blankfein [continuing]. To that buyer of the security. Senator Levin. Mr. Blankfein, stick to the point. I am talking about that security that you are selling out there. You go out and sell that security, oil security, I don't care what kind it is---- " FOMC20080430meeting--160 158,MR. STOCKTON.," Yes, 1980�82 is in there. Again, the composition of where these residuals are is obviously heavily tilted in this case to housing, some of which is already behind us. So it isn't quite as though all of this weakness is prospective. Some of this weakness we have already had, and so there are very big negative residuals now on housing relative to where you would otherwise have been. " CHRG-111hhrg51698--159 Mr. Pomeroy," We are over our time. They are basically the market maker on assessing the value of the underlying instrument. Whatever happened to underwriting? How come we can't just evaluate what the likelihood is this thing is actually going to get paid back and establish it on the underlying instrument, not a side bet being waged by third parties? " CHRG-111shrg56415--37 Mr. Tarullo," Senator, I think leverage on the expectation of rising asset prices was at the heart of the subprime problem, and indeed, it is at the heart of some of the other problems that we see, to some degree, in commercial real estate, as well. So, I would try to reinforce any instinct you have to push people toward better underwriting standards, and we, as the Chairman noted, are trying to do that ourselves. " FOMC20071031meeting--84 82,CHAIRMAN BERNANKE.," Thank you. Thank you everyone. Let me try to summarize this discussion. It is a little harder than usual. Broadly, the macroeconomic news came in slightly better than expected during the intermeeting period. Housing has been very weak, as expected; but consumption, investment, and net exports were relatively strong in recent months. In the aggregate data, there is yet no clear sign of a spillover from housing. Most participants expect several weak quarters followed by recovery later next year. The risks remain to the downside but may be less than at our last meeting. One issue, given all these factors, is determining the equilibrium short-term interest rate. Financial market conditions have improved somewhat since our last meeting, with investors discriminating among borrowers and with the process of price discovery proceeding. There was general agreement that conditions are not back to normal and that it would be some time before that happened. Some suggested that a risk of relapse remains, should credit quality worsen or further bad news be disclosed. Lending conditions have tightened, particularly for mortgages, and securitization remains impaired. There is not yet much evidence that this tightening is affecting business borrowing, however, although financial conditions may have somewhat increased uncertainty among business leaders. Views on how consumption would evolve were mixed. Consumer sentiment is on the weak side, house prices are down, and oil prices are up, which suggests some weakening ahead. However, the labor market remains reasonably solid, which should support consumer spending. Anecdotal information about consumer spending was unusually mixed. Some saw evidence of growing weakness in consumption. This evidence included weak reports from shippers and credit card companies. Others saw the consumer side as slowing a bit but generally healthy. Investment, including investment in commercial real estate, may also be slowing somewhat; but again, the evidence is mixed. Manufacturing growth appears to be moderating. Other sectors— including energy, agriculture, high-tech, and tourism—are doing well. Core inflation has moderated, and there was generally more comfort that this improvement would persist. There was less concern expressed about tightness in labor markets and wage pressures. Energy prices and food prices could lead total inflation to rise, perhaps even into next year, and there is the risk of pass-through to the core. Similar concerns apply to the dollar and to export prices. Some, but not all, TIPS-based measures of inflation expectations have risen, and survey-based measures have been stable. Most participants saw inflation risks to the upside, but at least some saw them as less pressing than earlier this year. That is my summary. Comments? Well, again, as usual, it is hard to be the last person to speak, but let me make just a few comments. First, as always, the Greenbook was very thoughtful. The authors have done a good job of balancing the risks, and I find their forecast very plausible as a modal forecast. Housing does seem to be very weak, of course, and manufacturing looks to be slowing further. But except for those sectors, there is a good bit of momentum still in the economy. Having said that, I think there is an unusual amount of uncertainty around the modal forecast, maybe less than in September but still a great deal. Let me talk briefly about three areas: financial markets, housing, and inflation. A lot of people have already spoken about financial markets. Market functioning certainly has improved. Our action in September helped on that. For example, commercial paper markets are working almost normally for good borrowers, the spreads are down, and volumes are stable. One concern that we had for quite a while was that banks would be facing binding balance sheet constraints because of all the contingent liabilities that they had—off-balance-sheet vehicles, leveraged loans, and so on. That problem seems to be somewhat less than it was. Some of the leveraged loans are being sold off, some of the worst off-balance-sheet vehicles are being wound down. So there is generally improvement in the financial market, certainly. In the past couple of weeks there has been some deterioration in sentiment, and I see that as coming from essentially two factors. First, there were a number of reports of unusually large and unanticipated losses, which reduced the confidence of investors that we had detected and unearthed all the bad news. This problem will eventually be resolved, but clearly we still have some way to go to clarify where people stand. The other issue, which I think is more pertinent to our discussion, is about economic fundamentals. There was a very bad response, for example, to Caterpillar’s profit report, and so the market is appropriately responding to economic fundamentals as they feed through into credit concerns. From our perspective, one of the key issues will be the availability of credit to consumers and firms going forward. My sense—based on my talking to supervisors, looking at the senior loan officer survey, and talking to some people in the markets—is that banks are becoming quite conservative, and that is what Kevin said. It is not necessarily a balance sheet constraint but more a concern about renewed weakness in markets. It is also a concern about the condition of borrowers, about credit risk, and the demands of investors for very tight underwriting. Now, of course, tight underwriting is not a bad thing; it is a good thing. But from our perspective, we need to think about its potential implications for growth and, if you like, for r*. The biggest effect of the tighter underwriting, of course, has been on mortgage loans, although we have seen a bit of improvement in the secondary market for prime jumbos, which is encouraging if that continues. This is the area in which vicious-circle effects, which Vice Chairman Geithner and others have talked about, is most concerning. House prices, according to the Greenbook, are projected to fall 4½ percent over the next two years. Clearly, there is some downside risk to that. If house prices were to fall much more, that would feed into credit evaluations, into balance sheets, back into credit extension, and so on. So I think there is a risk there, as Governor Kroszner and Governor Mishkin also discussed. The corporate sector is not much of a problem. Good firms are issuing debt without much problem. I don’t really have much read on small business, but I have not heard much complaining in that area either. With respect to consumers, my guess is that we are going to see some effects on consumers. Certainly, home equity loans and installment loans have tightened up. We can see that in the senior loan officer survey. We don’t see that yet for credit cards, but since a lot of credit cards are used by people with subprime credit histories, I suspect that we will see some tightening there. So I do expect to see some effect on consumers from credit conditions. As has already been mentioned, an area we also need to note is commercial real estate. Financing conditions have already tightened there quite considerably, and spreads are much wider. The senior loan officer survey shows the tightening of terms and conditions that matches previous recessions, and CMBS issuance has dropped very significantly. You can debate whether or not this tightening is justified by fundamentals. On the one hand, vacancy rates remain low, and rents are high. On the other hand, it is still also true that price-to-rent ratios are quite high. If you calculate an equity risk premium for commercial real estate analogously to the way you calculate one for stocks, you would find that it is at an unusually low level, which would tend to suggest that prices may fall. So it is uncertain, I would say. Certainly one area in which we might see further retrenchment in commercial real estate is the public sector: Tax receipts are slowing, and that might affect building decisions. So I do think this is another area in which we will be seeing some effects from credit tightening. I should be clear—the Greenbook already incorporates a considerable slowdown in commercial real estate, but that means it will no longer offset the residential slowdown. I just want to make one comment about housing, which I think we all agree is a central source of uncertainty, both for the credit reasons I have discussed and in terms of prices, wealth, and other issues. Let me just make one point that I found striking anyway, which is that—at least from the Greenbook—the forecast of a strengthening economy by next spring and the second half of next year is very closely tied to the assumption that housing will turn around next spring. In particular, if you look at all the final demand components for the economy, other than housing, in 2007 those components contributed 3.5 percentage points to GDP. According to the Greenbook forecast, in 2008 all those components together will contribute 2.0 percentage points to GDP. So the fact that GDP doesn’t slow any more than 0.6 comes from the assumption that the negative contribution of housing next year will be much less than it was in this year. It is certainly possible—again, I think the Greenbook authors have done a good job of balancing the risks. But as we have noted, we have missed this turn before, and it could happen again. So let me just note that as an important issue. If we do miss on that turn, the other forecast errors for consumption and so on obviously would be correlated with that miss. Finally, let me talk for a moment about inflation. I want to share the concerns that some people have noted. If you wanted to be defensive about inflation, you could point out that the movement in oil prices and the dollar and so on is in part due to our actions. But it is also due to a lot of other things—for example, the dollar in broad real terms is about where it was in the late ’90s. In that respect, it is perhaps about where it should be in terms of trying to make progress on the current account deficit. Similarly, with oil, a lot of other factors besides monetary policy are involved. That said, I share with Governor Warsh the concern that the visibility of these indicators day after day in financial markets and on television screens has a risk of affecting inflation psychology. I do worry about that. I think we should pay attention to that. So I do think that is a concern, and we obviously need to take it into consideration in our policies, in our statements, and in our public remarks. I have one more comment on housing before ending. In thinking about the turnaround for housing next year, Governor Kroszner talked about resets and those sorts of issues. We spend a lot of time here at the Board thinking about different plans for refinancing subprime borrowers or other borrowers into sustainable mortgages. We have looked at the FHA and other types of approaches. A very interesting paper by an economist named Joseph Mason at Drexel discusses, at a very detailed institutional level, the issues related to refinancing, in terms both of the servicers’ incentives and of the regulatory perspective. Mason points out that there are some serious regulatory problems with the massive refinancing effort, including consumer protection issues, because refinancing can be a source of scams. There are also issues of safety and soundness because refinancing can be a way to disguise losses, for example. If you read that paper, I think you will be persuaded—at least I am becoming increasingly persuaded—that a significant amount of refinancing will not be happening and that we will see substantial financial problems and foreclosures that will peak somewhere in the middle of next year. So I think that is an additional risk that we ought to take into account as we think about the evolution of housing. Those are just a few comments on the general outlook. Let me just note, we will adjourn in a moment. There will be a reception and a dinner, for those of you who wish to stay. There will be no program or business, so if you have other plans, feel free to pursue them. A number of pieces of data, including GDP, will arrive overnight, and we will begin tomorrow morning with a discussion of the new data. Perhaps that will help us in our discussion of policy. Thank you. The meeting is adjourned. [Meeting recessed] October 31, 2007—Morning Session" FinancialCrisisInquiry--182 Can you turn your mic on, Mr. Rosen? ROSEN: I’m Ken Rosen. I want to thank Chairman Angelides and Vice Chairman Thomas, and the commission for having me here. I want to not read my testimony since you have it. But I’m going to talk a little bit about what I think is the epicenter of the crisis—where this started, how it got there, and where we are today, which is the housing market—the housing and residential mortgage market. Excessively easy credit, extremely low interest rates created a house price bubble. And the house price bubble when it burst has really caused a significant part of the problems that we had—at least the—initially. And of course it caused—helped cause the great recession where we have lost over eight million jobs. I think the most important thing to say is how did we get here. And I would say that low interest rates is part of the blame, but really it’s the poorly structured products that came about in this environment. Innovative products are important, and a good thing. And I’ve written papers on—on this in the 1970s and 80s while we needed innovative mortgage products. And they’re good for some people—some households. Subprime— there is a need for having that. But not to the market share it got. Low down payment loans – Alt-A loans, option arms. All those made some sense for a portion of the population. What happened is we layered all these risks. We went from a conservatively written subprime loan to a subprime loan that had no down payment, and didn’t document someone’s income or employment. So we made a mistake from what was a good idea by financial institutions became a bad idea for the entire overall market. And then we combine that with a second component which was I thought bad underwriting. We lowered underwriting standards dramatically. We started this in California, and it spread everywhere. We—we do this sometimes. Liars loans which are stated income loans, and there was rampant fraud at the consumer level. We’ve heard discussion of this at the institutional level, but I think the consumer basically really did this so they could qualify for the loan. There was some complicity on the part of brokers and originators. I think—I do not think this was at the high level institutions, but it’s at the individual originator level. CHRG-111hhrg48875--178 Secretary Geithner," I am not quite sure that is fair. But you are right, you want to make sure that the margin regime, too--margin is like capital, just to use a simple thing. You want to make sure that institutions like AIG hold much more capital against the risks they are underwriting and are exposed to. And you want to have--in derivatives in particular, you want to have a margin regime that is also much more conservative. " CHRG-110hhrg46594--349 Mr. Perlmutter," If there were a bankruptcy--and this goes to you, Mr. Gettelfinger. One of the things I have been thinking, do we put the money in up front and allow things to go forward and hope that the economy improves and we don't have to come back, you don't have to come back for more money or do you take a Chapter 11, set the legacy benefits on the side and then we underwrite that through PBGC? " FinancialCrisisReport--190 It took nearly a month for OTS to launch its own investigation into the allegations set out in the New York Attorney General’s complaint. 709 In November 2007, when the director of OTS, John Reich, was presented with his agency’s investigation plan, he responded: “This appears to be a comprehensive (and impressive) review schedule. It doesn’t appear, on the surface anyway, to leverage off of WaMu’s own review. Do you think we might be totally reinventing the wheel and possibly taking too long to complete our review?” 710 Despite his concerns about how long the planned investigation might take, the OTS investigation proceeded as proposed. It took over 10 months, until September 2008, for OTS to gather, analyze, and reach conclusions about WaMu’s appraisal practices. The OTS investigation uncovered many instances of improper appraisals. After reviewing 225 loan files, the OTS appraisal expert found that “[n]umerous instances were identified where, because of undue influence on the appraiser, values were increased without supporting documentation.” 711 OTS also found that WaMu had violated the agency’s appraisal regulations by failing to comply with appraisal independence procedures after they outsourced the function. 712 The OTS investigation concluded that WaMu’s appraisal practices constituted “unsafe or unsound banking practices.” 713 The OTS investigation also concluded that WaMu was not in compliance with the Uniform Standards of Professional Appraisal Practice and other minimum appraisal standards. 714 Failure to Correct Appraisal Deficiencies. Shortly before WaMu was sold, OTS’ staff prepared a draft recommendation that the agency issue a cease and desist order to bar the bank from engaging in any activity that would lead to further violation of the appraisal regulations. 715 A cease and desist order would have been the first public enforcement action against WaMu regarding its lending practices. Ultimately, the legal staff submitted the memorandum to OTS’ Deputy Director and Chief Counsel on October 3, 2008, more than a week after the bank collapsed and was sold. 716 By this point, the recommendation was too late and the issue was moot. 709 See undated OTS internal memo to John Bowman, OTSWMSP-0000001936 [Sealed Exhibit]. 710 11/16/2007 email from OTS Director John Reich to OTS Operations Director Scott Polakoff, Reich_John- 00040045_001. 711 7/28/2008 Draft Memo to Hugo Zia from Bruce Thorvig, OTSWMEN-0000015851 [Sealed Exhibit]. 712 See 12 CFR Part 564. 713 Undated OTS internal memo, OTSWMSP-00000001936-51 at 47 [Sealed Exhibit]. 714 Id. at 37 [Sealed Exhibit]. The Subcommittee found no evidence that anyone in OTS senior management disputed the conclusions of the investigation. 715 Id. 716 OTS internal document, OTS Enforcement Status of Formal Investigations, Quigley_Lori-00231631_001. (d) Deficiencies Related to Long Beach FinancialCrisisInquiry--220 GEORGIOU: They take—I’m sorry? ROSEN: They take the riskiest piece of a security, they’ve underwritten it, and they feel confident of that underwriting and they keep that, and they’ve got a premium on the marketplace for their securities because they do that, the securitizations they do in the commercial mortgage area. GEORGIOU: Is there a reason why you wouldn’t identify that bank or... ROSEN: It’s Wells Fargo bank, and they’ve—that’s been their tradition. They believe in their own underwriting, and so they keep the riskiest piece in their own portfolio, risky only in the sense it’s at the, you know, bottom of the capital stack, and so—and they’ve had a premium in the marketplace. They’re not—they don’t do a lot of securitization, but it seems to me that if you get the risk return alignment better, I think it’s less likely you’re going to have some of the stuff that was done in this environment. GEORGIOU: Right. Dr. Zandi, I wonder if you could comment on the disparities of—of the impact of the recession in certain areas, as opposed to others. I mean, I happen to—actually, Ms. Murren and I now live in—both live in Nevada, where we have something like 75 percent of the homeowners owe more money than they—than their homes are worth and the economic—the underemployment rate has been extraordinarily high. FinancialCrisisReport--484 Goldman made a total of about $67 million in repurchase requests to New Century, which was among the five mortgage originators to whom Goldman directed the most repurchase requests in 2006 and 2007. 2046 In March 2007, however, New Century stopped paying Goldman’s claims due to insufficient cash, and the loan repurchase team sought advice from Mr. Gasvoda: “As you know, we have an extensive re-underwrite review underway on 06 NC2 [New Century second lien loans] and also other NC loans in the 2nds deals that are in the pipeline for scrubs. Should we change course at all here given the fact NC can’t pay?” 2047 Mr. Gasvoda responded: “Yes .... I think priority s/b [should be] on Fremont and Long Beach on 2 nd lien deals. Fremont first since they still have cash but may not for long. ... [O]n NC2 we need not halt that entirely but should pull back resources there. We should also move 06FM2 [Fremont second lien loans] up the priority list.” Goldman made a total of about $46 million in repurchase requests to Fremont, another subprime lender for whom Goldman had underwritten multiple securities and which was also among the five mortgage originators to whom Goldman made the most repurchase requests in 2006 and 2007. 2048 When Goldman personnel reviewed a loan pool purchased from Fremont, the results were even worse than for the New Century loans. Goldman concluded that “on average, about 50% of about 200 files look to be repurchase obligations.” 2049 Later, Goldman came to a similar (if 2nd liens). ... – approx 5% of the pool was possibly originated fraudulently based on the dd [due diligence] results. Main findings: possible ID theft, broker misrepresentations, straw buyer, and falsification of information in origination docs. ... “approx 62% of the pool has not made any payments (4% were reversed pymts/nsf [non-sufficient funds]) ... “approx 38% of the loans are out of [loan to value] tolerance. ” 2046 2047 See Goldman Sachs response to Subcommittee QFR at PSI_QFR_GS0040. 3/14/2007 Goldman email, “NC Visit, ” GS-MBS-E-002048050. See also 3/21/2007 email from Daniel Sparks to Tom Montag, GS M BS-E-002207114 (noting progress in cutting down funding commitments to mortgage originators to $300 million, including closeout of all funding to New Century in exchange for loans). 2048 2049 See Goldman Sachs response to Subcommittee QFR at PSI_QFR_GS0040. 3/14/2007 Goldman email, “NC Visit,” GS-MBS-E-002048050. See also 8/10/2007 email from Michelle Gill, “Fremont - Incremental Information, ” GS MBS-E-009860358 (Goldman ’s repurchase claims against Fremont would have amounted to a 9% ownership stake in Fremont after a proposed buyout by investor group; Goldman was not the largest purchaser of Fremont loans but its repurchase claims were 3-4 times larger than the claims of the nearest counterparty). conclusion after reviewing certain loans purchased from Countrywide, again finding that about 50% of the loans reviewed were candidates for return to the lender. 2050 CHRG-111hhrg74090--8 Mr. Waxman," Thank you very much. I want to thank you, Mr. Chairman, for holding this important hearing. Last year, as chairman of the House Oversight Committee, I held several hearings examining the causes of the financial crisis. Those hearings revealed a government regulatory structure that was unwilling and unable to meet the complexities of the modern economy. We found regulatory agencies that had fully abdicated their authority over banks and had done little or nothing to curb abusive practices like predatory lending. The prevailing attitude was that the market always knew best. Federal regulators became enablers rather than enforcers. The Obama Administration has developed an ambitious plan to address these failures and to strengthen accountability and oversight in the financial sector. Today's hearing will take a close look at one piece of that plan, the proposal to create a single agency responsible for protecting consumers of financial products. A new approach is clearly warranted. The banking agencies have shown themselves to be unwilling to put the interests of consumers ahead of the profit interests of the banks they regulate and the structure and division of responsibilities among these agencies has led to a regulatory race to the bottom. The Federal Trade Commission has taken steps to protect consumers but its jurisdiction is limited and it has been hampered by a slow and burdensome rulemaking process. I am pleased that this subcommittee is holding today's hearing and examining the Administration's proposal carefully. There are two areas of which attention and focus from this committee are particularly needed. First, the new agency must be structured to avoid the failures of the past. It only makes sense to create a new agency if that new agency will become a strong, authoritative voice for consumers. And second, we must ensure that the Federal Trade Commission is strengthened, not weakened, by any changes. Unlike the banking agencies, FTC has consumer protection as its core mission. In recent months, FTC has taken great strides to protect consumers of financial products, bringing enforcement actions against fraudulent debt settlement companies and writing new rules governing mortgages. The Administration's proposal would give most of the FTC's authority over financial practices and some of FTC's authority over privacy to the new agency. At the same time, the Administration proposes improving FTC's rulemaking authority and enforcement capabilities. It is not clear what impact these proposals would have on FTC or its ability to perform its consumer protection mission. As we build a new structure for protecting consumers of financial products, it is our responsibility to ensure that we do not weaken the agency currently responsible for consumer protections in this and many other areas. Once again, I thank Chairman Rush for holding this hearing. I welcome our witnesses to the committee and look forward to their testimony. " 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.  CHRG-110shrg46629--97 Chairman Bernanke," And essentially saying that there is some presumption that the lender will appropriately take into account ability to pay in making the loan. And that itself turns to some of the things that we are trying to think about under our HOEPA authority, which is whether or how to require underwriting to the fully indexed rate and how or whether to require more documentation than is currently required about ability to pay, for example, and what standards one might set in terms of linking ability to pay to the monthly payment. So those are some of the issues. Senator Schumer. So we are somewhat on the same page on some of these things. Thank you, Chairman Bernanke. Thank you, Mr. Chairman. " CHRG-111hhrg56778--87 Mr. Greenlee," When companies affiliate themselves with an insurance underwriter, there are different kinds of risks that aren't captured under those definitions, such as actuarial risks or risks from property and casualty businesses. And what we do with that is we work with the NAIC on producing a paper that explored those differences so that our supervisors can understand that and factor that into our overall assessment of capital adequacy at a holding company. " FinancialCrisisInquiry--707 ROSEN: It’s Wells Fargo bank, and they’ve—that’s been their tradition. They believe in their own underwriting, and so they keep the riskiest piece in their own portfolio, risky only in the sense it’s at the, you know, bottom of the capital stack, and so—and they’ve had a premium in the marketplace. They’re not—they don’t do a lot of securitization, but it seems to me that if you get the risk return alignment better, I think it’s less likely you’re going to have some of the stuff that was done in this environment. 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-111shrg57319--467 Mr. Rotella," I was referring to the two California retail offices from Montebello and Downey when I mentioned 2008. Senator Levin. If you take a look now at Exhibit 33.\2\ This is a report by Radian Guaranty, which insured some of WaMu's mortgages. They reviewed a number of 2007 loans to evaluate the underwriting and compliance with their guidance. They found so many problems that it rated WaMu's loan files unacceptable, if you will look at page 2 on Exhibit 33.--------------------------------------------------------------------------- \2\ See Exhibit 33, which appears in the Appendix on page 553.--------------------------------------------------------------------------- Now, just one of the loan examples. I am picking one from page 5, but there are many. This is a $484,000 loan given to a sign designer. That is somebody who designs signs, who claimed to be making $34,000 a month in income. And this is what the report said. ``Borrower's stated monthly income of $34,000 does not appear reasonable. . . .'' It noted another problem. The loan file appraised the house at $575,000, but another report said the probable value was $321,000, an amount less than the loan. That is just one of the loans that Radian found unacceptable and uninsurable. Were either of you aware of the Radian report? Mr. Rotella, were you aware of it? " CHRG-111shrg57320--375 Mr. Corston," It has everything to do with liquidity. If you have strong asset quality, you will not have liquidity issues because your assets--you can borrow either against them or you can sell them. If you have weak asset quality, you are going to have liquidity issues at some point. Senator Levin. Now, there are some that have said that WaMu's liquidity problems were unexpected and were the result simply of market forces. Isn't it the case, however, looking at these documents, that since liquidity is based in significant measure on asset quality, WaMu's liquidity problems arose, at least in significant part, because of bad quality of their mortgage loans, which were the bulk of their assets? " CHRG-111shrg57320--317 Mr. Corston," Absolutely. We certainly have concerns over any loan product that, again, has less information incorporated into an underwriting process that is layering on more risk. In this case, we came out with our guidance to provide examiners some guidance and the industry some guidance when the risk became very apparent to our agency and others. Senator Levin. On Exhibit 51b,\1\ if you will take a look at that exhibit, this is a 2005 memo entitled, ``Insured Institutions' Exposure to a Housing Slowdown.'' Mr. Corston, what were the FDIC's concerns about the structure of the loans that were popular at that time? What were the risk of those loans in bank portfolios?--------------------------------------------------------------------------- \1\ See Exhibit No. 51b, which appears in the Appendix on page 398.--------------------------------------------------------------------------- " CHRG-111shrg57321--45 Mr. Kolchinsky," Second of all, I do not believe in the cause of the crisis there was a lot of instances of outright fraud, legal fraud. There may have been some on the front end with the mortgage brokers in filing applications that were clearly fraudulent. But the way the system worked, you had a chain--it was almost like a game of telephone where you pass some information down the line, and everybody changes it just a little bit--not enough to jump over the fraud, but because the length of the chain from the mortgage broker to the originator to the aggregator to the CDO, by the time everybody takes a little cut, changes it a little bit, by the time you got to the end of the line, the information or the product was garbage. So that is why you have not seen a lot of cases of outright fraud because everybody pushed the envelope, clearly pushed the envelope. But because of everybody pushing the envelope, the end product was garbage. Senator Kaufman. Yes, but, I can see that in 1 day, I can see it 2 days, I can see it 5 days, I can see it a month, I can see it 2 months, I can see it 3 months. I just find it--these are very smart people. I mean, when you look and see you are in the middle of a chain and you see what is happening, at some point you say, there is something really going on here. And maybe it is nonfeasance. It is not malfeasance. They are not doing it to be bad. They just do not go back and look to find out what they do not want to know, what actually happened. " CHRG-111shrg57319--418 Mr. Beck," No. Senator Levin. Now, those Option ARMs, at least the ones that are called WMALT 2007, OA3--that is Exhibit 1g,\1\ if you will take a look at it--they show the delinquency rates for many, or a number of WaMu securities. That ARM, which is where you put these delinquency-prone Option ARMs--and by the way, Option ARMs are supposed to be prime--but these delinquency-prone Option ARMs now--you won't be able to see that. You will have to look in your book. That is Exhibit 1g. They now have a delinquency rate of more than 50 percent, which means more than half of the underlying loans are now delinquent. More than a quarter of the underlying mortgages are in foreclosure.--------------------------------------------------------------------------- \1\ See Exhibit 1g, which appears in the Appendix on page 221.--------------------------------------------------------------------------- Mr. Beck, purchasers of securities were relying on you as an underwriter to provide complete and truthful information. Is that correct? " CHRG-111hhrg54872--279 Mr. Yingling," It wasn't on--that there was not an adequate focus on consumer issues. And if you would look at the history, particularly the history of what caused this crisis, you can go back to a point in time and say, if the Fed had implemented HOEPA in an aggressive fashion, with the powers in HOEPA, from the consumer side we would not have had the degree of problem we had. One of the weaknesses that the Fed had to face at that point was that HOEPA gave them at the Federal level no enforcement over the non-banks. So with the mortgage brokers, even though HOEPA technically would have applied to them, the enforcement would have been left to the State level. And in that case, we know that the enforcement was inadequate. So if you look at that history, it seems to me that you draw the conclusion that the problem is a lack of focus at the Federal level on consumer issues, and an inability to ensure enforcement at the State level. In many cases, there is good State enforcement but, clearly, in the mortgage area there was not. What I was attempting to say in my testimony--and maybe didn't say it very well--was I don't think the case has been made that there aren't enough powers out there. The regulators have all the laws that you all have enacted, and there are a lot of them, the 1,700 pages of regulations I talked about. Plus they have a new aggressive tool that the Fed used in the credit card case, the Unfair and Deceptive Acts and Practices. You combine those, then I think that the power is there; and if it is not, you all can enact new laws. So what I am trying to say is, if you focus on the problems, the problems are a lack of focus at the Federal level and a weakness in certain mechanisms for enforcing at the State level. Ms. Bean. I will now recognize myself for 5 minutes. My first question is to Mr. Yingling in follow-up to Congressman Hensarling's question about what does one earn more or less relative to a delinquency versus a foreclosures? My question is in relation to servicers. I certainly agree with Mr. Menzies's contention that community banks aren't going to earn more in that situation. But can you please comment on how much more servicers make servicing a delinquency or servicing delinquency versus foreclosure? " CHRG-110hhrg44901--16 Mr. Bachus," Representative Paul mentioned the weak dollar. Obviously, it is helping us with our exports, and it is moving some consumption inward. Obviously, our constituents are being terribly stressed by the high energy costs. I believe one factor may be the weak dollar. What is your policy regarding exchange rate intervention? " CHRG-111shrg57320--325 Mr. Corston," In the case of Washington Mutual, certainly the standard 30-year fixed-rate amortizing mortgage is generally not a problem. Any product that you have that has amortization built in and a steady interest rate that does not vary with the capacity of the borrower to pay, generally, from an underwriting standpoint, is not a problem. That is not what 70 percent of these products were. Senator Levin. Now, as WaMu's condition continued to worsen in the summer of 2008, the FDIC conducted a capital analysis, recommended to OTS that a 4 rating was warranted. Take a look at Exhibit 63.\1\ Do you see that?--------------------------------------------------------------------------- \1\ See Exhibit No. 63, which appears in the Appendix on page 431.--------------------------------------------------------------------------- " CHRG-111shrg57320--36 Mr. Thorson," Right. Senator Coburn. On page 6 of your testimony, you said, ``OTS relied largely on WaMu management to track progress in correcting examiner-identified weaknesses and accepted assurances from WaMu management and its board of directors that problems would be solved.'' Do you mean to imply by this that OTS had no system in place to find out if WaMu was correcting the problems it said it was? And was there any evidence that if WaMu said it was correcting the problem, they went back in to see if, in fact, that happened? " fcic_final_report_full--116 THE MORTGAGE MACHINE CONTENTS Foreign investors: “An irresistible profit opportunity” ........................................  Mortgages: “A good loan” ..................................................................................  Federal regulators: “Immunity from many state laws is a significant benefit” .... Mortgage securities players: “Wall Street was very hungry for our product” ...... Moody’s: “Given a blank check” .........................................................................  Fannie Mae and Freddie Mac: “Less competitive in the marketplace” ...............  In , commercial banks, thrifts, and investment banks caught up with Fannie Mae and Freddie Mac in securitizing home loans. By , they had taken the lead. The two government-sponsored enterprises maintained their monopoly on securitiz- ing prime mortgages below their loan limits, but the wave of home refinancing by prime borrowers spurred by very low, steady interest rates petered out. Meanwhile, Wall Street focused on the higher-yield loans that the GSEs could not purchase and securitize—loans too large, called jumbo loans, and nonprime loans that didn’t meet the GSEs’ standards. The nonprime loans soon became the biggest part of the mar- ket—“subprime” loans for borrowers with weak credit and “Alt-A” loans, with charac- teristics riskier than prime loans, to borrowers with strong credit.  By  and , Wall Street was securitizing one-third more loans than Fannie and Freddie. In just two years, private-label mortgage-backed securities had grown more than , reaching . trillion in ;  were subprime or Alt-A.  Many investors preferred securities highly rated by the rating agencies—or were encouraged or restricted by regulations to buy them. And with yields low on other highly rated assets, investors hungered for Wall Street mortgage securities backed by higher-yield mortgages—those loans made to subprime borrowers, those with non- traditional features, those with limited or no documentation (“no-doc loans”), or those that failed in some other way to meet strong underwriting standards. “Securitization could be seen as a factory line,” former Citigroup CEO Charles Prince told the FCIC. “As more and more and more of these subprime mortgages were created as raw material for the securitization process, not surprisingly in hind- sight, more and more of it was of lower and lower quality. And at the end of that  process, the raw material going into it was actually bad quality, it was toxic quality, and that is what ended up coming out the other end of the pipeline. Wall Street obvi- ously participated in that flow of activity.”  FOMC20070918meeting--68 66,MR. STOCKTON.," On that last point, I think it probably would have been a little higher. But if we hadn’t revised the NAIRU, we might also have had a higher unemployment forecast going forward. It wouldn’t be just like “everything else equal” if we lowered the NAIRU. I think it did contribute to a slightly larger output gap in this forecast, but also contributing to the larger output gap in this forecast was a weakening of activity relative to potential that we are assuming is going to be driven by this. We are really splitting hairs because, as I indicated, we changed the forecast only 0.1 in each year, but it would have been a little less than that had we not changed the NAIRU. On the first point about our interpretation of employment, I was trying to convey a sense that a lot of people were very surprised at how weak employment was. We have been expecting weak employment. I think we were less surprised. We also, as I indicated, had written off some of this weakness in employment as sort of extracyclical labor hoarding, and we hadn’t really bought in fully to that. We let that show through in lower labor productivity. Now that we have actually seen some of the weakness that we were expecting all along, we don’t think there was as much labor hoarding as we previously thought. So it wasn’t as big a surprise. Still, there is just no denying the fact that the labor market report was weaker. Even if we had gone back to where we were, we weren’t expecting things to be that weak. So I think there was some small negative signal attached to the labor market report but probably not as much as would be suggested by the market reaction." CHRG-111hhrg48873--393 Mr. Lynch," Thank you, Mr. Chairman. Thank you, gentlemen, for trying to help the committee with its work. The AIG situation is a special case. I want to ask you about an agreement that I tried to question Mr. Liddy about last week. But AIG was a special case because of, as you said in your opening testimony, Mr. Secretary, that they were basically on the brink, and that you did act with greater urgency at a very precarious moment. We also--as the taxpayer, we stepped up in a very big way, taking a 79.9 percent share, call it 80 percent. We became the rescuer of AIG. But for the presence and intervention of the American taxpayer, I don't think anybody would argue this company was going under. And, in fact, I handed out copies of the retention bonus that is at the source of a lot of this hearing. The language in the retention bonus agreement drafted in December of 2007, basically covering the AIG financial products employees, anticipates this in a way; not in a way, specifically. It clearly says that the impact of the credit default swaps and underlying collateral debt obligations will not affect the bonuses. This infuriates me that employees at the firm in this business saw that these things were so weak and said, okay, what are we going to do here, we are going to build a firewall between the damage that is going to affect the taxpayer--they didn't know it was the taxpayer, but their creditors--and we are going to protect our bonuses. It makes me crazy that they did this. It also, in fact, reserves a certain part of the--well, $67.5 million, I think it was--that regardless of what happened to the company, they would get their bonuses. And it just seems to me that there are grounds in that for repudiating these contracts. The fact that as they saw bankruptcy looming, they said, okay, the creditors are going to come in here at any point now and lay claim to our assets, so what we are going to do is we are going to make a special agreement to take care of ourselves. And that is why I made the analogy last week of the captain and the crew reserving the lifeboats. This is completely objectionable. And I just want to ask you, you know, I think we have a cause of action here as shareholders. You know, I don't dispute bonuses generally. I think they can work. But in this special case, is there not, in essence, a fraudulent conveyance here to escape the creditors who are the people we represent, the people who stepped up and did the right thing, rescued this company? And what did we get, you know? We get this. So if you just talk to me about this. And I know about the Connecticut law, and I still think that these are supervening incidents that could delete the contract. Mr. Secretary? " CHRG-111hhrg48868--678 Mr. Scott," Okay. Now, the other point is, I asked the thrift person, and I want to ask you. And I know you came on the scene in September, but many of us believe that this was a fraudulent effort here. What do you think when they put forward the effort 1 year ago exactly this month to give $450 million in bonuses to this Financial Products division, which has only 367 people in it, to deal with this area when they were bleeding money at the time? And 4 or 5 months later, they had bled enough money to the tune of $40.5 billion, this very unit that drove AIG into the arms of the taxpayers. Somewhere down the line, it seems to me the question should be asked: Where were they thinking they were going to get this money? And was there any thought too, since there's such a close proximity here and they're bleeding money that somebody down the line might have thought down the road if we do this, the government will come to our rescue. And, thereby, that's where we could get our bonuses from, from the taxpayers. Had that thought occurred to you? " CHRG-110hhrg46596--259 Mr. Barrett," I agree with you 100 percent. I guess the key word is ``prudent.'' And as some of our banks have gotten larger, and I do agree, I think they are protecting some weak communities or some weak banks that in turn protect the community, how do we ensure that these bigger banks are using the prudent oversight so this doesn't manifest into the same thing on down the road? " 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-111shrg57320--401 Mr. Bowman," Good afternoon, Chairman Levin. My name is John Bowman. I am a career Federal employee who became Acting Director of the Office of Thrift Supervision a little over 1 year ago during the height of the financial crisis after about 5 years as the agency's chief counsel. It is not a role that I sought, but I am honored to serve.--------------------------------------------------------------------------- \1\ The prepared statement of Mr. Bowman appears in the Appendix on page 181.--------------------------------------------------------------------------- My written testimony summarizes OTS' supervision of Washington Mutual, and the reasons why WaMu failed. It is important to note that this failure came at no cost to the Deposit Insurance Fund and at no cost to the American taxpayer unlike recent failures of other financial institutions and the near collapse of some of the Nation's largest banks which were deemed ``too big to fail'' and, therefore, provided government assistance. The demise of WaMu came early in the procession of more than 200 banks and thrifts that have closed during this crisis. Lifelines, such as the Treasury's TARP program and the FDIC's increase in deposit insurance coverage, came too late for WaMu. During the real estate boom before the crisis, WaMu and other financial firms made a critical error by widely underwriting home mortgages based more on the value of the collateral represented by the homes than on the borrower's documented ability to repay. As home prices continued to rise, these practices supported a widely praised initiative to increase homeownership in America. Yet, as we now know, homeownership reached unsustainable levels and became too much of a good thing. Like all of the players in the home mortgage market, bank managers at WaMu and elsewhere mistakenly believed that they were effectively averting risks by moving loans off their books and securitizing them. Similarly, homeowners perceived little risk in their adjustable-rate mortgages because they thought they could sell their homes at a profit before rate resets kicked in. Investors believed mortgage-backed securities carried little risk because credit rating agencies rated them highly. Those beliefs proved misplaced when the real estate market collapsed, the secondary market froze, and the risks turned out to be all too real. The fallout hit financial institutions large and small, with State and Federal charters, overseen by every banking industry regulator. Since WaMu's failure, the OTS has taken lessons to heart from our own internal review of failed thrifts and from the Treasury Inspector General's Material Loss Reviews, and we have made strides to address the resulting recommendations. We have instituted controls to better track problems identified in their examination reports and to take timely, effective action when necessary. We have established a Large Bank Unit to keep close watch over our largest regulated institutions, strengthened oversight of our OTS regions, enhanced supervisory consistency among regions, tightened scrutiny of problem banks, and set deadlines for taking enforcement actions after safety and soundness downgrades. In short, we have made meaningful changes. Although some thrifts helped to overinflate the housing bubble, traditional thrifts whose managers stuck to their conservative business practices of lending to people they knew and keeping loans on their books weathered this economic storm and continue to provide badly needed credit in their communities. Because consumer and community lending remains important for American families, I continue to believe in the thrift charter and the need for thrifts to have a separate regulator. With the changes we have instituted, I believe we have made the OTS significantly stronger for the future. Thank you again, Mr. Chairman. I am happy to answer your questions. Senator Levin. Thank you very much, Mr. Bowman. Throughout the last few years of WaMu's operation, the FDIC as the back-up regulator made repeated requests to participate in OTS exams and was continually rebuffed. We heard in the second panel how the FDIC sought to participate in OTS exams of Washington Mutual, was limited in terms of staff, forbidden to do file review. For periods of time, OTS blocked FDIC access to exam material. Mr. Bowman, are you familiar with that, and was that the right course of action? " 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.”  CHRG-111hhrg54867--182 Secretary Geithner," I don't think I would say it quite that way. Remember, as we just said, a lot of what happened in the system was that we allowed institutions to underwrite a bunch of stuff, sell a bunch of stuff to people who couldn't afford it. They were outside any scope of authority provided by the Congress with no effective deterrence. You can't look it quite through the prism of the authority that Congress gave the Fed and the other supervisors because of the absence of any authority over-- " CHRG-111shrg57322--534 Mr. Birnbaum," But you are not necessarily betting the market is going to go down, and I agree, just like a call can be. Senator Coburn. OK. All right. So you do not see any connection between Goldman's position in mortgage underwriting sophisticated instruments and your position looking at a macro sense of what you see happening there and taking and shorting your competitors or buying a put insurance against your competitors? " FinancialCrisisReport--196 The joint report of the Treasury and the FDIC Inspectors General specifically identified WaMu’s poor quality loans and poor risk management practices as the real cause of its failure, rather than the liquidity crisis that hit the bank in 2008. 747 During the Subcommittee’s hearing, when asked why WaMu failed, a senior FDIC official put it this way: “Asset quality. Weak asset quality. It brought on the liquidity problems.” 748 He explained: “If you have strong asset quality, you will not have liquidity issues because your assets – you can borrow either against them or you can sell them. If you have weak asset quality, then you are going to have liquidity issues at some point.” 749 (4) OTS Turf War Against the FDIC As WaMu approached the end, tensions between OTS and the FDIC that had built up over two years evolved into a turf war. OTS examination and regional officials began to express distrust of their FDIC counterparts. The conflict was elevated to the top leaders of both agencies, who came to take different views of what to do with WaMu – the FDIC becoming more aggressive and OTS becoming more protective. When the bank’s imminent collapse was no longer a question, the result was a hasty seizure and sale. Had the two government agencies acted in concert, rather than as adversaries, it is likely that WaMu’s problems would have been resolved earlier and with less collateral damage. During an interview, the chairman of the FDIC, Sheila Bair, stated pointedly that WaMu “could have sold themselves in July if they had tried.” 750 The same outcome was not accomplished until two months later in September when no other options remained, and OTS worked with the FDIC to make it happen. As mentioned earlier, OTS was the primary, but not the only, federal bank regulator that oversaw Washington Mutual. Since WaMu was also an insured institution, the FDIC served as a backup examiner responsible for evaluating the risk that the bank posed to the Deposit Insurance Fund. Because WaMu was one of the eight largest insured institutions in the country, the FDIC had assigned a Dedicated Examiner whose full time responsibility was to determine whether the bank was operating in a safe and sound manner. The FDIC Examiner reviewed all OTS ROEs and examination findings, participated on many occasions in OTS examinations, and reviewed bank documents. The FDIC reviewed the CAMELS ratings for the bank, as well as LIDI ratings under its Large Insured Depository Institutions Program. For many years, FDIC examiners worked cooperatively with OTS examiners to conduct oversight of WaMu. But beginning in 2006, OTS management expressed increasing reluctance to allow FDIC examiners to participate in WaMu examinations and review bank documents. Claiming that joint efforts created confusion about which agency was WaMu’s primary 747 IG Report at 8. 748 April 16, 2010 Subcommittee Hearing at 76. John Corston was the Acting Deputy Director of the FDIC’s Division of Supervision and Consumer Protection, Complex Financial Institution Branch. 749 Id. 750 Subcommittee interview of Sheila Bair (4/5/2010). regulator, 751 OTS officials employed a variety of tactics to limit the FDIC oversight of the bank, including restricting its physical access to office space at the bank, its participation in bank examinations, and its access to loan files. In addition, as the FDIC began to express greater concern about the bank’s viability, recommend ratings downgrades, and urge enforcement action, OTS officials displayed increasing resistance to its advice. In the end, OTS not only undermined years of cooperative oversight efforts, but at times actively impeded FDIC oversight of one of the largest insured banks in the country. CHRG-110hhrg46591--346 The Chairman," The gentlewoman from Illinois. Ms. Bean. Thank you, Mr. Chairman, and Ranking Member Bachus, for holding this important hearing today on something so many Americans are concerned about. They are rightfully concerned about their own and our Nation's economic futures and want to know that we are going to put in place the oversight and transparency to avoid this kind of situation ever happening again. I am proud to chair the new Democratic Working Group on Regulatory Modernization and we have put together a number of issues we are focusing on. And so, I wanted to give each of you maybe one question that addresses one of those each issues. To Mr. Washburn, regarding the mortgage reform bill that this committee passed last year, I believe it was in April, but unfortunately didn't get through the Senate and get to the President to become law, in that bill that we passed, we eliminated many of the risky lending practices that contributed to the subprime fallout that has so affected the rest of the capital market structure. We also put liability to the securitizers to address what Congressman LaTourette I think rightly attributed to, one of the problems was that the originators weren't ultimately going to be holding the bag for bad loans that they might write. And by putting liabilities to the securitizer we also then gave them a home waiver provision; that if they had best practices in place to make sure that the originators were adhering--the ability to pay models and old underwriting standards that used to work, they wouldn't have that liability. So my question to Mr. Washburn is, how do you feel about that bill, had it become law; and if it had a year ago, would we have avoided the number or the severity of some of the challenges that we are facing in this crisis? Before you go there, I want to lay out a couple of other questions and then we will come back. To Mr. Yingling, on mark to market, I think the chairman earlier talked about how the real issue--and you just spoke to it briefly--is that the capital calls more than necessarily how you measure, but the consequences of the accounting rules that affect it. My question is, the SEC has changed some of those rules recently, and how do you think that is affecting balance sheets currently with those changes that allow a little more flexibility? To Mr. Ryan, my question is regarding the uptick in the collateral rules. Earlier in the previous panel, we had some questions about the uptick rule and, if that was reinstated, would it avoid some of the naked short selling that has gone on and contributed to the downward spiral of many securities? But also the collateral role, not just as applied to those, but to the credit default swaps that don't require collateral to get involved in them and how that has allowed so many people to even create greater degrees of risk and leverage, what are your thoughts on that? And if we get to it with timing to Mr. Bartlett, you talked about a clearinghouse for derivatives and disclosure of risk and what your comments are on that. So I would like to go to Mr. Washburn first. " 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-110hhrg45625--85 The Chairman," The recorders are very good, but they are a little weak on nods. The gentleman from New York. " FOMC20080130meeting--342 340,MR. GIBSON., Are you talking about the credit rating agency weaknesses? CHRG-111shrg49488--104 Mr. Clark," Maybe I should just mention one other feature that I have not underscored but we found a tremendous difference on the two sides of the border. In Canada, because we hold all the mortgages, modifying the mortgages is easy to do. We do not have to ask anyone's permission to modify the mortgage. And it is not the government coming to us and saying, ``Would you start? Here is our modification program.'' We just were instantly modifying the mortgages. Last year, we represented about 20 percent of the mortgage market in Canada. We only foreclosed on 1,000 homes in a whole year, to give you an order of magnitude. And every one of those thousand we regarded as a failure. And so the last thing we would ever want to do is actually foreclose on a good customer. And so we go out of our way to modify the mortgages, and that is just natural practice for us because I do not have to ask permission of some investor whether or not I want to do this or can do it or what rules are governing it. So I do think that has turned out in this crisis to be a second feature that, frankly, none of us would have thought about until the current crisis. In terms of our specifics, we are required, if we, in fact, lend more than 80 percent loan-to-value, to actually insure the mortgage so that represents a constraint. It would not have represented a constraint to the kind of no documentation lending that was done in the United States because the actual underwriting we are doing. But then again, because we actually would be holding the mortgages, we insisted on full documentation. There is not interest deductibility. I think there is no question that the feature of having interest deductibility in the United States is a major factor for leveraging up. And despite the fact that it is justified on the basis that it encourages homeownership, historically homeownership has actually been higher in Canada than it has been in the United States. So there is no evidence that the two are linked at all. All it does is inflate housing prices because, in fact, people look at the after-tax cost in computing the value on which they are to bid for the houses. So I would say those are the main features. We do have mortgage brokers, but they are originating mortgages which we then hold. We do not sell them on. And I think that is the core feature. Senator Collins. And just to clarify, in most cases the homebuyer is putting down 20 percent. Is that correct? " FOMC20080130meeting--314 312,MR. PARKINSON.," 6 Thank you, Mr. Chairman. The first exhibit provides some background on efforts to analyze the policy issues raised by recent financial developments and an overview of today's briefing. As indicated in the top panel, in response to a request from the G-7, at its meeting last September the Financial Stability Forum (FSF) created a Working Group on Market and Institutional Resilience. The working group's mandate calls for it to develop a diagnosis of the causes of the recent financial market turmoil, to identify weaknesses in markets and institutions that merit attention from policymakers, and to recommend actions needed to enhance market discipline and institutional resilience. The working group has been asked to prepare a report for consideration by the FSF at its meeting in March so that the FSF can complete a final report to the G-7 in April. The President's Working Group on Financial Markets (PWG) is conducting its own analysis along the same lines and will ensure coordination among the U.S. members of the FSF working group. Chairman Bernanke, Vice Chairman Kohn, and President Geithner asked the Board's Staff Umbrella Group on Financial Stability to organize and coordinate staff support for their participation in the FSF working group and the PWG's effort. Specifically, they asked the The materials used by Mr. Parkinson, Mr. Gibson, Ms. Hirtle, Mr. Greenlee, and Mr. Angulo are appended to this transcript (appendix 6). 6 staff to analyze the nine sets of issues listed in the middle panel. Subgroups of staff from the Board and the Federal Reserve Bank of New York were formed to address each set of issues, and work is well under way on all of them. The first four of these issues will be discussed in today's briefing. As shown in the bottom panel, today's briefing will consist of three presentations. I will start by presenting a diagnosis of the underlying reasons that losses on U.S. subprime mortgages triggered a global financial crisis. This diagnosis will suggest that among the most important factors were (1) a loss of investor confidence in the ratings of structuredfinance products and asset-backed commercial paper (ABCP), which caused structured-credit markets to seize up and ABCP markets to contract, and (2) the resulting losses and balance sheet pressures on financial intermediaries, especially many of the largest global financial services organizations. In the second presentation, Mike Gibson and Beverly Hirtle, to my left, will present an analysis of issues relating to credit rating agencies and investor practices with respect to credit ratings. Then, further to my left, Jon Greenlee and Art Angulo will make the final presentation, which will focus on risk-management weaknesses at large global financial services organizations and the extent to which bank regulatory policies contributed to, or failed to mitigate, those weaknesses. I should note that also at the table today we have Norah Barger, who worked with Art Angulo on the regulatory policy issues, and Brian Peters, who worked with Jon Greenlee on the risk-management issues. Turning to the next exhibit, the diagnosis begins with the extremely weak underwriting standards for U.S. adjustable-rate subprime mortgages originated between late 2005 and early 2007. As shown by the solid line in the top left panel, as housing prices softened in 2006 and 2007, the delinquency rate for such mortgages soared, exceeding 20 percent of the entire outstanding stock by late 2007. In contrast, the dashed line shows that the delinquency rate on the stock of outstanding fixed-rate subprime mortgages increased only 2 percentage points over the same period, to around 7 percent. Nearly all of the adjustable-rate subprime mortgages were packaged in residential mortgage-backed securities (RMBS), which were structured in tranches with varying degrees of exposure to credit losses. The top right panel shows indexes of prices of subprime RMBS that are collateralized by mortgages that were originated in the second half of 2006. The blue line shows that prices of BBB minus tranches already had fallen significantly below par in January 2007 and continued to decline throughout last year, falling to less than 20 percent of par by late October. Prices of AAA tranches (the black line), which are vulnerable only to very severe credit losses on the underlying subprime mortgages, remained near par until mid-July, but they slid to around 90 percent of par by early August. After stabilizing for a time, they fell more steeply in October and November and now trade at around 70 percent of par. As shown in the middle left panel, from 2004 through the first half of 2007, increasing amounts of subprime RMBS were purchased by managers of collateralized debt obligations backed by asset-backed securities--that is, ABS CDOs. High-grade CDOs purchased subprime RMBS with an average rating of AA, whereas mezzanine CDOs purchased subprime RMBS with an average rating of BBB. The middle right panel shows the typical ratings at origination of high-grade and mezzanine CDOs. In the case of high-grade CDOs, 5 percent of the securities were rated AAA, and a further 88 percent were ""super senior"" tranches, which would be exposed to credit losses only if the AAA tranches were wiped out. Even in the case of the mezzanine CDOs, the collateral was perceived to be sufficiently strong and diversified that 14 percent of the securities issued were rated AAA at origination and 62 percent were super senior. As delinquencies mounted and prices of RMBS slid well below par, the credit rating agencies were forced to downgrade (or place on watch for downgrade) very large percentages of outstanding ABS CDOs. The bottom left panel shows that such negative actions were quite frequent throughout the capital structures of both highgrade and mezzanine CDOs, even among the AAA-rated tranches. Moreover, the downgrades frequently were severe and implied very substantial writedowns, even of some AAA tranches. When this became apparent to investors, they lost not only faith in the ratings of ABS CDOs but also confidence in the ratings of a much broader range of structured securities. Likewise, sophisticated investors who relied on their own models lost faith in those models as writedowns significantly exceeded what the models led them to expect. As a result, large segments of the structured-credit markets seized up. In particular, as shown in the bottom right panel, issuance of all types of non-agency RMBS declined substantially over the second half of 2007. Although comprehensive data for January are not yet available, conversations with market participants suggest there has been very little or no issuance. Your next exhibit focuses on two other markets that were affected by a loss of investor confidence--the leveraged-loan market and the ABCP market. The top left panel of that exhibit shows that spreads on credit default swaps on leveraged loans (the solid black line) already had come under significant pressure in June. By July these spreads had widened about 150 basis points. Investors had become concerned about a substantial buildup of unfunded commitments to extend leveraged loans (the dashed blue line), which in the U.S. market eventually peaked at $250 billion in July. As shown in the top right panel, as many segments of the structured-credit markets seized up, issuance of collateralized loan obligations dropped off significantly in the third quarter, adding to the upward pressure on spreads on leveraged loans. Nonetheless, the CLO markets continued to function much more effectively than the non-agency RMBS and ABS CDO markets. As shown in the bottom left panel, from 2005 to 2007, the U.S. ABCP market grew very rapidly. Much of the growth was accounted for by conduits that purchased securities, including highly rated non-agency RMBS and ABS CDO tranches, rather than by more traditional ""multi-seller"" conduits that purchased short-term corporate and consumer receivables. As investors became aware that some of the underlying collateral consisted of RMBS and ABS CDOs, they pulled back from the ABCP market generally, even to some extent from the multi-seller programs. Between July and December, total ABCP outstanding declined about $350 billion, or nearly one-third. The bottom right panel provides additional information on the growth of ABCP by program type. As shown in the first column, during the period of rapid growth from 2005 to July 2007, ABCP issued by structured-investment vehicles (SIVs) and CDOs grew far more rapidly than any other program type. The second column shows that, when investors pulled back from the ABCP markets, those program types shrank especially rapidly. The only program type that declined more rapidly during that period was single-seller programs. The single-seller category included a significant amount of paper issued by nondepository mortgage companies to finance mortgages in their private securitization pipelines, and this paper has almost completely run off. The next exhibit focuses on how the seizing-up of structured-credit markets and the contraction of ABCP markets adversely affected banks, especially many of the largest global banks. As you know, a combination of balance sheet pressures, concerns about liquidity, and concerns about counterparty credit risk made banks reluctant to provide term funding to each other and to other market participants. The top left panel of exhibit 4 lists the principal sources of bank exposures to the recent financial stress: leveraged-loan commitments, sponsorship of ABCP programs, and the retention of exposures from underwriting ABS CDOs. The top right panel shows the banks that were the leading arrangers of leveraged loans in recent years. The three largest U.S. bank holding companies (BHCs) head this list. As spreads widened and liquidity declined in the leveraged-loan market, these banks became very concerned about potential losses and liquidity pressures from leveraged-loan exposures. Although these exposures were smaller at the U.S. securities firms, those firms were even more concerned because of their smaller balance sheet capacity. However, to date the adverse impact on banks and securities firms from these exposures has been relatively modest and manageable. The middle left panel shows the leading bank sponsors of global (U.S. and European) securities-related ABCP programs--that is, programs that invest in asset-backed securities, including SIVs, securities arbitrage programs, and certain hybrid programs. As the conduits that issued the ABCP encountered difficulty rolling their paper over, many of these banks, fearful of damage to their reputations, elected to purchase assets from the conduits or extend credit to them, which proved in many cases to be a significant source of balance sheet pressures. This list is dominated by European banks. Indeed, the only U.S. bank among the top nineteen sponsors is Citigroup. However, Citigroup was the largest sponsor of SIVs, which, in addition to issuing ABCP, issue substantial amounts of medium-term notes. Citigroup, like nearly all SIV sponsors, eventually felt obliged to provide full liquidity support for all the liabilities of its SIVs, which amounted to around $60 billion at year-end. The memo item shows that some other U.S. banks sponsored securities-related ABCP programs that were relatively small in absolute terms but significant as a share of their total assets. But losses from leveraged-loan commitments and conduit sponsorship have paled in comparison to the losses some banks and securities firms have incurred from the retention of super senior exposures from ABS CDOs. These include exposures that the underwriters never sold, exposures that originally were funded by ABCP issued by the CDOs that was supported by liquidity facilities provided by the underwriters, and relatively small amounts of exposures purchased from affiliated money funds for reputational reasons. The middle right panel shows the leading underwriters of ABS CDOs in 2006-07. Merrill Lynch, Citigroup, and UBS head the list. Each of those firms has suffered very large subprime CDO-related losses, and Citigroup and UBS still reported very significant exposures at year-end. As shown in the memo items, among the other very largest U.S. bank holding companies, only Bank of America has suffered significant losses or still has significant exposures from underwriting ABS CDOs. I should note that the exposures shown in the exhibit are net of hedges purchased from financial guarantors, and most of these firms have hedged a significant portion of their exposure. As you know, there are concerns about the ability of the guarantors to honor their obligations under the hedging contracts. Indeed, some firms have begun to write down the value of their hedges with the most troubled financial guarantors. The bottom left panel shows total risk-based capital ratios for the four largest U.S. bank holding companies. All four remained comfortably above the 10 percent minimum for wellcapitalized companies at year-end. Of course, Citigroup was able to do so only by raising substantial amounts of capital at a relatively high cost, and each of the other companies also announced capital-raising efforts. Moreover, Citigroup's year-end ratio of tangible common equity to risk-weighted managed assets was 5.7 percent, well below the 6.5 percent target ratio that several of the rating agencies monitor and that Citigroup seeks to meet. The bottom right panel shows credit default swap spreads for the three largest U.S. BHCs. On balance, spreads for all three have moved up about 60 to 70 basis points since the market turmoil began. The spread for Citigroup has been elevated since October, when investors began to become aware of its subprime CDO exposures. The spreads for Bank of America and JPMorgan were in line with a broad index of bank spreads at year-end but jumped in early January on Bank of America's announcement of its planned acquisition of Countrywide and JPMorgan's announcement of substantial additions to its loan-loss reserves. Spreads for all three companies fell back more in line with the index last week. Thank you. I will now take your questions on this presentation before you proceed to Mike and Beverly's presentation. " CHRG-111shrg57320--379 Mr. Doerr," I can read the chart. Is that where it is? Senator Levin. All right. Well, it is also in your book of exhibits, Exhibit 1b. These are some of the practices that we have talked about. One is low-document loans, teaser rate loans, stated income loans, interest-only rate loans, negatively amortizing loans. Those five that I just rattled off, what is the status of those practices today? Are they permitted? Are they frowned upon? " CHRG-111hhrg56766--92 Mr. Bernanke," Well, we have been working on it very hard. We have, for example, increased substantially our information-gathering so that we can make an assessment of how many loans are turned down, what is the rate of loss on small loans versus large loans. We added questions to the National Federation of Independent Businesses Survey asking small firms about their experience with borrowing and so on. So we are trying very hard. We have also our reserve banks around the country currently having a series of summit meetings with community leaders, development organizations, small business lenders, and small companies to try to figure out what the problems are. So we are actively going out and learning about the situation the best we can. It's very difficult because there will be some cases where tighter standards are justified because of the weakness of the economy and the weakness of the borrower's condition. We just want to make sure that when there is a creditworthy borrower that they can obtain credit. " CHRG-110shrg50409--82 Mr. Bernanke," Well, of course, fundamentally the market will do it. The free market will do it. But there are things that we can do. The Federal Reserve has already tried to address, some of the regulatory aspects of high-cost mortgage lending. We and our fellow regulators are also looking at the treatment of mortgages by banks and other lenders in terms of their capital and how they manage that. I think the banks and the private sector themselves are rethinking the standards, the underwriting standards, the loan-to-value ratios, those sorts of things as they go forward. So, I anticipate that we will have a healthy recovery in the housing market once we have gone through this necessary process. But it will probably be less exuberant than we saw earlier with somewhat tougher underwriting standards, more investment due diligence, probably less use of securitization or complex securitized products. But I am confident that, with the appropriate background--I probably include here the GSEs and FHA--the housing market will recover, and it will help be part of the economy's return to growth. Senator Carper. One of my colleagues asked you earlier about the drop in the value of the dollar and asked you quantify that. I will not ask you to do that again. But we have seen the dollar drop, whether it is 20 percent or 30 percent or some other number. We have seen exports, conversely, rise, but yet we have seen a continued loss in manufacturing jobs in this country. I think the last month I noticed maybe 30,000 or 40,000 additional manufacturing jobs had been lost. When do we see that turn around? And what do we need to do to turn it around, the loss of manufacturing jobs, that is? " CHRG-111hhrg53240--147 Chairman Watt," But then I am thinking that maybe if there is a potential for conflict, we may need to be removing even more of it. That was the conflict that I--now, the second question that the industry has raised over and over again, this potential for conflict between consumer and prudential. I keep having trouble identifying even what that is all about. The regulator, Ms. Duke, didn't suggest that that potential existed today, but the industry keeps telling me that there is a conflict between consumer regulation and prudential regulation. And is anybody able to tell me one instance where that would raise its head? Ms. Saunders. I was actually looking for those examples in industry testimony yesterday as I was preparing, and the ones that I came up with from their examples--interesting that Mr. Ireland did not repeat them this morning when you challenged him--one was check hold times. Now, the Expedited Funds Act actually is not one of the ones being proposed and given to the new agency. It would stay with the Fed. But let's assume that it was going. The idea is that the banks say, ``We have operational issues on how we clear checks and we have fraud issues and we just can't speed it up.'' And of course the consumer is saying, ``We want our money now.'' Why couldn't this agency take that into consideration? Nobody wants fraudulent checks cleared. Like any other agency, it is going to balance the issues. " CHRG-110shrg50409--49 Mr. Bernanke," Perhaps a weak effect, but I don't think it is a first-order effect. The linkage between the budget deficit and the trade deficit is there because the trade deficit does reflect our national savings and investment imbalance. But, empirically, the effect is relatively weak under most circumstances. Senator Tester. And the value of the dollar has devaluated by about 40 percent--is that correct?--over the last 4 or 5 years. " CHRG-111shrg57320--399 DEPOSIT INSURANCE CORPORATION Ms. Bair. Chairman Levin, I appreciate the opportunity to testify regarding the role of regulators in their supervision of Washington Mutual Bank (WaMu). The FDIC shares the Subcommittee's concerns about issues associated with the primary regulation of large and complex insured depository institutions that pose significant risk to the Deposit Insurance Fund and the FDIC's role as back-up supervisor.--------------------------------------------------------------------------- \1\ The prepared statement of Ms. Bair appears in the Appendix on page 156.--------------------------------------------------------------------------- To assist the FDIC in carrying out its deposit insurance responsibilities, Congress has given the FDIC ``back-up'' authority to examine insured banking organizations, like WaMu, that have a different agency as their primary Federal regulator. We have often used this authority in a collaborative process to convince the primary regulator to require corrective measures. However, when the collaborative process fails, our ability to independently access information is governed by a 2002 Interagency Agreement in which the FDIC agreed to conduct a special examination only when an institution ``represents a heightened risk'' to the Deposit Insurance Fund. As we learned in the case of WaMu, this is a self-defeating requirement as we must first gain entry before we can establish that the requisite triggering conditions exist. For example, in 2005, WaMu management made the decision to change its business strategy from conventional single-family loans to nontraditional and subprime loan products. OTS management determined that FDIC should not actively participate in OTS examinations at WaMu, citing the 2002 Interagency Agreement. In subsequent years, the FDIC faced repeated resistance to its efforts to fully participate in examinations of WaMu. Even as late as 2008, as problems at WaMu were becoming more apparent, OTS management sought to limit the number of FDIC examiners involved in the examination and did not permit the FDIC to review loan files. In the spring of 2008, WaMu raised additional capital, but the amount raised proved to be insufficient. Virtually all other high-risk mortgage lenders had closed, gone bankrupt, or had chosen to be acquired by other institutions. WaMu's board rejected an acquisition offer from a large commercial bank in favor of a capital infusion that allowed WaMu to retain its independence and management to stay in place, but limited future options for raising capital. In both July and September 2008, WaMu suffered substantial deposit runs, and liquidity was dissipating quickly. By September 24, cash on hand had declined to $4.4 billion, a dangerously low amount for a $300 billion institution that had seen average daily deposit withdrawals exceeding $2 billion in the previous week. The next day the OTS closed WaMu. It has been an extraordinarily challenging time for the Nation's banking industry, and we have all learned lessons at many levels. I am very proud of the FDIC's role as an early advocate for banning unaffordable abusive lending practices, for fighting against large bank capital reductions, and, most importantly, for maintaining confidence in the Nation's banking system by resolving failed institutions in an orderly way and ensuring that insured depositors have seamless access to their money. However, we too are learning important lessons from the crisis, and a central one is that we need to be more proactive in using our back-up authority, particularly for the larger institutions where our exposure is the greatest. We have welcomed the findings and recommendations of the Inspectors General of the FDIC and the Treasury from their WaMu review and have already begun a number of their suggested initiatives. In addition, the FDIC strongly supports pending legislative reform efforts to address the orderly resolution of large financial organizations. The ability to resolve these institutions in the same way that smaller banks are treated, as we did with WaMu, is essential to ending the too-big-to-fail doctrine. The FDIC also strongly supports the need for an independent consumer financial protection regulator. Products and practices that strip personal wealth undermine the foundation of the economy. Finally, we support legislation to require that issuers of mortgage securitizations retain some ``skin in the game'' to provide added discipline for underwriting quality. In fact, the FDIC Board will consider in May a proposal to require insured banks to retain a portion of the credit risk of any securitizations that they sponsor. The FDIC would always like to see troubled institutions return to health and safe and sound practices. However, as was the case with WaMu, when an institution is no longer viable, closing and resolution represent the best course. Further delay by the government would have significantly raised the cost to the FDIC, imposed losses on uninsured depositors, and creditors to even greater losses. The resolution went smoothly. The FDIC was able to preserve all of WaMu's deposits, both insured and uninsured. The resolution left branches open, preserved many jobs, and allowed for a seamless transition for WaMu's customers the day after the bank was closed. In other words, most of WaMu was saved. As with all FDIC resolutions, the institution was not bailed out but, rather, competitively bid to the private sector. We were able to sell it at zero cost to the Deposit Insurance Fund. In contrast, had the FDIC been forced to liquidate WaMu, the FDIC estimates that it would have suffered approximately $41 billion in losses. Thank you for the opportunity to testify, and I am pleased to answer your questions. Senator Levin. Thank you very much, Ms. Bair. Mr. Bowman. TESTIMONY OF JOHN E. BOWMAN,\1\ ACTING DIRECTOR, OFFICE OF FOMC20060920meeting--99 97,MR. STOCKTON.," Part of the difference stems increasingly from our more pessimistic take on potential output. Many of those outside forecasts have the unemployment rate rising to 5 percent, and we have it rising a bit more. Some of that difference is greater cyclical weakness that I would attribute to the depth of the housing downturn that we are forecasting. But some of it is just that we see potential output as very weak as well. That exaggerates or has the potential to create a GDP illusion in comparing the forecasts, where we look much, much weaker even though our output gap isn’t that much larger. For what it is worth, in the past week I have seen more people who do a serious tracking of the economy moving toward our outlook rather than away from it. So it wouldn’t surprise me if more outside forecasters weren’t showing not something as weak as maybe 1½ percent in the second half but something 2 percent or below." CHRG-111shrg52966--56 Mr. Sirri," I do not want to comment on any one firm, but what I will say is that there was considerable variation across the firms, especially with--let us take that same point, pricing. And one thing we saw--and this is mentioned--issues like this are dealt with in the Senior Supervisors report that the New York Fed led. The stronger your governance, the stronger your controls, it turns out the better you probably weathered the storm. The best-run firms had good processes, and some of the firms that got into the most trouble had distinct weaknesses. It varied from firm to firm. Senator Reed. Just to follow up, the firms that you saw, and some of which have failed, did you note those weaknesses? Did you communicate those weaknesses to the board? It goes to the essence of many of the questions we have raised. You know, making the diagnosis that you are ill and then not treating the patient is, you know, malpractice. What do you think? " CHRG-111hhrg56778--25 Chairman Kanjorski," When did you make somebody aware of weaknesses there? Ms. Gardineer. We communicated to them through our examination process. " CHRG-111shrg56415--47 Mr. Dugan," Yes. Senator Corker. And are each of you going to write standards that are dramatically different from those that got us into the situation? I mean, each of you agreed with Senator Gregg's questions, but I wonder if we are actually going to take action to make that occur. Ms. Bair. First of all, I want to clarify, there is plenty of bad underwriting. I want to emphasize that, the kinds of new credit problems we are seeing now are more economically driven. There was plenty of bad underwriting in both mortgage lending as well as commercial real estate. We have tightened the standards tremendously. I think we are being criticized in other quarters. Please note that we issued commercial real estate guidance in 2006. Senator Corker. Well, I---- Ms. Bair. The Federal Reserve Board has issued rules that apply to both banks and non-banks for mortgage lending that significantly tighten the standards. That already has taken place. Also, we are working on capital rules that will require greater capital charges against higher-risk loans, such as those with high LTVs. The bank regulators are doing all that, and have for some time. You still have a fairly significant non-bank sector, one that can come back as the capital markets heal. That is why I hope that, going forward, in terms of whatever reforms you come up with, that those reforms will reflect the fact that there are two different sectors, two different providers of credit in this country. We can keep tamping down on the banks as we have been. But if the non-bank sector is left, by and large, unregulated, that is not going to fix the problem. " CHRG-111shrg57320--222 Mr. Carter," We knew there was a greater propensity for fraud in stated income loans. From an examination standpoint, we would look at the fraud risk management practices of the institution from the top down. Senator Kaufman. And if you saw this going on, you were aware of these numbers, you would have at least asked them to make a referral to the Justice Department? If not, you would have referred it yourself? " CHRG-111hhrg67816--263 Mr. Rheingold," I don't think so. I actually think there are two things happening here, and I think to be fair the FTC was not the controlling regulatory agency. The OCC and the OTS really failed and they had a lot of things that they could have done to prevent the disaster we have today. I think the OCC through its enforcement powers, if they in fact had been effective enforcers and using those decisions, I think the perfect example of a strong enforcement agency can do is what the Massachusetts AG did in the Freemon case where they brought a case against the mortgage company who was engaged in unfair practices, where they were making loans that people could not afford, and using the unfairness authority that court declared that these practices, A, B, C, and D, making a loan at a teaser rate that explodes and people can't afford it is unfair. Making a loan to people over 50 percent of their gross income is per se unfair. If the FTC would have taken some of those actions, even in the Fairbanks case there was an opportunity to declare certain practices that the service industry does as unfair, it could have had a real impact on the type of practices that exist throughout the mortgage industry. " 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-111shrg57320--10 Mr. Thorson," The ability to state your own income is--especially I had not seen it before about redacting out W-2s. We talk a lot about risk here. You are just increasing the risk exponentially when you do something like that. I guess it still comes down, if I were on the other side trying to argue, well, the strength of the borrower, etc. But the problem is, you can't assess the strength of the borrower and that has got to be at the foundation of underwriting, risk assessment, risk management of any of this. Senator Levin. Without that information? " CHRG-111shrg57320--231 Mr. Dochow," I think that gets to the linchpin. Senator Kaufman. I think that is basically--I am sorry to have gone so far over, Mr. Chairman. Senator Levin. No, not at all. I am glad you are doing what you are doing--it is exactly on target. It is not, though, just what you have discussed. It is also the cultural environment inside the regulatory agency. I want to read you a couple more emails about that cultural environment. If you take a look at Exhibit 39\1\, right in the middle there, it says--this is to you, Mr. Dochow. ``We are going to have the same battle on the complaint memo, although I still stand by the findings. Since we weren't able to do a separate evaluation of the process, they will fight it. It doesn't matter that we are right, what matters is how it is framed. And all we can do''--listen to this--``is point to the pile of complaints and say there is a problem.''--------------------------------------------------------------------------- \1\ See Exhibit No. 39, which appears in the Appendix on page 357.--------------------------------------------------------------------------- That is not all you can do. You can do a lot more than that if you have the will to do it. Take a look at Exhibit 34.\2\ This one is really pretty dramatic stuff. Exhibit 34, this is a time when OTS was looking at an underwriting recommendation, and they were going to be a little bit tougher in their recommendation, and they were talked out of it by the bank. Take a look at page 2. ``OTS confirmed today that they will re-issue this memo without the `Criticism.' It will be a `Recommendation.' '' So it starts off as a criticism, but then OTS is talked into making it less than a criticism. It is just going to be a recommendation.--------------------------------------------------------------------------- \2\ See Exhibit No. 34, which appears in the Appendix on page 335.--------------------------------------------------------------------------- And then if you look at the first page of Exhibit 34, you will see a memo, ``Good news''--this is inside of the bank. ``Good news--John''--and that is Robinson at WaMu--``was able to get the OTS to see the light''--you guys were really seeing the light a lot--``and revise the Underwriting rating to a Recommendation. Our response is already complete.'' And then at the top of this memo from the head of Home Loans, ``I'll bet you're a happy guy!!! Well done.'' Well, they were too happy too often with OTS backing off from taking strong action. And then take a look, if you would, at--and, by the way, while Senator Kaufman is here, I think that stated income loans are still not prohibited at all. We just heard that from the last panel, so I think, Mr. Reich, when you said that you thought---- " FOMC20080130meeting--317 315,MR. PARKINSON.," Mike is going to address that in his briefing. I guess I'd prefer to delay and just simply say that I think we can point to aspects of their methodology that look fairly weak so that it wasn't simply an ex post result but one that should have been foreseen at least to a degree if they had had a stronger methodology ex ante. Obviously that's Monday morning quarterbacking, but still you can point to specific things that were weaknesses. " CHRG-111shrg57319--424 Mr. Beck," I am not sure whether the loans that Mr. Shaw identified---- Senator Levin. Should you know? Should you have known? Look, you are being told that your Option ARMs have a real high propensity for delinquency. You write emails back and forth--high delinquency, fear of delinquency. You identify those Option ARMs. First you identify the risks. Three billion dollars is authorized; a billion and a half of Option ARMs from that inventory are sold. You have done a study. You know the propensity. You have an obligation to tell your purchasers as an underwriter complete and truthful information. Did your investors know of your high delinquency expectation? Do you know? " CHRG-111hhrg53244--174 Mr. Klein," Thank you, Mr. Chairman. And thank you, Mr. Chairman, for being with us today. I am going to bring the conversation back to what I continue to believe are the most current issues, and that is home foreclosures and lending to businesses. I have been a believer from the beginning that, when we started this process on dealing with the recession and dealing with the banking crisis, I think you and others said we need to deal with both, you can't do one without the other, can't make the investment in the recovery without making liquidity available to businesses, and you can't fix the banks without stimulating and getting things moving on the private side. What I also believe, and I support your position, is that we are going to have a slow, maybe a little bumpy recovery, but it is probably moving in the right direction. And what our goal, of course, as people in the public and private side, is to mitigate or reduce the amount of time it takes for the natural cycles to work their way through. That being said, I am from Florida, as you and I have talked about, and we are in a very precarious time. The banks are overexposed, in many ways. The residential markets are overexposed. And we do not see enough activity, movement. And that is speaking to Realtors on short sales and workouts and things like that on the residential side; and on the business side, real estate and/or business, the lending practices. And there is a lot of frustration out there, maybe justified, maybe not justified, but certainly intuitively justified, that banks that received Federal assistance--and maybe they are in a separate category--but that they have a higher responsibility to work out this scenario. Nobody is pushing them to make unreasonable and unjustified underwriting decisions. But they really are not part of the process of solving the problem. Specifically on the foreclosure area, I think it was the Federal Reserve of Boston, did a paper that talked about 3 percent of the serious delinquent loans have been resolved since the 2007 period of time. That obviously is not working in any successful way. Can you share with us, whether it is the Federal Reserve or whether just your general experience, what we can do to deal with the foreclosure--what can we do to stimulate the banks to help work this out on a much more efficient, much more quick basis? " 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. " FinancialCrisisReport--322 Market Maker, Underwriter, Placement Agent, Broker-Dealer Investment banks typically play a variety of significant roles when dealing with their clients, including that of market maker, underwriter, placement agent, and broker-dealer. Each role brings different legal obligations under federal securities law. Market Maker. A “market maker” is typically a dealer in financial instruments that stands ready to buy and sell for its own account a particular financial instrument on a regular and continuous basis at a publicly quoted price. 1242 A major responsibility of a market maker is filling orders on behalf of customers. Market markers do not solicit customers; instead they maintain, buy, and sell quotes in a public setting, demonstrating their readiness to either buy or sell the specified security, and customers come to them. For example, a market maker in a particular stock typically posts the prices at which it is willing to buy or sell that stock, attracting customers based on the competitiveness of its prices. This activity by market makers helps provide liquidity and efficiency in the trading market for the security. 1243 It is common for a particular security to have multiple market makers who competitively quote the security. Market makers generally use the same inventory of assets to carry out both their market- making and proprietary trading activities. Market makers are allowed, in certain circumstances specified by the SEC, to sell securities short in situations to satisfy market demand when they do not have the securities in their inventory in order to provide liquidity. Market makers have among the most narrow disclosure obligations under federal securities law, since they do not actively solicit clients or make investment recommendations to them. Their disclosure obligations are generally limited to providing fair and accurate information related to the execution of a particular trade. 1244 Market makers are also subject to the securities laws’ prohibitions against fraud and market manipulation. In addition, they are subject to legal requirements relating to the handling of customer orders, for example using best execution efforts when placing a client’s buy or sell order. 1245 Underwriter and Placement Agent. If an investment bank agrees to act as an “underwriter” for the issuance of a new security to the public, such as an RMBS, it typically 1242 Section 3(a)(38) of the Securities Exchange Act of 1934 states: “The term “market maker ” means any specialist permitted to act as a dealer, any dealer acting in the capacity of block positioner, and any dealer who, with respect to a security, holds himself out (by entering quotations in an inter-dealer communications system or otherwise) as being willing to buy and sell such security for his own account on a regular or continuous basis.” See also SEC website, http://www.sec.gov/answers/mktmaker.htm; FINRA website, FAQs, “W hat Does a Market Maker Do? ” http://finra.atgnow.com/finra/categoryBrowse.do. 1243 See SEC website, http://www.sec.gov/answers/mktmaker.htm; FINRA website, FAQs, “W hat Does a Market Maker Do? ” http://finra.atgnow.com/finra/categoryBrowse.do. 1244 1/2011 “Study on Investment Advisers and Broker-Dealers,” study conducted by the U.S. Securities and Exchange Commission, at 55, http://www.sec.gov/news/studies/2011/913studyfinal.pdf. 1245 See Responses to Questions for the Record from Goldman Sachs at PSI_QFR_GS0046. purchases the securities from the issuer, holds them on its books, conducts the public offering, and bears the financial risk until the securities are sold to the public. By law, securities sold to the public must be registered with the SEC. Underwriters help issuers prepare and file the registration statements filed with the SEC, which explain to potential investors the purpose of a proposed public offering, the issuer’s operations and management, key financial data, and other important facts. Any offering document, or prospectus, given to the investing public in connection with a registered security must also be filed with the SEC. FinancialCrisisReport--100 At the Subcommittee hearing, Mr. Vanasek agreed these were “eye popping” rates of fraud. 329 On November 18, 2005, Cheryl Feltgen, the Home Loans Chief Credit Officer, “had a very quick meeting” with Home Loans President David Schneider, the head of Home Loans sales, Tony Meola, and others in which she reviewed the memorandum and presentation on the fraud investigation. 330 After the meeting, she sent an email to the Risk Mitigation Team stating: “The good news is that people are taking this very seriously. They requested some additional information that will aid in making some decisions on the right course of action.” 331 She asked the Risk Mitigation Team to prepare a new spreadsheet with the loan information, which the team did over the weekend in anticipation of a Monday meeting. The trail of documentation in 2005 about the fraud investigation ends there. Despite the year-long effort put into the investigation, the written materials prepared, the meetings held, and fraud rates in excess of 58% and 83% at the Downey and Montebello offices, no discernable actions were taken by WaMu management to address the fraud problem in those two offices. No one was fired or disciplined for routinely violating bank policy, no anti-fraud program was installed, no notice of the problem was sent to the bank’s regulators, and no investors who purchased RMBS securities containing loans from those offices were alerted to the fraud problem underlying their high delinquency rates. Mr. Vanasek retired from the bank in December 2005, and the new Chief Risk Officer Ron Cathcart was never told about the fraud investigation. Senior personnel, including Mr. Schneider, Mr. Meola, and Ms. Feltgen, failed to follow up on the matter. Over the next two years, the Downey and Montebello head loan officers, Messrs. Ramirez and Fragoso, continued to issue high volumes of loans 332 and continued to win awards for their loan productivity, including winning trips to Hawaii as members of WaMu’s “President’s Club.” One of the loan officers even suggested to bank President Steve Rotella ways to further relax bank lending standards. 333 In June 2007, however, the fraud problem erupted again. That month, AIG, which provided mortgage insurance for some of WaMu’s residential mortgages, contacted the bank with concerns about material misrepresentations and fraudulent documents included in 328 8/30/2005 email from Tim Bates to Jim Vanasek and others, JPM_WM04026075, Hearing Exhibit 4/13-23b. 329 April 13, 2010 Subcommittee Hearing at 28. 330 11/18/2005 email from Cheryl Feltgen to Nancy Gonseth on the Risk Mitigation Team and Tim Bates, JPM_WM03535695, Hearing Exhibit 4/13-23a. 331 Id. 332 At the Subcommittee’s hearing, Mr. Vanasek testified that as much as $1 billion in loans originated out of these two offices per year. April 13, 2010 Subcommittee Hearing at 27. 333 See, e.g., 3/2006 WaMu email chain, JPM_WM03985880-83. mortgages being issued by Mr. Fragoso, the loan officer heading the Montebello office. 334 When no one responded to its concerns, in September 2007, AIG filed a Suspected Fraud Claim with the California Department of Insurance which, in turn, notified OTS of the problem. 335 The OTS FOMC20070321meeting--12 10,MR. DUDLEY.," You’re absolutely right. The market was much smaller at that time. I would characterize the deterioration that you saw in 2001 as probably mostly driven by the macroeconomy, and the deterioration that you saw in 2006 as driven mostly by two things: more laxity in the underwriting process and a change in the trajectory of home prices. So I think the causes of the deterioration in the two cases were quite different. The subprime mortgage market in 2006 is several times the size of the originations in 2001; so obviously it will have a bigger consequence." CHRG-111shrg57319--563 Mr. Rotella," Clearly, this report indicates that in September 2008, about 3 weeks before the seizure of the institution. Senator Levin. It says something else. It says that there is ``evidence that this control weakness has existed for some time.'' A lack of controls for fraud, according to this report--this is your own internal report--has existed for some time. What was your reaction when you read that? " 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? " CHRG-111shrg57320--20 Mr. Rymer," Yes, sir. I agree with what Mr. Thorson said. I think that the examiners, from what I have seen here, were pointing out the problems, underwriting problems, riskier products, concentrations, distributions, and markets that may display more risk--they were all significant problems and they were identified. At the end of the day, though, I don't think forceful enough action was taken. Senator Levin. But they are serious enough that enforcement action was needed because management was not addressing it. Is that a fair conclusion? " CHRG-111shrg57320--28 Mr. Rymer," Yes, sir, just to follow up, I mean, Mr. Thorson was alluding to the guidance. The OTS guidance says, ``If an association has a high exposure to credit risk, it is not sufficient to demonstrate that the loans are profitable or that the association has not experienced significant loan losses in the near term.'' That is directly from the OTS Handbook. Senator Levin. Now, in a departure from its usual practices, OTS did not independently track its finding in WaMu's responses. Instead, it relied on WaMu's ERICS tracking system. Didn't that make OTS dependent on WaMu, Mr. Thorson? " CHRG-111shrg52619--63 Mr. Dugan," I think that is a very good question. I think capital is not enough by itself. I think you are right. And as I mentioned in my testimony, in the area of mortgages, I think if we had had or if we would have in the future some sort of more national standard in the area of--and if I think of two areas going back that I wish we had over again 10 years ago, it is in the area of stated income or no-documentation loans, and it is in the area of loan-to-value ratios or the requirement for a significant downpayment. Those are underwriting standards. They are our loan standards, and I think if we had more of a national minimum, as, for example, they have had in Canada and as we had in the GSE statutes for GSE conforming loans, I think we would have had far fewer problems. Now, fewer people would have gotten mortgages, and there would have been fewer people that would have been able to purchase homes, and there would be pressure on affordability. But it would have been a more prudent, sound, underwriting standard that would have protected us from a lot of problems. Senator Corker. I hope as we move forward with this you will continue to talk about that, because I think that is a very important component that may be left by the wayside. And I hope that all of us will look at a cause-neutral solution going forward. Right now we are focused on home mortgages and credit default swaps. But we do not know what the next cause might be. Mr. Tarullo, you mentioned something about credit default swaps, and I am not advocating this, but I am just asking the question. In light of the fact that it looks like as you go down the chain, I mean, we end up having far more credit default swap mechanisms in place than we have actual loans or collateral that is being insured, right? I mean, it is multiplied over and over and over. And it looks like that the person that is at the very end of the chain is kind of the greater fool, OK, because everybody keeps laying off. Is there any thought about the fact that credit default swaps may be OK, but the only people who should enter into those arrangements ought to be people that actually have an interest in the actual collateral itself and that you do not, in essence, put in place this off-racetrack-betting mechanism that has nothing whatsoever to do with the collateral that is being insured itself? Have there been any thoughts about that? " FOMC20060808meeting--42 40,MR. FISHER.," Is that net of our weakness or our declining? This is just guess work, but I am curious." CHRG-111shrg56376--127 RESPONSES TO WRITTEN QUESTIONS OF SENATOR BUNNING FROM JOHN C. DUGANQ.1. What is the best way to decrease concentration in the banking industry? Is it size limitations, rolling back State preemption, higher capital requirements, or something else?A.1. The financial crisis has highlighted the importance of inter-linkages between the performance of systemically important banks, financial stability, and the real economy. It has also highlighted the risks of firms that are deemed ``too big to fail.'' There are a range of policy options that are under active consideration by U.S. and global supervisors to address these issues. Given the multifaceted nature of this problem, we believe that a combination of policy responses may be most appropriate. A crucial first step, we believe, is strengthening and raising the current capital standards for large banking organizations to ensure that these organizations maintain sufficient capital for the risks they take and pose to the financial system. Part of this effort is well underway through initiatives being taken by the Basel Committee on Bank Supervision (the ``Committee''). As announced in July, the Committee has adopted a final package of measures that will strengthen and increase the capital required for trading book and certain securitization structures. The results of a recent quantitative analysis conducted by the Committee to assess the impact of the trading book rule changes suggest that these changes will increase average trading book capital requirements by two to three times their current levels, although the Committee noted significant dispersion around this average. The Committee has underway several other key initiatives that we believe are also critical to reduce the risks posed by large, internationally active banks. These include: Strengthening the quality, international consistency, and transparency of a bank's capital base; Developing a uniform Pillar -1 based leverage ratio, which, among other requirements, would apply a 100 percent credit conversion factor to certain off- balance sheet credit exposures; Introducing a minimum global standard for funding liquidity that includes a stressed liquidity coverage ratio requirement, underpinned by a longer-term structural liquidity ratio; and Developing a framework for countercyclical capital buffers above the minimum requirement. The framework will include capital conservation measures such as constraints on capital distributions. The Basel Committee will review an appropriate set of indicators, such as earnings and credit-based variables, as a way to condition the build up and release of capital buffers. In addition, the Committee will promote more forward-looking provisions based on expected losses.The OCC has been actively involved in, and strongly supports, these initiatives. In addition to these actions, there are other policy initiatives under consideration, including the development of incremental capital surcharges that would increase with the size and/or risk of the institution, and measures to reduce the systemic impact of failure, such as reduced interconnectedness and resolution planning. As noted in my testimony, the OCC also endorses domestic proposals to establish a Financial Stability Oversight Council that would identify and monitor systemic risk, gather and share systemically significant information, and make recommendations to individual regulators. This council would consist of the Secretary of the Treasury and all of the Federal financial regulators, and would be supported by a permanent staff. We also endorse enhanced authority to resolve systemically significant financial firms. We believe that a multipronged approach, as outlined above; is far more appropriate than relying on a single measure, such as asset size, to address the risks posed by large institutions. We also believe that to ensure the competitiveness of U.S. financial institutions in today's global economy, many of these policy initiatives need to be coordinated with, and implemented by, supervisors across the globe. Finally, we strongly disagree with any suggestion that Federal preemption was a root cause of the financial crisis or that rolling back preemption would be a solution. In this regard, we would highlight that the systemic risk posed by companies such as AIG, Lehman Brothers, and Bear Stearns were outside of the OCC's regulatory authority and thus not affected by the OCC's application of Federal preemption decisions.Q.2. Treasury has proposed making the new banking regulator a bureau of the Treasury Department. Putting aside whether we should merge the current regulators, does placing the new regulator in Treasury rather than as a separate agency provide enough independence from political influence?A.2. It is critical that the new agency be independent from the Treasury Department and the Administration to the same extent that the OCC and OTS are currently independent. For example, current law provides the OCC with important independence from political interference in decision making in matters before the Comptroller, including enforcement proceedings; provides for funding independent of political control; enables the OCC to propose and promulgate regulations without approval by the Treasury; and permits the agency to testify before Congress without the need for the Administration's clearance of the agency's statements. It is crucial that these firewalls be maintained in a form that is at least as robust as current law provides with respect to the OCC and the OTS, to enable the new regulator to maintain comparable independence from political influence. In addition, consideration should be given to providing the new regulator the same independence from OMB review and clearance of its regulations as is currently provided for the FDIC and the Federal Reserve Board. This would further protect the new agency's rulemaking process from political interference.Q.3. Given the damage caused by widespread use of subprime and nontraditional mortgages--particularly low documentation mortgages--it seems that products that are harmful to the consumer are also harmful to the banks that sell them. If bank regulators do their job and stop banks from selling products that are dangerous to the banks themselves, other than to set standards for currently unregulated firms, why do we need a separate consumer protection agency?A.3. In the ongoing debate about reforming the structure of financial services regulation to address the problems highlighted by the financial crisis, relatively little attention has been paid to the initial problem that sparked the crisis: the exceptionally weak, and ultimately disastrous, mortgage underwriting practices accepted by lenders and investors. The worst of these practices included: The failure to verify borrower representations about income and financial assets (the low documentation loans mentioned in this question); The failure to require meaningful borrower equity in the form of real down payments; The acceptance of very high debt-to-income ratios; The qualification of borrowers based on their ability to afford artificially low initial monthly payments rather than the much higher monthly payments that would come later; and The reliance on future house price appreciation as the primary source of repayment, either through refinancing or sale.The consequences of these practices were disastrous not just for borrowers and financial institutions in the United States, but also for investors all over the world due to the transmission mechanism of securitization. To prevent this from happening again, while still providing adequate mortgage credit to borrowers, regulators need to establish, with additional legislative authorization as necessary, at least three minimum underwriting standards for all home mortgages: First, underwriters should verify income and assets. Second, borrowers should be required to make meaningful down payments. Third, a borrower should not be eligible for a mortgage where monthly payments increase over time unless the borrower can afford the later, high payments.It is critical that these requirements, and any new mortgage regulation that is adopted, apply to all credit providers to prevent the kind of competitive inequity and pressure on regulated lenders that eroded safe and sound lending practices in the past. Prudential bank supervisors, including the OCC, are best positioned to develop such new underwriting standards and would enforce them vigorously with respect to the banks they supervise. A separate regulatory mechanism would be required to ensure that such standards are implemented by nonbanks. While the proposed new Consumer Financial Protection Agency would have consumer protection regulatory authority with respect to nonbanks, they would not have--and they should not have--safety and soundness regulatory authority over underwriting standards.Q.4. Since the two most recent banking meltdowns were caused by mortgage lending, do you think it is wise to have a charter focused on mortgage lending? In other words, why should we have a thrift charter?A.4. When there are systemwide problems with residential mortgages, institutions that concentrate their activities in those instruments will sustain more losses and pose more risk to the deposit insurance fund than more diversified institutions. On the other hand, there are many thrifts that maintained conservative underwriting standards and have weathered the current crisis. The Treasury proposal would eliminate the Federal thrift charter--but not the State thrift charter--with all Federal thrifts required to convert to a national bank, State bank, or State thrift, over the course of a reasonable transition period. (State thrifts would then be treated as State ``banks'' under Federal law.) An alternative approach would be to preserve the Federal thrift charter, with Federal thrift regulation being conducted by a division of the merged agency. With the same deposit insurance fund, same prudential regulator, same holding company regulator, and a narrower charter (a national bank has all the powers of a Federal thrift plus many others), it is unclear whether institutions will choose to retain their thrift charters over the long term.Q.5. Should banking regulators continue to be funded by fees on the regulated firms, or is there a better way?A.5. Funding bank regulation and supervision through fees imposed on the regulated firms is preferable to the alternative of providing funding through the appropriations process because it ensures the independence from political control that is essential to bank supervision. For this reason, fee-based funding is the norm in banking regulation. In the case of the OCC and OTS, Congress has determined that assessments and fees on national banks and thrifts, respectively, will fund supervisory activities, rather than appropriations from the United States Treasury. Since enactment of the National Bank Act in 1864, the OCC has been funded by various types of fees imposed on national banks, and over the more than 145 years that the OCC has regulated national banks, this funding mechanism has never caused the OCC to weaken or change its regulation or supervision of national banks, including with respect to national banks' compliance with consumer protection laws. Neither the Federal Reserve Board nor the FDIC receives appropriations. State banking regulators typically also are funded by assessments on the entities they charter and supervise.Q.6. Why should we have a different regulator for holding companies than for the banks themselves?A.6. Combining the responsibilities for prudential bank supervision and holding company supervision in the same regulator would be a workable approach in the case of those holding companies whose business is comprised solely or overwhelmingly of one or more subsidiary banks. Elimination of a separate holding company regulator in these situations would remove duplication, promote simplicity and accountability, and reduce unnecessary compliance burden for institutions as well. Such a consolidated approach would be more challenging where the holding company has substantial nonbanking activities in other subsidiaries, such as complex capital markets activities, securities, and insurance. The focus of a dedicated, strong prudential banking supervisor could be significantly diluted by extending its focus to substantial nonbanking activities. The Federal Reserve has unique resources and expertise to bring to bear on supervision of these sorts of activities conducted by bank affiliates in a large, complex holding company. Therefore, a preferable approach would be to preserve such a role for the Federal Reserve Board, but to clearly delineate the respective roles of the Board and the prudential bank supervisors with respect to the holding company's activities.Q.7. Assuming we keep thrifts and thrift holding companies, should thrift holding companies be regulated by the same regulator as bank holding companies?A.7. Yes. Thrift holding companies, unlike bank holding companies, currently are not subject to consolidated regulation; for example, no consolidated capital requirements apply at the holding company level. This difference between bank and thrift holding company regulation created arbitrage opportunities for companies that were able to take on greater risk under a less rigorous regulatory regime. Yet, as we have seen--AIG is the obvious example--large nonbank firms can present similar risks to the system as large banks. This regulatory gap should be closed, and these firms should be subject to the same type of oversight as bank holding companies. The Treasury Proposal would make these types of firms subject to the Bank Holding Company Act and supervision by the Federal Reserve Board. We support this approach, including a reasonable approach to grandfathering the activities of some thrift holding companies that may not conform to the activities limitations of the Bank Holding Company Act.Q.8. The proposed risk council is separate from the normal safety and soundness regulator of banks and other firms. The idea is that the council will set the rules that the other regulators will enforce. That sounds a lot like the current system we have today, where different regulators read and enforce the same rules different ways. Under such a council, how would you make sure the rules were being enforced the same across the board?A.8. The Treasury proposal establishes the Financial Services Oversight Council to identify potential threats to the stability of the U.S. financial system; to make recommendations to enhance the stability of the U.S. financial markets; and to provide a forum for discussion and analysis of emerging issues. Based on its monitoring of the U.S. financial services marketplace, the Council would also play an advisory role, making recommendations to, and consulting with, the Board of Governors of the Federal Reserve System. As I understand the Treasury proposal, however, the Council's role is only advisory; it will not be setting any rules. Therefore, we do not anticipate any conflicting enforcement issues to arise from the Council's role.Q.9. Mr. Dugan, in Mr. Bowman's statement he says Countrywide converted to a thrift from a national bank after it had written most of the worst loans during the housing bubble. That means Countrywide's problems were created under your watch, not his. How do you defend that charge and why should we believe your agency will be able to spot bad lending practices in the future?A.9. In evaluating the Countrywide situation, it is important to know all the facts. Both Countrywide Bank, N.A., and its finance company affiliate, Countrywide Home Loans, engaged in mortgage lending activities. While the national bank was subject to the supervision of the OCC, Countrywide Home Loans, as a bank holding company subsidiary, was subject to regulation by the Federal Reserve and the States in which it did business. Mortgage banking loan production occurred predominately at Countrywide Home Loans, \1\ the holding company's finance subsidiary, which was not subject to OCC oversight. Indeed, all subprime lending, as defined by the borrower's FICO score, was conducted at Countrywide Home Loans and not subject to OCC oversight. The OCC simply did not allow Countrywide Bank, N.A., to engage in such subprime lending.--------------------------------------------------------------------------- \1\ Countrywide Financial Corporation 10-Q (Mar. 31, 2008).--------------------------------------------------------------------------- When Countrywide Financial Corporation, the holding company, began to transition more of the mortgage lending business from Countrywide Home Loans to the national bank, the OCC started to raise a variety of supervisory concerns about the bank's lending risk and control practices. Shortly thereafter, on December 6, 2006, Countrywide Bank applied to convert to a Federal savings bank charter. Countrywide Bank became a Federal savings bank on March 12, 2007. Going forward, Countrywide Bank, FSB, was regulated by OTS, and Countrywide Home Loans was regulated by the OTS and the States in which it did business. Countrywide Financial Corporation continued to transition its mortgage loan production to the Countrywide Bank, FSB. By the end of the first quarter of 2008, over 96 percent of mortgage loan production of Countrywide Financial Corporation occurred at Countrywide Bank, FSB. \2\--------------------------------------------------------------------------- \2\ Countrywide Financial Corporation 10-Q (Mar. 31, 2008).--------------------------------------------------------------------------- Bank of America completed its acquisition of Countrywide Financial Corporation on June 30, 2008. Countrywide Bank, N.A., was not the source of toxic subprime loans. The OCC raised concerns when Countrywide began transitioning more of its mortgage lending operations to its national bank charter. It was at that point that Countrywide flipped its national bank charter to a Federal thrift charter. The facts do not imply lax supervision by the OCC, but rather quite the opposite. The OCC continues to identify and warn about potentially risky lending practices. On other occasions, the OCC has taken enforcement actions and issued guidance to curtail abuses with subprime credit cards and payday loans. Likewise, the Federal banking agencies issued guidance to address emerging compliance risks with nontraditional mortgages, such as payment option ARMs, and the OCC took strong measures to ensure that that guidance was effectively implemented by national banks throughout the country.Q.10. All of the largest financial institutions have international ties, and money can flow across borders easily. AIG is probably the best known example of how problems can cross borders. How do we deal with the risks created in our country by actions somewhere else, as well as the impact of actions in the U.S. on foreign firms?A.10. As noted in our response to Question 1, the global nature of today's financial institutions increasingly requires that supervisory policies and actions be coordinated and implemented on a global basis. The OCC is an active participant in various international supervisory groups whose goal is to coordinate supervisory policy responses, to share information, and to coordinate supervisory activities at individual institutions whose activities span national borders. These groups include the Basel Committee on Bank Supervision (BCBS), the Joint Forum, the Senior Supervisors Group (SSG), and the Financial Stability Board. In addition to coordinating capital and other supervisory standards, these groups promote information sharing across regulators. For example, the SSG recently released a report that evaluates how weaknesses in risk management and internal controls contributed to industry distress during the financial crisis. The observations and conclusions in the report reflect the results of two initiatives undertaken by the SSG. These initiatives involved a series of interviews with firms about funding and liquidity challenges and a self-assessment exercise in which firms were asked to benchmark their risk management practices against recommendations and observations taken from industry and supervisory studies published in 2008. One of the challenges that arise in resolving a cross-border bank crisis is that crisis resolution frameworks are largely designed to deal with domestic failures and to minimize the losses incurred by domestic stakeholders. As such, the current frameworks are not well suited to dealing with serious cross-border problems. In addition to the fact that legal systems and the fiscal responsibility are national matters, a basic reason for the predominance of the territorial approach in resolving banking crises and insolvencies is the absence of a multinational framework for sharing the fiscal burdens for such crises or insolvencies. To help address these issues, the BCBS has established a Cross-border Bank Resolution Group to compare the national policies, legal frameworks and the allocation of responsibilities for the resolution of banks with significant cross-border operations. On September 17, 2009, the BCBS issued for comment a report prepared by this work group that sets out 10 recommendations that reflect the lessons from the recent financial crisis and are designed to improve the resolution of a failing financial institution that has cross-border activities. The report's recommendations fall into three categories including: The strengthening of national resolution powers and their cross-border implementation; Ex ante action and institution-specific contingency planning, which involves the institutions themselves as well as critical home and host jurisdictions; and, Reducing contagion and limiting the impact on the market of the failure of a financial firm by actions such as further strengthening of netting arrangements.We believe adoption of these recommendations will enhance supervisors' ability to deal with many of the issues posed by resolving a cross-border bank. ------ CHRG-111hhrg58044--143 Mr. Snyder," Well, in one sense it might force the industry to go back to larger classifications and rely more on those, such as territory and other factors which themselves were controversial. With the addition of credit-based insurance scores, you have added a degree of objectivity and individual tailoring that did not exist before, and it allows both not only accurate rating and underwriting of individuals but has improved availability in the market because the confidence companies have that they have the ability to price every risk and therefore, many more risks are being written in the voluntary market. " CHRG-111hhrg53240--93 Mr. Green," Okay. The reason I am asking is because every survey indicates that African Americans, minorities who apply for loans, are less likely to get the same treatment as equally qualified persons who are not minorities. And I am concerned that, given the history of this, and the lack of what I see as affirmative action to correct it, what will happen if we leave it there? It seems to me that a consumer protection agency would probably look at these things a little bit closer and see it as a greater mission than it has been accorded where it is currently. Ms. Duke. I would just say that our examiners take this very seriously. And there really are two parts to the examination process. Sometimes they may find a practice that is not in itself discrimination but looks suspect or looks dangerous, and they will talk with the bank and maybe take informal action to get that practice stopped. In those cases, the practice does stop. In cases where either that is not an option or the practice does not stop, those cases are referred to Justice. " CHRG-111hhrg53248--27 Secretary Geithner," Chairman Frank, Ranking Member Bachus, and members of the committee, thanks for giving me the chance to come before you today. Let me first begin by commending you for the important work you have already undertaken to help build consensus on financial reform. We have an opportunity to bring about fundamental change to our financial system, to provide greater protection for consumers and for businesses. We share a responsibility to get this right and to get this done. On June 17th, the President outlined a proposal for comprehensive change of the basic rules of the road for the financial system. These proposals were designed to lay the foundation for a safer, more stable financial system, one less vulnerable to booms and busts, less vulnerable to fraud and manipulation. The President decided we need to move quickly while the memory of the searing damage caused by this crisis was still fresh and before the impetus to reform faded. These proposals have led to an important debate about how best to reform this system, how to achieve a better balance between innovation and stability. We welcome this debate, and we will work closely with the Congress to help shape a comprehensive and strong package of legislative changes. My written testimony reviews the full outlines of these proposals. I just want to focus my opening remarks on two central areas for reform. The first is our proposal for a Consumer Financial Protection Agency. We can all agree, I believe, that in the years leading up to the current crisis, our consumer protection regime fundamentally failed. It failed because our system allowed a range of institutions to escape effective supervision. It failed because our system was fragmented, fragmenting responsibility for consumer protection over numerous regulators, creating opportunities for evasion. And it failed because all of the Federal financial services regulators have higher priorities than consumer protection. The result left millions of Americans at risk, and I believe for the first time in the modern history of financial crises in our country, we face an acute crisis, a crisis which brought the financial system to the edge of collapse in significant part because of failures in consumer protection. The system allowed--this system allowed the extreme excesses of the subprime mortgage lending boom, loans without proof of income, employment or financial assets that it reset to unaffordable rates that consumers could not understand and that have contributed to millions of Americans losing their homes. Those practices built up over a long period of time. They peaked in 2006. But it took Federal banking agencies until June of 2007 after the peak to reach consensus on supervisory guidance that would impose even general standards on the sale and underwriting of subprime mortgages. And it took another year for these agencies to settle on a simple model disclosure for subprime mortgages. These actions came too late to help consumers and homeowners. The basic standards of protection were too weak. They were not effectively enforced, and accountability was diffused. We believe that the only viable solution is to provide a single entity in the government with a clear mandate for consumer protection and financial products and services with clear authority to write rules and to enforce those rules. We proposed to give this new agency jurisdiction over the entire marketplace. This will provide a level playing field where the reach of Federal oversight is extended for the first time to all financial firms. This means the agency would send examiners into nonbanks as well as to banks reviewing loan files and interviewing sales people. Consumers will be less vulnerable to the type of race-to-the-bottom standard that was produced by allowing institutions without effective supervision to compete alongside banks. We believe that effective protection requires consolidated authority to both write and enforce rules. Rules written by those not responsible for enforcing them are likely to be poorly designed with insufficient feel for the needs of consumers and for the realities of the market. Rule-writing authority without enforcement authority would risk creating an agency that is too weak dominated by those with enforcement authority. And leaving enforcement authority divided as it is today among this complicated mix of supervisors and other authorities would risk continued opportunities for evasion and uneven protections. Our proposals are designed to preserve the incentives and opportunities for innovation. Many of the practices of consumer lending that led to this crisis gave innovation a bad name. What they claim was innovation was often just predation. But we want to make it possible for future innovations and financial products to come with less risk of damage. We need to create an agency that restores the confidence of consumers and the confidence of financial investors with authority to prevent abusive and unfair practices while at the same time promoting innovation and consumer access to financial products. The second critical imperative to reform is to create a more stable system. In the years leading up to this crisis, our regime, our regulatory framework, permitted an excess buildup of leverage both outside the banking system and within the banking system. The shock absorbers that are critical to preserving the stability to the system, these are shock absorbers in the form of capital requirements, margin, liquidity requirements, were inadequate to withstand the force of the global recession. They left the system too weak to withstand the failure of a major financial institution. Addressing this challenge will require very substantial changes. It will require putting in place stronger constraints on risk taking with stronger limits on leverage and more conservative standards for funding and liquidity management. These standards need to be enforced more broadly across the financial system overall, covering not just all banks but institutions that present potential risk to the stability of the financial system. This will require bringing the markets that are critical to the provision of credit and capital, the derivatives markets, the securitization markets and the credit rating agencies, within a broad framework or oversight. This will require reform to compensation practices to reduce incentives for excessive risk taking in the future. This will require much stronger cushions or shock absorbers in the critical centralized financial infrastructure, so that the system as a whole is less vulnerable to contagion and is better able to withstand the pressures that come with financial shocks and the risk of failure of large institutions. And this will require stronger authority to manage the failure of these institutions. Resolution authority is essential to any credible plan to make it possible to limit moral hazard risk in the future and to limit the need for future bailouts. Alongside these changes, we need to put in place some important changes to the broader oversight framework. Our patchwork, antiquated balkanized segmented structure of oversight responsibility created large gaps in coverage, allowed institutions to shop for the weakest regulator, and left authorities without the capacity to understand and stay abreast of the changing danger of risk in our financial system. To address this, we proposed establishing a council responsible for looking at the financial system as a whole. No single entity can fully discharge this responsibility. Our proposed Financial Services Oversight Council would bring together the heads of all the major Federal financial regulatory agencies, including the Federal Reserve, the SEC, etc. This council would be accountable to the Congress for making sure that we have in place strong protections for the stability of the financial system; that policy is closely coordinated across responsible agencies; that we adapt the safeguards and protections as the system changes in the future and new sources of risk emerge; and that we are effectively cooperating with countries around the world in enforcing strong standards. This council would have the power to gather information from any firm or market to help identify emerging risks, and it would have the responsibility to recommend changes in laws and regulation to reduce future opportunities for arbitrage, to help ensure we put in place and maintain over time strong safeguards against the risk of future crises. The Federal Reserve will have an important role in this framework. It will be responsible for the consolidated supervision of all large interconnected firms whose failure could threaten the stability of this system, regardless of whether they own a depository institution. The Fed, in our judgment, is the only regulatory body with the experience, the institutional knowledge, and the capacity to do this. This is a role the Fed largely already plays today. And while our plan does clarify this basic responsibility and gives clear accountability to the Fed for this responsibility, it also takes away substantial authority. We propose to take away from the Fed today responsibility for writing rules for consumer protection, and for enforcing those rules, and we propose to require the Fed to receive written approval from the Secretary of the Treasury before exercising its emergency lending authority. Now, we look forward to refining these recommendations through the legislative process. To help advance this process, we have already provided detailed draft legislative language to the Hill on every piece of the President's reform package. " 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 CHRG-111hhrg46820--62 Mr. Allison," Main Street needs SBA lending and frankly commercial banks, because of the current shift towards more regulation, more scrutiny, which we can certainly understand given where we have been over the last year in the financial market, but let us not overreact and take it all out on the small business sector. And really this is what I see is probably one of the greatest problems in the capital end of the problem, is you have got local banks that are sitting on money, even with SBA taking the majority of the risk. However, I do recommend that SBA take a greater percentage of the underwriting of these loans in this--in at least the interim period and that we think in terms of lowering qualification standards, that we exempt fees, anything we can do to streamline it and make money more accessible and quickly. " fcic_final_report_full--490 III. THE U.S. GOVERNMENT ’S ROLE IN FOSTERING THE GROWTH OF THE NTM MARKET The preceding section of this dissenting statement described the damage that was done to the financial system by the unprecedented number of defaults and delinquencies that occurred among the 27 million NTMs that were present there in 2008. Given the damage they caused, the most important question about the financial crisis is why so many low quality mortgages were created. Another way to state this question is to ask why mortgage standards declined so substantially before and during the 1997-2007 bubble, allowing so many NTMs to be created. This massive and unprecedented change in underwriting standards had to have a cause—some factor that was present during the 1990s and thereafter that was not present in any earlier period. Part III addresses this fundamental question. The conventional explanation for the financial crisis is the one given by Fed Chairman Bernanke in the same speech at Morehouse College quoted at the outset of Part II: Saving inflows from abroad can be beneficial if the country that receives those inflows invests them well. Unfortunately, that was not always the case in the United States and some other countries. Financial institutions reacted to the surplus of available funds by competing aggressively for borrowers, and, in the years leading up to the crisis, credit to both households and businesses became relatively cheap and easy to obtain . One important consequence was a housing boom in the United States, a boom that was fueled in large part by a rapid expansion of mortgage lending. Unfortunately, much of this lending was poorly done, involving, for example, little or no down payment by the borrower or insuffi cient consideration by the lender of the borrower’s ability to make the monthly payments . Lenders may have become careless because they, like many people at the time, expected that house prices would continue to rise--thereby allowing borrowers to build up equity in their homes--and that credit would remain easily available, so that borrowers would be able to refinance if necessary. Regulators did not do enough to prevent poor lending, in part because many of the worst loans were made by firms subject to little or no federal regulation. [Emphasis supplied] 59 In other words, the liquidity in the world financial market caused U.S. banks to compete for borrowers by lowering their underwriting standards for mortgages and other loans. Lenders became careless. Regulators failed. Unregulated originators made bad loans. One has to ask: is it plausible that banks would compete for borrowers by lowering their mortgage standards? Mortgage originators—whether S&Ls, commercial banks, mortgage banks or unregulated brokers—have been competing for 100 years. That competition involved offering the lowest rates and the most benefits to potential borrowers. It did not, however, generally result in 59 Speech at Morehead College April 14, 2009. 485 or involve the weakening of underwriting standards. Those standards—what made up the traditional U.S. mortgage—were generally 15 or 30 year amortizing loans to homebuyers who could provide a downpayment of at least 10-to-20 percent and had good credit records, jobs and steady incomes. Because of its inherent quality, this loan was known as a prime mortgage. CHRG-111shrg55117--54 Mr. Bernanke," We will absolutely do it, so long as we are not forced to do something different by Congress. Senator Bunning. Even if the economy is still weak? " CHRG-111shrg57319--47 Mr. Cathcart," Correct. Senator Levin. And ``Weak credit infrastructure impacting credit quality,'' do you see that? " 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. fcic_final_report_full--217 And Merrill continued to push its CDO business despite signals that the market was weakening. As late as the spring of , when AIG stopped insuring even the very safest, super-senior CDO tranches for Merrill and others, it did not reconsider its strategy. Cut off from AIG, which had already insured . billion of its CDO bonds  —Merrill was AIG’s third-largest counterparty, after Goldman and Société Générale—Merrill switched to the monoline insurance companies for protection. In the summer of , Merrill management noticed that Citigroup, its biggest com- petitor in underwriting CDOs, was taking more super-senior tranches of CDOs onto its own balance sheet at razor-thin margins, and thus in effect subsidizing returns for investors in the BBB-rated and equity tranches. In response, Merrill continued to ramp up its CDO warehouses and inventory; and in an effort to compete and get deals done, it increasingly took on super-senior positions without insurance from AIG or the monolines.  This would not be the end of Merrill’s all-in wager on the mortgage and CDO businesses. Even though it did grab the first-place trophy in the mortgage-related CDO business in , it had come late to the “vertical integration” mortgage model that Lehman Brothers and Bear Stearns had pioneered, which required having a stake in every step of the mortgage business—originating mortgages, bundling these loans into securities, bundling these securities into other securities, and selling all of them on Wall Street. In September , months after the housing bubble had started to deflate and delinquencies had begun to rise, Merrill announced it would acquire a subprime lender, First Franklin Financial Corp., from National City Corp. for . billion. As a finance reporter later noted, this move “puzzled analysts because the market for subprime loans was souring in a hurry.”  And Merrill already had a  million ownership position in Ownit Mortgage Solutions Inc., for which it provided a warehouse line of credit; it also provided a line of credit to Mortgage Lenders Net- work.  Both of those companies would cease operations soon after the First Franklin purchase.  Nor did Merrill cut back in September , when one of its own analysts issued a report warning that this subprime exposure could lead to a sudden cut in earnings, because demand for these mortgages assets could dry up quickly.  That assessment was not in line with the corporate strategy, and Merrill did nothing. Finally, at the end of , Kim instructed his people to reduce credit risk across the board.  As it would turn out, they were too late. The pipeline was too large. REGULATORS: “ARE UNDUE CONCENTRATIONS OF RISK DEVELOPING? ” As had happened when they faced the question of guidance on nontraditional mort- gages, in dealing with the rapidly changing structured finance market the regulators failed to take timely action. They missed a crucial opportunity. On January , , one year after the collapse of Enron, the U.S. Senate Permanent Subcommittee on In- vestigations called on the Fed, OCC, and SEC “to immediately initiate a one-time, joint review of banks and securities firms participating in complex structured finance products with U.S. public companies to identify those structured finance products, transactions, or practices which facilitate a U.S. company’s use of deceptive account- ing in its financial statements or reports.” The subcommittee recommended the agen- cies issue joint guidance on “acceptable and unacceptable structured finance products, transactions and practices” by June .  Four years later, the banking agencies and the SEC issued their “Interagency Statement on Sound Practices Con- cerning Elevated Risk Complex Structured Finance Activities,” a document that was all of nine pages long.  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-111hhrg48868--124 Mr. Polakoff," Congressman, if I could offer a couple of points for your consideration of the bailout that has occurred. And AIG recently did a press release breaking down the money--$52 billion went for credit default swap-related issues, and $40 billion went for security lending issues. So there were multiple issues associated with AIG. There are many large financial institutions in the United States today that underwrite credit default swaps. The issue is not the product. " CHRG-111shrg57320--386 Mr. Corston," I would say, Chairman Levin, under no circumstances would these be considered acceptable to the level that Washington Mutual was putting these loans on the books. I mean, if these are one-off situations--I do not know I could speak to that necessarily, but, no, this is not an acceptable structure for an institution to do in any type of volume. We have seen the type of risk and the results. Senator Levin. So since there is no regulation on the books for these kinds of risky practices, how are we going to get them on the books? How are the regulators going to put into the books that you can--obviously, there may be circumstances where you can have a stated income loan under the kind of circumstance you talked about. But as a general practice, no. How do we get these kind of important practices and policies in place? They are not there now. Should we legislate? I am tempted, frankly--and I may do it--to just ban negatively amortizing loans. But you point out if you have a guy who has plenty of assets and securities, you might want to, for some reason I cannot imagine, have a negatively amortizing loan. But how are we going to do it? Should we legislate it? " CHRG-111shrg52966--2 Mr. Cole," Chairman Reed, Ranking Member Bunning, it is my pleasure today to discuss the state of risk management in the banking industry and the steps taken by supervisors to address risk management shortcomings. The Federal Reserve continues to take vigorous and concerted steps to correct the risk management weaknesses at banking organizations revealed by the current financial crisis. In addition, we are taking actions internally to improve supervisory practices addressing issues identified by our own internal review. The U.S. financial system is experiencing unprecedented disruptions that have emerged with unusual speed. Financial institutions have been adversely affected by the financial crisis itself, as well as by the ensuing economic downturn. In the period leading up to the crisis, the Federal Reserve and other U.S. banking supervisors took several important steps to improve the safety and soundness of banking organizations and the resilience of the financial system, such as improving banks' business continuity plans and the compliance with the Bank Secrecy Act and anti-money-laundering requirements after the September 11 terrorist attacks. In addition, the Federal Reserve, working with the other U.S. banking agencies, issued several pieces of supervisory guidance before the onset of the crisis such as for nontraditional mortgages, commercial real estate, and subprime lending, and this was to highlight the emerging risks and point bankers to prudential risk management practices they should follow. We are continuing and expanding the supervisory actions mentioned by Vice Chairman Kohn last June before this Subcommittee to improve risk management at banking organizations. While additional work is necessary, supervised institutions are making progress. Where we do not see sufficient progress, we demand corrective action from senior management and boards of directors. Bankers are being required to look not just at risks from the past, but also to have a good understanding of their risks going forward. For instance, we are monitoring the major firms' liquidity positions on a daily basis, discussing key market developments with senior management and requiring strong contingency funding plans. We are conducting similar activities for capital planning and capital adequacy, requiring banking organizations to maintain strong capital buffers over regulatory minimums. Supervised institutions are being required to improve their risk identification practices. Counterparty credit risk is also receiving considerable focus. In all of our areas of review, we are requiring banks to consider the impact of prolonged, stressful environments. The Federal Reserve continues to play a leading role in the work of the Senior Supervisors Group whose report on risk management practices at major U.S. and international firms has provided a tool for benchmarking current progress. Importantly, our evaluation of banks' progress in this regard is being incorporated into the supervisory exam process going forward to make sure that they are complying and are making the improvements we are expecting. In addition to the steps taken to improve banks' practices, we are taking concrete steps to enhance our own supervisory practices. The current crisis has helped us recognize areas in which we can improve. Vice Chairman Kohn is leading a systematic internal process to identify lessons learned and develop recommendations. As you know, we are also meeting with Members of Congress and other Government bodies, including the Government Accountability Office, to consult on lessons learned and to hear additional suggestions for improving supervisory practices. We have already augmented our internal process to disseminate information to examination staff about emerging risks within the industry. Additionally, with the recent Federal Reserve issuance of supervisory guidance on consolidated supervision, we are not only enhancing the examination of large, complex firms with multiple legal entities, but also improving our understanding of markets and counterparties, contributing to our broader financial stability efforts. Looking forward, we see opportunity to improve our communication of supervisory expectations to firms we regulate to ensure those expectations are understood and heeded. We realize now more than ever that when times are good and when bankers are particularly confident, we must have even firmer resolve to hold firms accountable for prudent risk management practices. Finally, despite our good relationship with fellow U.S. regulators, there are gaps and operational challenges in the regulation and supervision of the overall U.S. financial system that should be addressed in an effective manner. I would like to thank you and the Subcommittee for holding this second hearing on risk management, a crucially important issue in understanding the failures that have contributed to the current crisis. Our actions with the support of Congress will help strengthen institutions' risk management practices and the supervisory and regulatory process itself--which should, in turn, greatly strengthen the banking system and the broader economy as we recover from the current difficulties. I look forward to answering your questions. Senator Reed. Mr. Long. STATEMENT OF TIMOTHY W. LONG, SENIOR DEPUTY COMPTROLLER, BANK SUPERVISION POLICY AND CHIEF NATIONAL BANK EXAMINER, OFFICE OF CHRG-111shrg52966--73 PREPARED STATEMENT OF TIMOTHY W. LONG Senior Deputy Comptroller, Bank Supervision Policy and Chief National Bank Examiner March 18, 2009Introduction Chairman Reed, Ranking Member Bunning, and members of the Subcommittee, my name is Timothy Long and I am the Senior Deputy Comptroller for Bank Supervision Policy and Chief National Bank Examiner at the Office of the Comptroller of the Currency (OCC). I welcome this opportunity to discuss the OCC's perspective on the recent lessons learned regarding risk management, as well as the steps we have taken to strengthen our supervision and examination processes in this critical area, and how we supervise the risk management activities at the largest national banking companies. Your letter of invitation also requested our response to the findings of the GAO regarding the OCC's oversight of bank risk management. Because we only received the GAO's summary statement of facts on Friday night, we have not had an opportunity to thoroughly review and assess their full report and findings. Therefore, I will only provide some brief observations on their initial findings. We take findings and recommendations from the GAO very seriously and will be happy to provide Subcommittee members a written response to the GAO's findings once we have had the opportunity to carefully review their report.Role of Risk Management The unprecedented disruption that we have seen in the global financial markets over the last eighteen months, and the events and conditions leading up to this disruption, have underscored the critical need for effective and comprehensive risk management processes and systems. As I will discuss in my testimony, these events have revealed a number of weaknesses in banks' risk management processes that we and the industry must address. Because these problems are global in nature, many of the actions we are taking are in coordination with other supervisors around the world. More fundamentally, recent events have served as a dramatic reminder that risk management is, and must be, more than simply a collection of policies, procedures, limits and models. Effective risk management requires a strong corporate culture and corporate risk governance. As noted in the March 2008 Senior Supervisors Group report on ``Observations on Risk Management Practices During the Recent Market Turmoil,'' companies that fostered a strong risk management culture and encouraged firm-wide identification and control of risk, were less vulnerable to significant losses, even when engaged in higher risk activities.\1\--------------------------------------------------------------------------- \1\ See Senior Supervisors Group Report, ``Observations on Risk Management Practices,'' at http://www.newyorkfed.org/newsevents/news/banking/2008/SSG_Risk_Mgt_doc_final.pdf.--------------------------------------------------------------------------- While current economic conditions have brought renewed attention to risk management, it is during periods of expansionary economic growth when risk management can be most critical and challenging both for bankers and supervisors. Financial innovation and expansion of credit are important drivers of our economy. Banks must be able to respond to customer and investor demand for new and innovative products and services. They must also be able to compete with firms that may be less regulated and with financial service companies across the globe. Failure to allow this competition risks ceding the prominent role that U.S. financial firms have in the global marketplace. Banks are in the business of managing financial risk. Competing in the marketplace and allowing market innovation means that there will be times when banks lose money. There will also be times when, despite a less favorable risk/reward return, a bank will need to maintain a market presence to serve its customers and to retain its role as a key financial intermediary. These are not and should not be viewed as risk management failures. The job of risk management is not to eliminate losses or risk, but rather to ensure that risk exposures are fully identified and understood so that bank management and directors can make informed business decisions about the firm's level of risk. In this regard, a key issue for bankers and supervisors is determining when the accumulation of risks either within an individual firm or across the system has become too high, such that corrective or mitigation actions are needed. Knowing when and how to strike this balance is one of the most difficult jobs that supervisors and examiners face. Taking action too quickly can constrain economic growth and impede credit to credit worthy borrowers; waiting too long can result in an overhang of risk becoming embedded into banks and the marketplace. Effective risk management systems play a critical role in this process.Risk Management Lessons Learned It is fair to ask what the banking industry and supervisors have learned from the major losses that have occurred over the past 18 months. The losses have been so significant, and the damage to the economy and confidence so great, that we all must take stock of what we missed, and what we should have done differently to make sure that we minimize the possibility that something like this happens again. Below are some of our assessments: Underwriting Standards Matter, Regardless of Whether Loans are Held or Sold--The benign economic environment of the past decade, characterized by low interest rates, strong economic growth and very low rates of borrower defaults led to complacency on the part of many lenders. Competitive pressures drove business line managers to ease underwriting standards for the origination of credit and to assume increasingly complex and concentrated levels of risk. Increased investor appetite for yield and products, fueled by a global abundance of liquidity, led many larger banks to adopt the so-called ``originate-to-distribute'' model for certain commercial and leveraged loan products, whereby they originated a significant volume of loans with the express purpose of packaging and selling them to investors. Many of these institutional investors were willing to accept increasingly liberal repayment terms, reduced financial covenants, and higher borrower leverage on these transactions in return for marginally higher yields. Similar dynamics were occurring in the residential mortgage markets, where lenders, primarily non-bank lenders, were aggressively relaxing their underwriting standards. Given the abundance of liquidity and willing investors for these loans, lenders became complacent about the risks underlying the loans. However, in the fall of 2007 the risk appetite of investors changed dramatically and, at times, for reasons not directly related to the exposures that they held. This abrupt change in risk tolerance left banks with significant pipelines of loans that they needed to fund as the syndicated loan and securitization markets shut down. Bankers and supervisors underestimated the rapidity and depth of the global liquidity freeze. A critical lesson, which the OCC and other Federal banking agencies noted in their 2007 Shared National Credit results, is that banking organizations should ensure that underwriting standards are not compromised by competitive pressures. The agencies warned that ``consistent with safe and sound banking practice, agent banks should underwrite funding commitments in a manner reasonably consistent with internal underwriting standards.''\2\--------------------------------------------------------------------------- \2\ See Joint Release, NR 2007-102 at: http://www.occ.treas.gov/ftp/release/2007-102.htm. Risk Concentrations Can Accumulate Across Products and Business Lines and Must be Controlled--Risk concentrations can arise as banks seek to maximize their expertise or operational efficiencies in a highly competitive business. Community banks can often develop significant concentrations as their lending portfolios tend to be highly concentrated in their local markets. For larger institutions, a key issue has been the ability to aggregate risk exposures across business and product lines and to identify risks that may be highly correlated. For example, many national banks underestimated their exposure to subprime mortgages because they did not originate them. Indeed, some senior bank management thought they had avoided subprime risk exposures by deliberately choosing to not originate such loans in the bank--only to find out after the fact that their investment bank affiliates had purchased subprime loans elsewhere to structure them into collateralized debt obligations. Because of inadequate communication within these firms, those structuring businesses were aggressively expanding activity at the same time that retail lending professionals in the bank were avoiding or exiting the business because of their refusal to meet weak underwriting conditions prevalent in the market. These failures were compounded when products, markets, and geographic regions that previously were looked to as a source of risk diversification became more highly correlated as contagion effects spread across the globe. Additionally, significant corporate acquisitions, especially if they were not consistent with the bank's business strategy and corporate culture, affected the institutions' financial well being, their risk positions and reputations, and placed significant strains --------------------------------------------------------------------------- on their risk management processes. Asset-Based Liquidity Provides a Critical Cushion--There is always a tension of how much of a bank's balance sheet capacity should be used to provide a cushion of liquid assets--assets that can be readily converted to liquid funds should there be a disruption in the bank's normal funding markets or in its ability to access those markets. Because such assets tend to be low risk and, thus, low yielding, many banks have operated with very minimal cushions in recent years. These decisions reflected the abundance of liquidity in the market and the ease with which banks could tap alternative funding sources through various capital and securitization markets. Here again, when these markets became severely constrained, many banks faced significant short-term funding pressures. For some firms, these funding pressures, when combined with high credit exposures and increased leverage, resulted in significant strains and, in some cases, liquidity insolvency. Systemically Important Firms Require State-of-the-Art Infrastructure--As noted in a number of visible cases during this period of market turmoil, a large firm's ability to change its risk profile or react to the changing risk tolerance of others is dependent on an extremely robust supporting infrastructure. The velocity with which information is transmitted across financial markets and the size, volume and complexity of transactions between market participants has been greatly expanded through technology advancements and globalization of markets. Failure to have sufficient infrastructure and backroom operations resulted in failed trades and increased counterparty exposures, increasing both reputation and credit risks. Need for Robust Capital Levels and Capital Planning Processes--Although we are clearly seeing strains, the national banking system, as a whole, has been able to withstand the events of the past 18 months due, in part, to their strong levels of regulatory capital. The strong levels of capital in national banks helped to stabilize the financial system. National banking organizations absorbed many weaker competitors (e.g., Bear Stearns, Countrywide, and WAMU). This relative strength is more apparent when compared to the highly leveraged position of many broker-dealers. Nonetheless, it is clear that both banks' internal capital processes and our own supervisory capital standards need to be strengthened to more fully incorporate potential exposures from both on- and off-balance sheet transactions across the entire firm. In addition, capital planning and estimates of potential credit losses need to be more forward looking and take account of uncertainties associated with models, valuations, concentrations, and correlation risks throughout an economic cycle. These findings are consistent with reports issued by the SSG's report on ``Risk Management Practices,'' the Financial Stability Forum's (FSF) report on ``Enhancing Market and Institutional Resilience,'' the Joint Forum's report on ``Cross- Sectoral Review of Group-wide Identification and Management of Risk Concentrations,'' and the Basel Committee on Banking Supervision's consultative paper on ``Principles for Sound Stress Testing Practices and Supervision.''\3\ Two common themes from these reports and other studies in which the OCC has actively participated are the need to strengthen risk management practices and improve stress testing and firm-wide capital planning processes. The reports also note several areas where banking supervisors need to enhance their oversight regimes. The recommendations generally fall into three broad categories: 1) providing additional guidance to institutions with regard to the risk management practices and monitoring institutions' actions to implement those recommendations; 2) enhancing the various aspects of the Basel II risk-based capital framework; and 3) improving the exchange of supervisory information and sharing of best practices.--------------------------------------------------------------------------- \3\ Senior Supervisors Group Report, ``Observations on Risk Management Practices,'' at http://www.newyorkfed.org/newsevents/news/banking/2008/SSG_Risk_Mgt_doc_final.pdf; Financial Stability Forum, ``Enhancing Market and Institutional Resilience,'' at http://www.fsforum.org/publications/FSF_ Report_to_G7_11_April.pdf; Joint Forum, ``Cross-sectoral review of group-wide identification and management of risk concentrations'' at http://www.bis.org/publ/joint19.htm; and Basel Committee on Banking Supervision Report, ``Sound principles for stress testing practices and supervision,'' at http://www.bis.org/publ/bcbs147.htm. ---------------------------------------------------------------------------OCC Supervisory Responses The OCC has been actively involved in the various work groups that issued these reports, and we are taking a number of steps, primarily in our large bank supervision program, to ensure that our supervisory process and the risk management practices of our institutions incorporate these recommendations. I will focus on the three key areas identified by the Subcommittee: liquidity risk management, capital requirements, and enterprise-wide risk management.Liquidity Risk Management The sudden and complete shutdown in many traditional funding markets was not contemplated by most contingency funding plans. This period of market disruption has magnified the risks associated with underestimating liquidity risk exposures and improperly planning for periods of significant duress. The SSG report specifically noted that better performing firms carefully monitored their and on- and off-balance sheet risk exposures and actively managed their contingent liquidity needs. In April 2008, the OCC developed a liquidity risk monitoring program to standardize liquidity monitoring information across our large bank population and provide more forward looking assessments. We developed a template for the monthly collection of information about balance sheet exposures, cash-flow sources and uses, and financial market risk indicators. Our resident examiners complete this template each month and then work with our subject matter specialists in the Credit and Market Risk (CMR) division in Washington to produce a monthly report that summarizes the liquidity risk profile, based on levels of risk and quality of risk management, for 15 banking companies in our Large and Mid-size bank programs. These risk profiles provide a forward looking assessment of liquidity maturity mismatches and capacity constraints, both of which are considered early warning signals of potential future problems. In September 2008, the Basel Committee on Banking Supervision (Basel Committee) issued a report on, ``Principles for Sound Liquidity Risk Management and Supervision.''\4\ This report represents critical thinking that was done by supervisors in over 15 jurisdictions on the fundamental principles financial institutions and supervisors must adopt to provide appropriate governance of liquidity risk. OCC subject matter specialists in our CMR division were actively involved in the development of this important paper on risk management expectations, and are now contributing to the second phase of this work which is focused on identifying key liquidity metrics and benchmarks that may be valuable for enhancing transparency about liquidity risk at financial institutions. We are also working with the other U.S. Federal banking agencies to adapt and apply these key principles more broadly to all U.S. banking institutions through an interagency policy statement.--------------------------------------------------------------------------- \4\ See Basel Committee on Banking Supervision, ``Principles for Sound Liquidity Management and Supervision,'' at http://www.bis.org/publ/bcbs144.htm. --------------------------------------------------------------------------- The OCC reviews bank liquidity on an ongoing basis and we have incorporated these valuable lessons into our evaluations. Our strategic bank supervision operating plan for 2009 directs examiners at our largest national banks to focus on banks' firm-wide assessments of their liquidity risk and the adequacy of their liquidity cushions (short-term liquid assets and collateralized borrowing capacity) to meet short and medium term funding needs, as well as on the effectiveness of their liquidity risk management, including management information systems and contingency funding plans.Capital Requirements The market turmoil has highlighted areas where the current Basel II capital framework needs to be strengthened. The OCC, through its membership on the Basel Committee and work with the FSF, has been actively involved in formulating improvements to the capital framework. Among the refinements recommended by the Basel Committee in its January 2009 consultative papers are higher capital requirements for re-securitizations, such as collateralized debt obligations, which are themselves comprised of asset-backed securities.\5\ These structured securities suffered significant losses during the recent market turmoil. Other proposed changes to the Basel II framework would increase the capital requirements for certain liquidity facilities that support asset-backed commercial paper conduits.--------------------------------------------------------------------------- \5\ See: ``Proposed enhancements to the Basel II framework,'' ``Revisions to the Basel II Market Risk Framework,'' and ``Guidelines for computing capital for incremental risk in the trading book,'' January 2009 at http://www.bis.org/press/p090116.htm. --------------------------------------------------------------------------- In addition, the Basel Committee has proposed requirements for certain banks to incorporate default risk and credit migration risk in their value-at-risk models. These proposals are designed to better reflect the risks arising from the more complex, and less liquid, credit products that institutions now hold in their trading portfolios. The intention is also to reduce the extent of regulatory capital arbitrage that currently exists between the banking and trading books. The January consultative paper that proposed enhancements to the Basel II framework would also strengthen supervisory guidance regarding Pillar 2, or the supervisory review process of Basel II. Specifically, the proposed supervisory guidance would address firm-wide governance and risk management; capturing the risk of off-balance sheet exposures and securitization activities; and incentives to manage risk and returns over the long-term. More recently, following its meeting last week, the Basel Committee announced additional initiatives to strengthen capital in the banking system. These include introducing standards to promote the buildup of capital buffers that can be drawn down in periods of stress, as well as a non-risk-based capital measure like our leverage ratio.\6\ Once the Basel Committee finalizes these and other changes to the Basel II framework, the OCC and other Federal banking agencies will jointly consider their adoption in the U.S. through the agencies' notice and comment process.--------------------------------------------------------------------------- \6\ See ``Initiatives on capital announced by the Basel Committee,'' March 12, 2009 at: http://www.bis.org/press/p090312.htm. ---------------------------------------------------------------------------Enterprise Risk Management As previously noted, the recent market turmoil has highlighted the importance of a comprehensive firm-wide risk management program. The SSG report advised that striking the right balance between risk appetite and risk controls was a distinguishing factor among firms surveyed in its study. Additionally, the FSF report noted that, ``Supervisors and regulators need to make sure that the risk management and control framework within financial institutions keeps pace with the changes in instruments, markets and business models, and that firms do not engage in activities without having adequate controls.''\7\--------------------------------------------------------------------------- \7\ See ``Report of the Financial Stability Forum on Enhancing Market and Institutional Resilience,'' April 2008 at: http://www.fsforum.org/publications/r_0804.pdf.--------------------------------------------------------------------------- Proper risk governance was a key focus of guidance that the OCC, the SEC, and other Federal banking regulators issued in January 2007 on complex finance activities.\8\ That guidance stressed the need for firms to have robust internal controls and risk management processes for complex structured finance transactions. The guidance emphasized the importance of a strong corporate culture that includes and encourages mechanisms that allow business line and risk managers to elevate concerns to appropriate levels of management and to ensure the timely resolution of those concerns. It also stressed the need to ensure appropriate due diligence at the front-end, before products are offered, to ensure that all risks have been appropriately considered and can be effectively identified, managed and controlled. At the OCC, approval of new or novel banking activities is predicated on the bank having sufficient risk management controls in place.--------------------------------------------------------------------------- \8\ See: OCC Bulletin 2007-1, ``Complex Structured Finance Transactions'' at http://www.occ.gov/ftp/bulletin/2007-1.html. --------------------------------------------------------------------------- Assessing management's ability to effectively identify, measure, monitor, and control risk across the firm and to conduct effective stress testing is a key focus of our examination strategies for large national banks this year. Stress tests are a critical tool for effective enterprise-wide risk assessments. Such tests can help identify concentrations and interconnected risks and determine the adequacy of capital and liquidity. As with most other issues, the success of a stress testing program depends importantly on the support and sponsorship provided by senior management. In banks where risk management functions did not perform well, stress testing typically was a mechanical exercise. Management viewed stress tests as more of a ``requirement'' than an important risk management tool that could lead to internal discussions and debate about whether existing exposures constituted unacceptable risks. In addition, many stress tests failed to fully estimate the potential severity and duration of stress events and to identify and capture risks across the firm. Often, stress tests would focus on a single line of business and/or use only historical statistical relationships. When designing a stress test, particularly after a prolonged period of abundant liquidity, low credit spreads and low interest rates, it is important to probe for weaknesses in the portfolio that may not be evident from historically based stress exercises. Expert judgment can help define scenarios to address the likely breakdown in normal statistical relationships, as well as feedback loops, in a crisis. Such scenario-based stress tests, often dismissed as implausible by business unit personnel, allow firms to shock multiple market factors (e.g., interest rates credit spreads and commodity prices) simultaneously. Such stress tests are an important way to capture risks missed in traditional stress testing exercises, such as market liquidity risk and basis risk.OCC's Supervision of Risk Management at Large National Banks Let me now turn to how we apply and incorporate our perspective on risk management into the supervision of large national banks. The OCC is responsible for supervising over 1,600 banks, including some of the largest in the world that offer a wide array of financial services and are engaged in millions of transactions every day. Pursuant to the provision of the Gramm Leach Bliley Act (GLBA), the OCC serves as the primary Federal banking regulator for activities conducted within the national bank charter and its subsidiaries, except for those activities where jurisdiction has been expressly provided to another functional supervisor, such as the Securities and Exchange Commission (SEC), for certain broker-dealer activities. Nonetheless, we work closely with the Federal Reserve Board, the SEC, and other appropriate regulators to help promote consistent and comprehensive supervision across the company. The foundation of the OCC's supervisory efforts is our continuous, onsite presence of examiners at each of our 14 largest banking companies. These 14 banking companies account for approximately 89 percent of the assets held in all of the national banks under our supervision. The resident examiner teams are supplemented by subject matter specialists in our Policy Division and PhD economists from our Risk Analysis Division trained in quantitative finance. Our Large Bank program is organized with a national perspective. It is highly centralized and headquartered in Washington, and structured to promote consistent uniform coordination across institutions. The onsite teams at each or our 14 largest banks are led by an Examiner-In-Charge (EIC), who reports directly to the Deputy Comptrollers in our Large Bank Supervision Office in Washington, DC. The Large Bank Deputies are in ongoing communication with the EICs, in addition to holding monthly calls and quarterly face-to-face meetings with all EICs. To enhance our ability to identify risks and share best practices across the large bank population, we have established a program of examiner network groups in Large Banks. There are eight main network groups (Commercial Credit, Retail Credit, Mortgage Banking, Capital Markets, Asset Management, Information Technology, Operational Risk and Compliance) and numerous subgroups. These groups facilitate sharing of information, concerns and policy application among examiners with specialized skills in these areas. The EICs and leadership teams of each of the network groups work closely with specialists in our Policy and Risk Analysis Divisions to promote consistent application of supervisory standards and coordinated responses to emerging issues. All of this enables the OCC to maintain an on-going program of risk assessment, monitoring, and communication with bank management and directors. Nonetheless, given the volume and complexity of bank transactions, it is not feasible to review every transaction in each bank, or for that matter, every single product line or bank activity. Accordingly, we focus on those products and services posing the greatest risk to the bank through risk-based supervision. Resident examiners apply risk-based supervision to a broad array of risks, including credit, liquidity, market, compliance and operational risks. Supervisory activities are based upon supervisory strategies that are developed for each institution that are risk-based and focused on the more complex banking activities. Although each strategy is tailored to the risk profile of the individual institution, our strategy development process is governed by supervisory objectives set forth annually in the OCC's bank supervision operating plan. Through this operating plan, the OCC identifies key risks and issues that cut across the industry and promotes consistency in areas of concerns. With the operating plan as a guide, EICs develop detailed strategies that will direct supervisory activities and resources for the coming year. Each strategy is reviewed by the appropriate Large Bank Deputy Comptroller. Our risk-based supervision is flexible, allowing strategies to be revised, as needed, to reflect the changing risk profile of the supervised institutions. We have a Quality Assurance group within our Large Bank program that selects strategies to review as part of a supervisory program review to ensure reasonableness and quality supervision. Our supervisory goal is to ensure banks have sound risk governance processes commensurate with the nature of their risk-taking activities. Risk management systems must be sufficiently comprehensive to enable senior management to identify and effectively manage risk throughout the firm. Therefore, examinations of our largest banks focus on the overall integrity and effectiveness of risk management systems. The first step in risk-based supervision is to identify the most significant risks and then to determine whether a bank has systems and controls to identify and manage those risks. Next, we assess the integrity and effectiveness of risk management systems, with appropriate validation through transaction testing. This is accomplished through our supervisory process which involves a combination of ongoing monitoring and targeted examinations. The purpose of our targeted examinations is to validate that risk management systems and processes are functioning as expected and do not present any significant supervisory concerns. Our supervisory conclusions, including any risk management deficiencies, are communicated directly to bank senior management. Thus, not only is there ongoing evaluation, but there is also a process for timely and effective corrective action when needed. To the extent we identify concerns, we ``drill down'' to test additional transactions. These concerns are then highlighted for management and the Board as ``Matters Requiring Attention'' (``MRAs'') in supervisory communications. Often these MRAs are line of business specific, and can be corrected relatively easily in the normal course of business. However, a few MRAs address more global concerns such as enterprise risk management or company-wide information security. We also have a consolidated electronic system to monitor and report outstanding MRAs. Each MRA is assigned a due date and is followed-up by onsite staff at each bank. If these concerns are not appropriately addressed within a reasonable period, we have a variety of tools with which to respond, ranging from informal supervisory actions directing corrective measures, to formal enforcement actions, to referrals to other regulators or law enforcement. Our supervision program includes targeted and on-going analysis of corporate governance at our large national banks. This area encompasses a wide variety of supervisory activities including: Analysis and critique of materials presented to directors; Review of board activities and organization; Risk management and audit structures within the organization, including the independence of these structures; Reviews of the charters, structure and minutes of significant decisionmaking committees in the bank; Review of the vetting process for new and complex products and the robustness of new product controls; and Analysis of the appropriateness and adequacy of management information packages used to measure and control risk. It is not uncommon to find weaknesses in structure, organization, or management information, which we address through MRAs and other supervisory processes described above. But more significantly, at some of our institutions what appeared to be an appropriate governance structure was made less effective by a weak corporate culture, which discouraged credible challenge from risk managers and did not hold lines of business accountable for inappropriate actions. When the market disruption occurred in mid 2007, it became apparent that in some banks, risk management lacked support from executive management and the board to achieve the necessary stature within the organization, or otherwise did not exercise its authority to constrain business activities. At institutions where these issues occurred, we took strong supervisory actions, and we effected changes in personnel, organization and/or processes. Just as we adjust our strategies for individual banks, we also make adjustments to our overall supervisory processes, as needed. And of course we are adjusting our supervisory processes to incorporate the lessons we have learned during this period of extreme financial distress. For example, recent strategy guidance prepared by our Large Bank network groups and issued by Large Bank senior management increases our focus on: Risk concentrations across the enterprise; Refinancing risk arising from illiquidity in credit markets and changes in underwriting standards that limit the ability of many borrowers to refinance debt as originally intended; Collections, recovery and loss mitigation programs; Decision modeling; Liquidity contingency planning; Allowance for loan and lease loss adequacy; Capital buffers and stress assessments; and Syndication and other distribution processes and warehouse/ pipeline controls. Our supervisory activities at individual banks are often supplemented with horizontal reviews of targeted areas across a group of banks. These horizontal reviews can help us to identify emerging risks that, while not posing a significant threat to any one institution could, if not corrected, pose more system-wide implications for the industry. For example, reviews of certain credit card account management practices several years ago revealed that as a result of competitive pressures, banks were reducing minimum payments required from credit card customers to the point where many consumers could simply continue to increase their outstanding balances over time with no meaningful reduction in principal. We were concerned that these competitive pressures could mask underlying deterioration in a borrower's condition and could also result in consumers becoming over-extended. Because of the highly competitive nature of this business, we recognized that we needed to address this problem on a system-wide basis and as a result, worked with the other Federal banking agencies to issue the 2003 guidance on Credit Card Account Management Practices.\9\--------------------------------------------------------------------------- \9\ See OCC Bulletin 2003-1, ``Credit Card Lending: Account Management and Loss Allowance Guidance,'' at http://www.occ.gov/ftp/bulletin/2003-1.doc.--------------------------------------------------------------------------- In addition to the aforementioned liquidity monitoring data we have begun collecting, we have also initiated loan level data collection from our major banks for residential mortgages, home equity loans, large corporate credits, and credit card loans. This data is being used to enhance our horizontal risk assessments in these key segments and offers a tool for examiners to benchmark their individual institution against the industry. More recently, in early 2008 we began developing a work plan to benchmark our largest national banks against the risk management ``best practices'' raised in various reports issued by the President's Working Group (PWG), SSG, FSF, and Basel Committee. OCC staff developed a template for our examining staff to collect information to conduct this benchmarking exercise and we shared this with our colleagues at the PWG and SSG. In the interest of expanding the pool of firms and expediting the collection of risk management information, agency principals elected to use the SSG as the forum for undertaking the risk management assessment. In December 2008, a self-assessment template was sent to 23 globally active financial firms and the completed self-assessments are now in the process of being collected and shared among the participating agencies. These self-assessments will be supplemented with interviews at selected firms to discuss the status of addressing risk management deficiencies already identified and also probe for further information on emerging issues that may not yet be evident. To summarize, the goal of our supervision is to ensure that banks are managed in a safe and sound manner, to identify problems or weaknesses as early as possible and to obtain corrective action. Through our examinations and reviews, we have directed banks to be more realistic in assessing their credit risks; to improve their valuation techniques for certain complex transactions; to raise capital as market opportunities permit; to aggressively build loan loss reserves; and to correct various risk management weaknesses. As previously noted, we have a staff of specialists who provide on-going technical assistance to our onsite examination teams. Our Risk Analysis Division includes 40 PhD economists and mathematicians who have strong backgrounds in statistical analysis and risk modeling. These individuals frequently participate in our risk management examinations to help evaluate the integrity and empirical soundness of banks' risk models and the assumptions underlying those models. Our policy specialists assist by keeping abreast of emerging trends and issues within the industry and the supervisory community. Staffs from our CMR, Operational Risk, and Capital Policy units have been key participants and contributors to the ongoing work of the SSG, FSF, PWG and Basel Committee. In 2008, we established a Financial Markets Group within the agency and tasked them with the build-out of a market intelligence program. Their mission is to look around corners, to seek out early warning signs of emerging and/or systemic risk issues. This team is comprised of highly experienced bank examiners and subject matter specialists hired from the industry, and they spend considerable time meeting with bank investors, bank counterparties, bank competitors, bank analysts, and other relevant stakeholders. Their work is discussed with members of the OCC's senior management team on a bi-weekly basis, or more frequently when needed, and discussed in detail with the OCC's National Risk Committee members, who represent all lines of bank supervision within the OCC, as well as our legal and economics teams.Coordination with Other Supervisors Successful execution of our supervisory priorities requires an effective working relationship with other supervisors, both domestically and internationally. The events of the past 18 months highlight the global nature of the problems we are facing and the need for global responses. The OCC has taken a significant leadership role in the interagency work underway to address risk management issues raised during this period of market turmoil. Comptroller Dugan is an active member of the PWG and also serves as the Chair of the Joint Forum. In that capacity, he has sponsored critical work streams to address credit risk transfer, off-balance sheet activities and reliance on credit rating agencies. The Joint Forum work not only builds transparency about how large, financial conglomerates manage critical aspects of risk management, but it also serves as a vehicle for identifying risk management ``best practices.'' Close coordination with our supervisory colleagues at the other banking agencies, as well as the securities agencies, has proven beneficial for all parties--firms, supervisors and policymakers. One example where this is evident has been the cooperative work among major market players and key regulators (the New York Federal Reserve Bank, the Federal Reserve Board, the OCC, the SEC, and other key global regulators) to strengthen the operational infrastructure and backroom processes used for various over-the-counter (OTC) derivative transactions. This is another example where a collective effort was needed to address problems where there was not a clear incentive for any individual firm to take corrective action. As a result of these efforts, we have seen material improvements in the reduction of unconfirmed trades across all categories of OTC derivatives, with the most notable reduction in the area of credit derivatives, where the large dealers have reduced by over 90 percent the backlog of credit derivatives confirmations that are outstanding by more than 30 days.GAO Report As I noted in my introduction, we received the GAO's draft statement of findings on Friday night and, as requested, provided them with summary comments on those draft findings on Monday morning. Once we receive the GAO's final report, we will give careful consideration to its findings and any recommendations therein for improvement in our supervisory processes. We will be happy to share our conclusions and responses with the Subcommittee. As I have described in my testimony, the OCC has a strong, centralized program for supervising the largest national banks. But clearly, the unprecedented global disruptions that we have witnessed across the credit and capital markets have revealed risk management weaknesses across banking organizations that need to be fixed and we are taking steps to ensure this happens. In this regard, it is important to recognize that risk management systems are not static. These systems do and must evolve with changes in markets, business lines, and products. For example, improving and validating risk models is an ongoing exercise at our largest institutions. Therefore it should not be surprising that we routinely have outstanding MRAs that direct bank management to make improvements or changes to their risk models and risk management practices. This is an area where we continuously probe to look for areas of improvement and best practices. As I described earlier, we have systems in place to monitor and track these MRAs and, when we determine that the bank is not making sufficient progress to address our concerns, we can and do take more forceful action. However, unless we believe the model deficiency is so severe as to undermine the bank's safety and soundness, we will allow the bank to continue to use the model as it makes necessary refinements or adjustments. Given the iterative process of testing and validating risk models, it simply is not realistic to suggest that a bank suspend its operations or business whenever it needs to make enhancements to those processes. One of the GAO's major findings is that institutions failed to adequately test for the effects of a severe economic downturn scenario. As I have discussed, we agree that the events of the past 18 months have underscored the need for improved and more robust stress testing. Banks' stress tests need to more fully incorporate potential interconnection risks across products, business lines and markets, and evaluate such exposures under extreme tail-events. The OCC was actively involved in developing the January 2009 report issued by the Basel Committee cited by the GAO. Indeed, many of the findings and recommendations in that report were drawn from our findings and work in our large banking institutions. We will be working with these institutions to ensure that they incorporate those recommendations into their stress testing processes.Conclusion The events of the past 18 months have highlighted and reinforced the need for effective risk management programs and revealed areas where improvements are needed. I believe the OCC and the banking industry are taking appropriate steps to implement needed changes. I also believe that these events have demonstrated the strength of the OCC's large bank supervision program. Throughout the recent market turmoil, our resident examination staffs at the largest institutions have had daily contact with the business and risk managers of those institutions' funding, trading, and lending areas to enable close monitoring of market conditions, deal flow and funding availability. Their insights and on-the-ground market intelligence have been critical in helping to assess appropriate policy and supervisory responses as market events have continued to unfold. Indeed, I believe that the OCC's large bank supervision program, with its centralized oversight from Washington D.C., and highly experienced resident teams of bank examiners and risk specialists, is the most effective means of supervising large, globally active financial firms.Statement Required by 12 U.S.C. Sec. 250: The views expressed herein are those of the Office of the Comptroller of the Currency and do not necessarily represent the views of the President. ______ CHRG-111shrg51395--92 Chairman Dodd," Sure. Senator Reed. I will address it to Professor Coffee, because it might be way off the beaten track. In fact, it sounds like an extra credit question in a law exam. [Laughter.] Senator Reed. So here it goes. Whatever happened to Rule 10b-5? I mean, I have been listening to discussions of potential fraud in the marketplace, securities that had no underlying underwriting. And I grew up thinking that material omissions as well as material commissions gives the SEC in every capacity, as long as it is a security, to go in vigorously to investigate, a private right of action, and yet I have been before the Committee now for 2 and 3 years, and I do not think anyone has brought up, you know, Rule 10b-5 actions. Can you just sort of---- " 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 . FOMC20080430meeting--97 95,MR. LOCKHART.," Thank you, Mr. Chairman. Our high-level view of current circumstances is that the real economy is quite weak, with weakness widespread. The financial markets are turning optimistic, and elevated prices and inflation remain a serious concern. Reports from our directors and District business contacts were broadly similar to the incoming national data and information from other Districts reported in the Beige Book. Observations from such District input support themes in the national data--for example, employment growth is quite weak. In this round of director reports and conversations, I heard an increasing number of reports of holds on hiring and expansion plans. One representative of a major retailer of home improvement goods reported that hiring for seasonal employees will be down 40 percent this spring. This translates to approximately 45,000 jobs. Nonresidential real estate development continues to slow in the District, especially in Florida and Georgia. Of the 18 commercial contractors contacted in April, 15 expect that commercial construction will be weaker for the rest of 2008 than for the same period in 2007, with several predicting even more pronounced weakness in 2009. On the brighter side, Florida Realtors are anticipating that sales over the next few months will exceed year-ago levels, and builders are signaling less weakness than in recent reports. This is a level of optimism we have not heard from Florida for some time. However, housing markets in the rest of the District continue to weaken. We heard several complaints that obtaining financing is a serious problem for commercial and residential developers and consumer homebuyers. In sum, the information from the Sixth District seems to confirm what I believe is the continuing story of the national real economy captured in the Greenbook--that is, shrinking net job creation, developing weakness in nonresidential construction, and a bottom in the housing market still not in sight. In contrast, conditions in the financial markets appear to have improved substantially. As has been my practice, I had several conversations with contacts in a variety of financial firms. There was a consistent tone suggesting that financial markets are likely to have seen the worst. This does not mean that no concerns were expressed. Some contacts had concerns about European banks and credit markets, and concern about the value of the dollar, notwithstanding the recent rally, is coming up in more contexts. Concern was expressed about the dollar's disruptive effect on commodity markets, in turn affecting the general price level--in particular, the effect of high energy prices on a wide spectrum of businesses' consumer products and even on crime rates in rural and far suburban areas related to the theft of copper wiring and piping from vacant homes and air conditioning units. I worry that a narrative is developing along the lines that the ECB is concerned about inflation and the Fed not so much. This narrative encourages a dollar carry trade mentioned, again, by some financial contacts that puts downside pressure on the dollar that potentially undermines both growth and inflation objectives. I remain concerned about the vulnerability of financial markets to a shock or surprise, but overall, my contacts express the belief that conditions are improving. The Atlanta forecast submission sees flat real GDP growth in the first half of 2008, with gradual improvement in the second half. We continue to believe that the drag on economic activity from the problems in the housing and credit markets will persist into 2009. On the inflation front, I am still projecting a decline in the rate of inflation over this year. I've submitted forecasts of declining headline inflation in 2009 and 2010, but I should note that my staff's current projections suggest that improvement to the degree I would like to see may require some rises in the federal funds rate. It is my current judgment that, with an additional 25 basis point reduction in the fed funds rate target, policy will be appropriately calibrated to the gradual recovery of growth and the lowering of the inflation level envisioned in our forecast. This judgment is based on the view that, with a negative real funds rate by some measures, policy is in stimulative territory; that a lower cost of borrowing in support of growth depends more on market-driven tightening of credit spreads than a lower policy rate; that further cuts may contribute to unhelpful movements in the dollar exchange rate; and that extension of the four liquidity facilities may allow us to decouple liquidity actions from the fed funds rate target. In my view, we are in a zone of diminishing returns from further funds rate cuts beyond a possible quarter in this meeting. That said, as stated in the Greenbook, uncertainty surrounding the outlook for the real economy is very high, and the Committee needs, in my view, to preserve flexibility to deal with unanticipated developments. Thank you, Mr. Chairman. " FinancialCrisisReport--222 Without even asking for income or assets/liabilities, the loans are collateral-dependent. This is imprudent … [T]he interagency NTM Guidance states specifically that collateral dependent loans are unsafe and unsound. … Does WAMU have any plans to amend its policies per no doc loans?” 844 The Examiner-in-Charge, Benjamin Franklin, relayed the inquiry to the then Director of the OTS Western Region Office, Darrel Dochow, and stated that, while WaMu had not issued “true NINAs” in the past, the bank had begun “doing NINA’s in 2006 through their conduit program. As such, all these loans are held for sale.” He estimated WaMu then had about $90 million of NINA loans held for sale, had originated about $600 million in 2006, and would originate the same amount again in 2007. 845 Mr. Dochow responded that he was already in regular contact with OTS officials in Washington about WaMu and “there is no need to duplicate with Bill Magrini as far as I know.” 846 Later the same day, Mr. Dochow wrote: “I am being told that Bill’s views may not necessarily represent OTS policy in these matters. I value Bill’s input, but we should be careful about relaying his views to others as being OTS policy, absent collaborating written guidance. [His] views … are somewhat inconsistent with NTM guidance and industry practice. I also understand Grovetta [another OTS official] promised to clarify section 212 of the handbook in several areas as a result of the NTM roundtable discussion in Wash DC last month.” 847 That same day, another OTS official, Mark Reiley, sent an email indicating his belief that sections of the OTS handbook barred WaMu from issuing NINA loans, even when those loans were originated for sale to Wall Street: “The Handbook guidance Section 212 states that no-doc loans (NINAs) are unsafe and unsound loans (Pg. 212.7). Furthermore, even if the no-doc (NINA) loans are originated and held for sale the guidance indicates (pg. 212.8) the association must use prudent underwriting and documentation standards and we have already concluded they are unsafe and unsound. Even if the institution holds the loans for a short period of time. … [T]his is a hot topic in DC and we are getting a significant amount of push back from the 844 See 5/15/2007 email from OTS Examiner-in-Charge Benjamin Franklin to OTS Western Region Director Darrel Dochow, Franklin_Benjamin-00020449_001, Hearing Exhibit 4/16-79 (quoting email from Bill Magrini). See also 3/27/2007 email from OTS official Bill Magrini to OTS colleagues, Quigley_Lori-00110324 , Hearing Exhibit 4/16- 76 (“I noted that several of our institutions make NINA loans. That, in my humble opinion is collateral dependent lending and deemed unsafe and unsound by all the agencies. … It is not at all surprising that delinquencies are up, even among Alt-A. In my opinion, credit standards have gone too low.”). See also undated OTS document, “Option ARM Neg Am Review Workprogram 212A(1) & Nontraditional Mortgage Guidance Review,” at OTSWMEF-0000009891, Hearing Exhibit 4/16-74 (determining that 73% of the Option ARMs in WaMu’s portfolio were “low doc” loans). 845 5/16/2007 email from OTS Western Region Director Darrel Dochow to OTS Examiner-in-Charge Benjamin Franklin, Franklin_Benjamin-00020449_001, Hearing Exhibit 4/16-79. 846 Id. 847 Id. industry. … At this point I don’t think a memo is the best avenue, I think we need to request in writing that WAMU respond to us on how the NINA’s comply with the handbook guidance?” fcic_final_report_full--181 Rejected Loans Waived in by Selected Banks From January 2006 through June 2007, Clayton rejected 28% of the mortgages it reviewed. Of these, 39% were waived in anyway. A ACCEPTED B REJECTED C REJECTED D REJECTED E FINANCIAL LOANS LOANS LOANS LOANS AFTER INSTITUTION (Event 1 & 2)/ Total pool of loans (Event 3)/ Total pool of loans WAIVED IN BY FINANCIAL INSTITUTIONS WAIVERS (B–C) WAIVER RATE (C/B) Financial Institution Citigroup 58% 42% 13% 29% 31% Credit Suisse 68 32 11 21 33 Deutsche 65 35 17 17 50 Goldman 77 23 7 16 29 JP Morgan 73 27 14 13 51 Lehman 74 26 10 16 37 Merrill 77 23 7 16 32 UBS 80 20 6 13 33 WaMu 73 27 8 19 29 Total Bank Sample 72% 28% 11% 17% 39% NOTES: From Clayton Trending Reports. Numbers may not add due to rounding. SOURCE: Clayton Holdings Figure . guidelines. “As you know, there was stated income, they were telling us look for rea- sonableness of that income, things like that.”  With stricter guidelines, one would ex- pect more rejections, and, after the securitizer looks more closely at the rejected loans, possibly more waivers. As Moody’s Investors Service explained in a letter to the FCIC, “A high rate of waivers from an institution with extremely tight underwrit- ing standards could result in a pool that is less risky than a pool with no waivers from an institution with extremely loose underwriting standards.”  Nonetheless, many prospectuses indicated that the loans in the pools either met guidelines outright or had compensating factors, even though Clayton’s records show that only a portion of the loans were sampled, and that of those that were sampled, a substantial percentage of Grade  Event loans were waived in. Johnson said he approached the rating agencies in  and  to gauge their interest in the exception-tracking product that Clayton was developing. He said he shared some of their company’s results, attempting to convince the agencies that the data would benefit the ratings process. “We went to the rating agencies and said, ‘Wouldn’t this information be great for you to have as you assign tranche levels of risk? ’” Johnson recalled. The agencies thought the due diligence firm’s data were “great,” but they did not want the information, Johnson said, because it would pre- sumably produce lower ratings for the securitizations and cost the agency business— even in , as the private securitization market was winding down.  CHRG-111shrg57319--464 Mr. Rotella," I became aware of this particular situation when it was brought to my attention in 2008---- Senator Levin. That is the first---- Mr. Rotella [continuing]. As was referenced in your documents from later in the binder. Senator Levin. Now, in 2007, we had a review. This is Exhibit 21.\1\ This went to you, also. This was now a problem that corporate credit review did. High risk: ``Ineffectiveness of fraud detection tools,'' and ``Weak credit risk infrastructure impacting credit quality.'' They looked at 187 loans they were reviewing. Of the 187 files that were looked at, of those 132 that were sampled were identified with ``red flags that were not addressed by the business unit.'' Eighty had stated income loans that were identified as being unreasonable. Eighty-seven ``exceeded program parameters.'' And 133 had ``credit evaluation or loan decision errors present.''--------------------------------------------------------------------------- \1\ See Exhibit 21, which appears in the Appendix on page 477.--------------------------------------------------------------------------- And this was sent to you, according to the cover sheet here, Mr. Rotella, Exhibit 21. Do you remember this one? " FinancialCrisisReport--136 Washington Mutual had longstanding relationships with a number of government sponsored enterprises (GSEs), including the Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac). 488 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. 489 While the majority of those loans involved lower risk, fixed rate mortgages, WaMu also sold Fannie and Freddie billions of dollars in higher risk Option ARMs. Relationships with Fannie and Freddie. Fannie Mae and Freddie Mac purchase residential mortgages that meet specified underwriting standards and fall below a specified dollar threshold, so-called “conforming loans.” They often enter into multi-year contracts with large mortgage issuers to purchase an agreed-upon volume of conforming loans at agreed-upon rates. Prior to 2005, Washington Mutual sold most of its conforming loans to Fannie Mae, with relatively little business going to Freddie Mac. 490 From at least 1999 through 2004, WaMu sold those loans to Fannie Mae through a long term “Alliance Agreement,” 491 that resulted in its providing more than 85% of its conforming loans to Fannie Mae. 492 In 2004, WaMu calculated that it “contributed 15% of Fannie Mae’s 2003 mortgage business,” 493 and was “Fannie Mae’s 2nd largest provider of business (behind Countrywide).” 494 Among the advantages that WaMu believed it gained from its relationship with Fannie Mae were help with balance sheet 487 “Select Delinquency and Loss Data for Washington Mutual Securitizations,” chart prepared by the Subcommittee, Hearing Exhibit 4/13-1g. 488 See 9/29/2005 “GSE Forum,” internal presentation prepared by WaMu, Hearing Exhibit 4/16-91 at JPM_WM02575608. As mentioned earlier, GSEs are Congressionally chartered, nongovernment owned financial institutions created for public policy purposes. At the time of the financial crisis, the GSEs included Fannie Mae, Freddie Mac, and the Federal Home Loan Bank System (FHLBS), all of which were created by Congress to strengthen the availability of capital for home mortgage financing. 489 See chart, below, using loan data from Inside Mortgage Finance . 490 See 4/12/2004 “Pre-Meeting for Fannie Mae,” internal presentation prepared by WaMu, at JPM_WM02405463, Hearing Exhibit 4/16-86 (“At current level, alternative executions, e.g., Freddie Mac, FHLB, and private investors, do not win a significant level of business.”). 491 See 4/12/2004 “Pre-Meeting for Fannie Mae,” internal presentation prepared by WaMu, at JPM_WM02405462, Hearing Exhibit 4/16-86 (chart entitled, “Timeline of the Alliance Agreement”). 492 See 4/12/2004 “Pre-Meeting for Fannie Mae,” internal presentation prepared by WaMu, at JPM_WM02405461, Hearing Exhibit 4/16-86 (“Under this Alliance Agreement with Fannie Mae, WaMu has agreed to deliver no less than 75% of eligible, conforming loans to Fannie Mae.”); 2/23/2005 email exchange between David Beck and WaMu executives, Hearing Exhibit 4/16-85 (“5 years of 85%+ share with Fannie”). 493 4/12/2004 “Pre-Meeting for Fannie Mae,” internal presentation prepared by WaMu, at JPM_WM02405459, Hearing Exhibit 4/16-86. 494 Id. at JPM_WM02405467, Subcommittee Hearing Exhibit 4/16-86. management, underwriting guidance, and support for WaMu’s Community Reinvestment Act initiatives. 495 FinancialCrisisReport--81 In addition to the early payment default problem, a September 2005 WaMu audit observed that at Long Beach, policies designed to mitigate the risk of predatory lending practices were not always followed. The audit report stated: “In 24 of 27 (88%) of the refinance transactions reviewed, policies established to preclude origination of loans providing no net tangible benefit to the borrower were not followed.” 226 In addition, in 8 out of 10 of the newly issued refinance loans that WaMu reviewed, Long Beach had not followed procedures designed to detect “loan flipping,” an industry term used to describe the practice of unscrupulous brokers or lenders quickly or repeatedly refinancing a borrower’s loan to reap fees and profits but provide no benefit to the borrower. 227 2006 Purchase of Long Beach. In response to all the problems at Long Beach, at the end of 2005, WaMu fired Long Beach’s senior management and moved the company under the direct supervision of the President of WaMu’s Home Loans Division, David Schneider. 228 Washington Mutual promised its regulator, OTS, that Long Beach would improve. 229 The bank also filed a formal application, requiring OTS approval, to purchase Long Beach from its parent company, so that it would become a wholly owned subsidiary of the bank. 230 WaMu told OTS that making Long Beach a subsidiary would give the bank greater control over Long Beach’s result of the EPD provision for the year ended December 31, 2005 was $837.3 million. The net loss from these repurchases was approximately $107 million.”). 223 Id. 224 Id. 225 Washington Mutual Inc. 2005 10-K filing with the SEC. 226 9/21/2005 WaMu audit of Long Beach, JPM_WM04656627. 227 Id. 228 Subcommittee interview of David Schneider (2/17/2010). 229 See, e.g., 12/21/2005 OTS memorandum, “Long Beach Mortgage Corporation (LBMC),” OTSWMS06-007 0001009, Hearing Exhibit 4/16-31. 230 Id. at OTSWMS06-007 0001009 (stating WaMu filed a 12/12/2005 application to acquire Long Beach). operations and allow it to strengthen Long Beach’s lending practices and risk management, as well as reduce funding costs and administrative expenses. 231 In addition, WaMu proposed that it replace its current “Specialty Mortgage Finance” program, which involved purchasing subprime loans for its portfolio primarily from Ameriquest, with a similar loan portfolio provided by Long CHRG-111hhrg48867--202 Mr. Bartlett," Congressman, I suppose I understand why the discussion keeps, sort of, trending over towards identifying specific firms, but let me try to offer some clarity. That is not the goal. It is a set of practices and activities across the markets, it is the system that we should focus on. There is no--at least we don't have a proposal to identify, ``systemically significant firms.'' That should not be done. It should not be size-mattered. It should be related to whether their system or the practices create systemic risk. Now, let me give you a real-life example of one that we just went through. Hundreds of thousands of mortgage brokers, not big companies but hundreds of thousands, had a practice of selling mortgage products not related to whether they were good mortgages or not, without the ability to repay. Thousands of lenders--42 percent were regulated banks; 58 percent were unregulated by anyone--had a practice of originating those loans, even though they were systemically a major risk, as it turned out, and then selling them to mortgage-backed securities on Wall Street, who then put them into pools, who then had them insured, that were regulated by 50 State insurance commissioners. So the system itself was the systemic failure. It wasn't any one of those firms. And so the goal here, I think, is to create a regulatory system that can identify those patterns or practices that then can result in a systemic collapse before it happens. " CHRG-111hhrg58044--156 Mr. Neugebauer," Thank you, Mr. Chairman. I want to go back to one of the things that seems to be a common theme, and I do not want to put words in people's mouth, but that the credit scores are used in part of the underwriting process. What is not standardized is some companies put more weight on that credit score than others. If I am a company and I am competing for business, if I am overly penalizing people for their credit scores and using that as a higher rate, I am probably losing business because I would say I would be pricing myself out of the market. Is that a reasonable assumption? " CHRG-111shrg57320--246 Mr. Carter," This is not single family underwriting overall. This is looking at a specific action plan where they had made promises in the past---- Senator Levin. They had not kept them. Mr. Carter [continuing]. And we had to judge how much progress they made on that action plan. They didn't do nothing. I think that is a double negative, but they had made progress on the action plan. We had to make a judgment call. Did they make sufficient progress that we would say it would be adequate? Did they make so insufficient of progress that we would say they were totally inadequate? Senator Levin. It does not have to be ``totally.'' Just ``inadequate.'' " 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. CHRG-111shrg57322--113 Mr. Sparks," Well, with respect to the origination practices--and, again, I would have to look at the particular deal---- Senator Kaufman. We got the origination practices. What we are trying to do here today is talk about what happened after the originators got through with it and after the rating agencies put the rating on it and the rest of it and then it went out. There was this great sucking from Wall Street to get more and more of these loans into the marketplace, and you can see that it was an explosion. Is it fair to say there was an explosion in these CDOs and RMBSs? " CHRG-111shrg57319--36 Mr. Cathcart," There was a surge of loans just after I arrived, and I believe that was the $800 million that Mr. Melby was just talking about. Senator Levin. All right. Now, in 2006, Washington Mutual made Long Beach a direct subsidiary of the bank and put it under the direct supervision of the Home Loans Division, but that did not seem to help. Mr. Melby, take a look at Exhibit 19.\2\ Your audit team--this is August 20, 2007--issued another Long Beach audit report, and it reported a failure to follow underwriting guidelines and if you look at Exhibit 19, accurate reporting and tracking of exceptions to policy does not exist. That is on page 2. Do you see that?--------------------------------------------------------------------------- \2\ See Exhibit No. 19, which appears in the Appendix on page 462.--------------------------------------------------------------------------- " CHRG-111shrg62643--137 Mr. Bernanke," Very weak, yes. Senator Menendez. We were losing three-quarters of a million jobs in January and February and March of 2009. " CHRG-111shrg51303--176 PREPARED STATEMENT OF SCOTT M. POLAKOFF Acting Director, Office of Thrift Supervision March 5, 2009 Good morning, Chairman Dodd, Ranking Member Shelby, and Members of the Committee. Thank you for inviting me to testify regarding the Office of Thrift Supervision's (OTS) examination and supervisory program and its oversight of American International Group, Inc. (AIG). I appreciate the opportunity to familiarize the Committee with the complex, international operations of AIG as well as the steps the OTS took to oversee the company. At the Committee's request, in my testimony today, I will discuss the complicated set of circumstances that led to the government intervention in AIG. I will provide details on our role as the consolidated supervisor of AIG, the nature and extent of AIG's operations, the risk exposure that it accepted, and the excessive concentration by one of its companies in particularly intricate, new, and unregulated financial instruments. I will also outline the Agency's supervisory and enforcement activities. I will describe some lessons learned from the rise and fall of AIG, and offer my opinion, in hindsight, on what we might have done differently. Finally, I will outline some needed changes that could prevent similar financial companies from repeating AIG's errors in managing its risk, as well as actions Congress might consider in the realm of regulatory reform.History of AIG AIG is a huge international conglomerate that operates in 130 countries worldwide. As of year-end 2007, the combined assets of the AIG group were $1 trillion. The AIG group's primary business is insurance. AIG's core business segments fall under four general categories (e.g., General Insurance, Life Insurance and Retirement Services, Financial Services, and Asset Management). AIG's core business of insurance is functionally regulated by various U.S. State regulators, with the lead role assumed by the New York and Pennsylvania Departments of Insurance, and by foreign regulators throughout the 130 countries in which AIG operates. My testimony will focus primarily on AIG, the holding company, and AIG Financial Products (AIGFP). Many of the initial problems in the AIG group were centered in AIGFP and AIG's Securities Lending Business. It is critically important to note that AIG's crisis was caused by liquidity problems, not capital inadequacy. AIG's liquidity was impaired as a result of two of AIG's business lines: (1) AIGFP's ``super senior'' credit default swaps (CDS) associated with collateralized debt obligations (CDO), backed primarily by U.S. subprime mortgage securities and (2) AIG's securities lending commitments. While much of AIG's liquidity problems were the result of the collateral call requirements on the CDS transactions, the cash requirements of the company's securities lending program also were a significant factor. AIG's securities lending activities began prior to 2000, Its securities lending portfolio is owned pro-rata by its participating, regulated insurance companies. At its highest point, the portfolio's $90 billion in assets comprised approximately 9 percent of the group's total assets. AIG Securities Lending Corp., a registered broker-dealer in the U.S., managed the much larger, domestic piece of the securities lending program as agent for the insurance companies in accordance with investment agreements approved by the insurance companies and their functional regulators. The securities lending program was designed to provide the opportunity to earn an incremental yield on the securities housed in the investment portfolios of AIG's insurance entities. These entities loaned their securities to various third parties, in return for cash collateral, most of which AIG was obligated to repay or roll over every two weeks, on average. While a typical securities lending program reinvests its cash in short duration investments, such as treasuries and commercial paper, AIG's insurance entities invested much of their cash collateral in AAA-rated residential mortgage-backed securities with longer durations. Similar to the declines in market value of AIGFP's credit default swaps, AIG's residential mortgage investments declined sharply with the turmoil in the housing and mortgage markets. Eventually, this created a tremendous shortfall in the program's assets relative to its liabilities. Requirements by the securities lending program's counterparties to meet margin requirements and return the cash AIG had received as collateral then placed tremendous stress on AIG's liquidity. AIGFP had been in operation since the early 1990s and operated independently from AIG's regulated insurance entities and insured depository institution. AIGFP's $100 billion in assets comprises approximately 10 percent of the AIG group's total assets of $1 trillion. AIGFP's CDS portfolio was largely originated in the 2003 to 2005 period and was facilitated by AIG's full and unconditional guarantee (extended to all AIGFP transactions since its creation), which enabled AIGFP to assume the AAA rating for market transactions and counterparty negotiations. AIGFP's CDS provide credit protection to counterparties on designated portfolios of loans or debt securities. AIGFP provided such credit protection on a ``second loss'' basis, under which it repeatedly reported and disclosed that its payment obligations would arise only after credit losses in the designated portfolio exceeded a specified threshold amount or level of ``first losses.'' Also known as ``super senior,'' AIGFP provided protection on the layer of credit risk senior to the AAA risk layer. The AIGFP CDS were on the safest portion of the security from a credit perspective. In fact, even today, there have not been credit losses on the AAA risk layer. AIGFP made an internal decision to stop origination of these derivatives in December 2005 based on their general observation that underwriting standards for mortgages backing securities were declining. At this time, however, AIGFP already had $80 billion of CDS commitments. The housing market began to unravel starting with subprime defaults in 2007, triggering a chain of events that eventually led to government intervention in AIG.OTS's Supervisory Role and ActionsSupervisory Responsibilities Mr. Chairman, I would like next to provide an overview of OTS' responsibilities in supervising a savings and loan holding company (SLHC). In doing so, I will describe many of the criticisms and corrective actions OTS directed to AIG management and its board of directors, especially after the most recent examinations conducted in 2005, 2006, and 2007. As you will see, our actions reveal a progressive level of severity in our supervisory criticism of AIG's corporate governance. OTS criticisms addressed AIG's risk management, corporate oversight, and financial reporting, culminating in the Supervisory Letter issued by OTS in March 2008, which downgraded AIG's examination rating. You will also see that where OTS fell short, as did others, was in the failure to recognize in time the extent of the liquidity risk to AIG of the ``super senior'' credit default swaps in AIGFP's portfolio. In hindsight, we focused too narrowly on the perceived creditworthiness of the underlying securities and did not sufficiently assess the susceptibility of highly illiquid, complex instruments (both CDS and CDOs) to downgrades in the ratings of the company or the underlying securities, and to declines in the market value of the securities. No one predicted, including OTS; the amount of funds that would be required to meet collateral calls and cash demands on the credit default swap transactions. In retrospect, if we had identified the absolute magnitude of AIGFP's CDS exposures as a liquidity risk, we could have requested that AIGFP reduce its exposure to this concentration. OTS' interaction with AIG began in 1999 when the conglomerate applied to form a Federal Savings Bank (FSB). AIG received approval in 2000, and the AIG FSB commenced operations on May 15, 2000. OTS is the consolidated supervisor of AIG, which is a savings and loan holding company by virtue of its ownership of AIG Federal Savings Bank. OTS supervises savings associations and their holding companies to maintain their safety, soundness, and compliance with consumer laws, and to encourage a competitive industry that meets America's financial services needs. As the primary Federal regulator of savings and loan holding companies, OTS has the authority to supervise and examine each holding company enterprise, but relies on the specific functional regulators for information and findings regarding the specific entity for which the functional regulator is responsible. Once created, a holding company is subject to ongoing monitoring and examination. Managerial resources, financial resources and future prospects continue to be evaluated through the CORE holding company examination components (i.e., Capital, Organizational Structure, Risk Management and Earnings). The OTS holding company examination assesses capital and earnings in relation to the unique organizational structure and risk profile of each holding company. During OTS's review of capital adequacy, OTS considers the risk inherent in an enterprise's activities and the ability of the enterprise's capital to absorb unanticipated losses, support the level and composition of the parent company's and subsidiaries' debt, and support business plans and strategies. The focus of this authority is the consolidated health and stability of the holding company enterprise and its effect on the subsidiary savings association. OTS oversees the enterprise to identify systemic issues or weaknesses, as well as ensure compliance with regulations that govern permissible activities and transactions. The examination goal is consistent across all types of holding company enterprises; however, the level of review and amount of resources needed to assess a complex structure such as AIG's is vastly deeper and more resource-intensive than what would be required for a less complex holding company.OTS Supervisory Actions OTS's approach to holding company supervision has continually evolved to address new developments in the financial services industry and supervisory best practices. At the time AIG became a savings and loan holding company in 2000, OTS focused primarily on the impact of the holding company enterprise on the subsidiary savings association. With the passage of Gramm-Leach-Bliley, not long before AIG became a savings and loan holding company, OTS recognized that large corporate enterprises, made up of a number of different companies or legal entities, were changing the way such enterprises operated and would need to be supervised. These companies, commonly called conglomerates, began operating differently from traditional holding companies and in a more integrated fashion, requiring a more enterprise-wide review of their operations. In short, these companies shifted from managing along legal entity lines to managing along functional lines. Consistent with changing business practices and how conglomerates then were managed, in late 2003 OTS embraced a more enterprise-wide approach to supervising conglomerates. This shift aligned well with core supervisory principles adopted by the Basel Committee and with requirements adopted by European Union (EU) regulators that took effect in 2005, which required supplemental regulatory supervision at the conglomerate level. OTS was recognized as an equivalent regulator for the purposes of AIG consolidated supervision within the EU, a process that was finalized with a determination of equivalence by the French regulator, Commission Bancaire. Under OTS's approach of classifying holding companies by complexity, as well as the EU's definition of a financial conglomerate, AIG was supervised, and assessed, as a conglomerate. OTS exercises its supervisory responsibilities with respect to complex holding companies by communicating with other functional regulators and supervisors who share jurisdiction over portions of these entities and through our own set of specialized procedures. With respect to communication, OTS is committed to the framework of functional supervision Congress established in Gramm-Leach-Bliley. Under Gramm-Leach-Bliley, the consolidated supervisors are required to consult on an ongoing basis with other functional regulators to ensure those findings and competencies are appropriately integrated into our own assessment of the consolidated enterprise and, by extension, the insured depository institution we regulate. Consistent with this commitment and as part of its comprehensive, consolidated supervisory program for AIG, OTS began in 2005 to convene annual supervisory college meetings. Key foreign supervisory agencies, as well as U.S. State insurance regulators, participated in these conferences. During the part of the meetings devoted to presentations from the company, supervisors have an opportunity to question the company about any supervisory or risk issues. Approximately 85 percent of AIG, as measured by allocated capital, is contained within entities regulated or licensed by other supervisors. Another part of the meeting includes a ``supervisors-only'' session, which provides a venue for participants to ask questions of each other and to discuss issues of common concern regarding AIG. OTS also uses the occasion of the college meetings to arrange one-on-one side meetings with foreign regulators to discuss in more depth significant risk in their home jurisdictions. As OTS began its early supervision of AIG as a conglomerate, our first step was to better understand its organizational structure and to identify the interested regulators throughout the world. In this regard, AIG had a multitude of regulators in over 100 countries involved in supervising pieces of the AIG corporate family. OTS established relationships with these regulators, executed information sharing agreements where appropriate, and obtained these regulators' assessments and concerns for the segment of the organization regulated. As OTS gained experience supervising AIG and other conglomerates, we recognized that a dedicated examination team and continuous onsite presence was essential to overseeing the dynamic and often fast-paced changes that occur in these complex structures. In 2006, OTS formally adopted a risk-focused continuous supervision program for the oversight of large and complex holding companies. This program combines on- and off-site planning, monitoring, communication, and analysis into an ongoing examination process. OTS's continuous supervision and examination program comprises development and maintenance of a comprehensive risk assessment, which consists of: an annual supervisory plan; risk-focused targeted reviews; coordination with other domestic and foreign regulators; an annual examination process and reporting framework; routine management meetings; and an annual board of directors meeting. OTS conducted continuous consolidated supervision of the AIG group, including an onsite examination team at AIG headquarters in New York. Through frequent, ongoing dialogue with company management, OTS maintained a contemporaneous understanding of all material parts of the AIG group, including their domestic and cross-border operations. OTS's primary point of contact with the holding company was through AIG departments that dealt with corporate control functions, such as Enterprise Risk Management (ERM), Internal Audit, Legal/Compliance, Comptroller, and Treasury. OTS held monthly meetings with AIG's Regulatory and Compliance Group, Internal Audit Director, and external auditors. In addition, OTS held quarterly meetings with the Chief Risk Officer, the Treasury Group, and senior management, and annually with the board of directors. OTS reviewed and monitored risk concentrations, intra-group transactions, and consolidated capital at AIG, and also directed corrective actions against AIG's Enterprise Risk Management. OTS also met regularly with Price Waterhouse Coopers (PwC), the company's independent auditor. Key to the continuous supervision process is the risk assessment, resulting supervisory plan, and targeted areas of review for each year. OTS focused on the corporate governance, risk management, and internal control centers within the company and completed targeted reviews of non-functionally regulated affiliates within the holding company structure. In 2005, OTS conducted several targeted, risk-focused reviews of various lines of business, including AIGFP, and made numerous recommendations to AIG senior management and the board with respect to risk management oversight, financial reporting transparency and corporate governance. The findings, recommendations, and corrective action points of the 2005 examination were communicated in a report to the AIG Board in March 2006. With respect to AIGFP, OTS identified and reported to AIG's board weaknesses in AIGFP's documentation of complex structures transactions, in policies and procedures regarding accounting, in stress testing, in communication of risk tolerances, and in the company's outline of lines of authority, credit risk management and measurement. Our report of examination also identified weaknesses related to American General Finance (AGF), another non-functionally regulated subsidiary in the AIG family that is a major provider of consumer finance products in the U.S. These weaknesses included deficiencies regarding accounting for repurchased loans, evaluation of the allowance for loan losses: Credit Strategy Policy Committee reporting, information system data fields, and failure to forward copies of State examination reports and management response to the Internal Audit Division. The examination report also noted weaknesses in AIG's management and internal relationships, especially with the Corporate Legal Compliance Group and the Internal Audit Division, as well as its anti-money laundering program. In 2006 OTS noted nominal progress on implementing corrective measures on the weaknesses noted in the prior examination; however, the Agency identified additional weaknesses requiring the board of directors to take corrective action. Most notably, OTS required the board to establish timely and accurate accounting and reconciliation processes, enhance and validate business line capital models, address compliance-related matters, adopt mortgage loan industry best practices, and assess the adequacy of its fraud detection and remediation processes. During 2007, when there were signs of deterioration in the U.S. mortgage finance markets, OTS increased surveillance of AGF and AIGFP. OTS selected AGF for review because of its significant size and scope of consumer operations, and to follow up on the problems noted in prior examinations. OTS also has supervisory responsibility for AIG Federal Savings Bank. OTS took action against AIG FSB in June, 2007, in the form of a Supervisory Agreement for its failure to manage and control in a safe and sound manner the loan origination services outsourced to its affiliate, Wilmington Finance, Inc. (WFI). The Agreement addressed loan origination activities and required AIG FSB to identify and provide timely assistance to borrowers who were at risk of losing their homes because of the thrift's loan origination and lending practices. OTS also required a $128 million reserve to be established to cover costs associated with providing affordable loans to borrowers. Later, in light of AIG's growing liquidity needs to support its collateral obligations, OTS took action in September 2008 at the FSB level to ensure that depositors and the insurance fund were not placed at risk. OTS actions precluded the bank from engaging in transactions with affiliates without OTS knowledge and lack of objection; restricted capital distributions; required maintenance of minimum liquidity and borrowing capacity sensitive to the unfolding situation; and required retention of counsel to advise the board in matters involving corporate reorganization and attendant risks related thereto. AIG FSB continues to be well capitalized and maintains adequate levels of liquidity. After a 2007 targeted review of AIGFP, OTS instructed the company to revisit its modeling assumptions in light of deteriorating subprime market conditions. In the summer of 2007, after continued market deterioration, OTS questioned AIG about the valuation of CDS backed by subprime mortgages. In the last quarter of 2007, OTS increased the frequency of meetings with AIG's risk managers and PwC. Due to the Agency's progressive concern with corporate oversight and risk management, in October 2007 we required AIG's Board to: Monitor remediation efforts with respect to certain material control weaknesses and deficiencies; Ensure implementation of a long-term approach to solving organizational weaknesses and increasing resources dedicated to solving identified deficiencies; Monitor the continued improvement of corporate control group ability to identify and monitor risk; Complete the holding company level risk assessment, risk metrics, and reporting initiatives and fully develop risk reporting; Increase involvement in the oversight of the firm's overall risk appetite and profile and be fully informed as to AIG Catastrophic Risk exposures, on a full-spectrum (credit, market, insurance, and operational) basis; and Ensure the prompt, thorough, and accountable development of the Global Compliance program, a critical risk control function where organizational structure impediments have delayed program enhancements. OTS further emphasized to AIG management and the board that it should give the highest priority to the financial reporting process remediation and the related long-term solution to financial reporting weaknesses. In connection with the 2007 annual examination, the Organizational Structure component of the CORE rating was downgraded to reflect identified weakness in the company's control environment. Shortly after OTS issued the 2007 report, AIG disclosed its third quarter 2007 financial results, which indicated for the first time a material problem in the Multi Sector CDS portfolio evidenced by a $352 million valuation charge to earnings and the disclosure that collateral was being posted with various counterparties to address further market value erosion in the CDS portfolio. As PwC was about to issue the accounting opinions on the 2007 financial statements, the independent auditor concluded that a material control weakness existed in AIGFP's valuation processes and that a significant control deficiency existed with Enterprise Risk Management's access to AIGFP's valuation models and assumptions. Due to intense pressure from PwC, in February 2008, AIG filed an SEC Form 8K announcing the presence of the material weakness. AIG pledged to implement complete remediation efforts immediately. OTS's subsequent supervisory review and discussions with PwC revealed that AIGFP was allowed to limit access of key risk control groups while material questions relating to the valuation of super senior CDS portfolio were mounting. As a result of this gap, corporate management did not obtain sufficient information to completely assess the valuation methodology. In response to these matters, AIG's Audit Committee commissioned an internal investigation headed by Special Counsel to the Audit Committee to review the facts and circumstances leading to the events disclosed in the SEC Form 8K. The Special Counsel worked with OTS to evaluate the breakdown in internal controls and financial reporting. Regulatory entities such as the Securities Exchange Commission and Department of Justice then also commenced inquiries. The OTS met with AIG senior management on March 3, 2008, and communicated significant supervisory problems over the disclosures in the SEC Form 8K and the unsatisfactory handling of the Enterprise Risk Management relationship with AIGFP. OTS downgraded AIG's CORE ratings and communicated the OTS's view of the company's risk management failure in a letter to AIG's General Counsel on March 10, 2008. As part of this remediation process and to bolster corporate liquidity and oversight, AIG successfully accessed the capital markets in May of 2008 and raised roughly $20 billion in a combination of common equity and equity hybrid securities. This action coupled with existing liquidity at the AIG parent, provided management with reasonable comfort that it could fund the forecasted collateral needs of AIGFP. AIG also added a Liquidity Manager to its corporate Enterprise Risk Management unit to provide senior management with more timely stress scenario reporting and formed a liquidity monitoring committee composed of risk managers, corporate treasury personnel, and business unit members to provide oversight. On July 28, 2008, AIG submitted a final comprehensive remediation plan, which OTS reviewed and ultimately accepted on August 28, 2008. The AIG audit committee approved the company's remediation plan, which also was used by PwC to assess AIG's progress in resolving the material control weakness covering the valuation of the CDS portfolio and the significant control deficiency attributable to AIG's corporate risk oversight of AIGFP, AGF, and International Lease Finance Corporation (ILFC). OTS continues to monitor these remediation efforts to this day, notwithstanding AIG's September 2008 liquidity crisis. As AIG's liquidity position became more precarious, OTS initiated heightened communications with domestic and international financial regulators. Through constant communication, OTS monitored breaking events in geographic areas where AIG operates, kept regulators in those jurisdictions informed of events in the U.S. and clarified the nature of AIG's stresses. OTS's identification of AIGFP as the focal point of AIG's problems added perspective that allowed foreign regulators to more accurately assess the impact on their regulated entities and to make informed supervisory decisions. In September 2008 the Federal Reserve Bank of New York (FRB-NY) extended an $85 billion loan to AIG and the government took an 80 percent stake in AIG. On the closure of this transaction? Federal statute no longer defined AIG as a savings and loan holding company subject to regulation as such. This result would be true whether AIG had been a savings and loan holding or bank holding company subject to regulation by the Federal Reserve Board. Nonetheless, OTS has continued in the role of equivalent regulator for EU and international purposes. FRB-NY's intervention had no impact on OTS's continued regulation and supervision of AIG FSB. Although OTS has scaled back some regulatory activities with regard to AIG, the Agency continues to meet regularly with key corporate control units and receive weekly reports on various exposures and committee activities. OTS closely monitors the activities at AIGFP to reduce risk, as well as the divesture efforts of the holding company. OTS will continue to focus on Residential Mortgage Backed Securities exposures and the ultimate performance of underlying mortgage assets. OTS is tracking AIG's remediation efforts. Finally, OTS continues to work with global functional regulators to keep them apprised of conditions at the holding company, as well as to learn of emerging issues in local jurisdictions.Lessons Learned Despite OTS's efforts to point out AIGFP's weaknesses to the company and to its Board of Directors, OTS did not foresee the extent of the risk concentration and the profound systemic impact CDS products caused within AIG. By the time AIGFP stopped originating these derivatives in December 2005, they already had $65 billion on their books. These toxic products posed significant liquidity risk to the holding company. Companies that are successful have greater opportunities for growth. AIG was successful in many regards for many years, but it had issues and challenges. OTS identified many of these issues and attempted to initiate corrective actions, but these actions were not sufficient to avoid the September market collapse. It is worth noting that AIGFP's role was not underwriting, securitizing, or investing in subprime mortgages. Instead; AIGFP simply provided insurance-like protection against declines in the values of underlying securities. Nevertheless, in hindsight, OTS should have directed the company to stop originating CDS products before December 2005. OTS should also have directed AIG to try to divest a portion of this portfolio. The pace of change and deterioration of the housing market outpaced our supervisory remediation measures for the company. By the time the extent of the CDS liquidity exposure was recognized, there was no orderly way to reduce or unwind these positions and the exposure was magnified due to the concentration level. The CDS market needs more consistent terms and conditions and greater depth in market participants to avoid future concentration risks similar to AIG. I believe it is important for the Committee to understand the confluence of market factors that exposed the true risk of the CDS in AIGFP's portfolio. OTS saw breakdowns in market discipline, which was an important element of our supervisory assessment. Areas that we now know were flawed included: overreliance on financial models, rating agency influence on structured products, lack of due diligence in the packaging of asset-backed securities, underwriting weaknesses in originate-to-distribute models, and lack of controls over third party (brokers, conduits, wholesalers) loan originators. Shortcomings in modeling CDS products camouflaged some of the risk. AIGFP underwrote its super senior CDS using proprietary modeling similar to that used by rating agencies for rating structured securities. AIGFP's procedures required modeling based on simulated periods of extended recessionary environments (i.e., ratings downgrade, default, loss, recovery). Up until June 2007, the results of the AIGFP models indicated that the risk of loss was a remote possibility, even under worst-case scenarios. The model used mainstream assumptions that were generally acceptable to the rating agencies, PwC, and AIG. Following a targeted review of AIGFP in early 2007, OTS recommended that the company revisit its modeling assumptions in light of deteriorating subprime market conditions. In hindsight, the banking industry, the rating agencies and prudential supervisors, including OTS, relied too heavily on stress parameters that were based on historical data. This led to an underestimation of the unprecedented economic shock and misjudgment of stress test parameters. Approximately 6 months after OTS's March 2008 downgrade of AIG's examination rating, the credit rating agencies also downgraded AIG on September 15, 2008. That precipitated calls that required AIGFP to post huge amounts of collateral for which it had insufficient funds. The holding company capital was frozen and AIGFP could not meet the calls.Recommendations From the lessons learned during our involvement with supervising AIG, we would like you to consider two suggestions in your future exploration of regulatory reform.Systemic Risk Regulator First, OTS endorses the establishment of a systemic risk regulator with broad authority, including regular monitoring, over companies that if, due to the size or interconnected nature of their activities, their actions, or their failure would pose a risk to the financial stability of the country. Such a regulator should be able to access funds, which would present options to resolve problems at these institutions. The systemic risk regulator should have the ability and the responsibility for monitoring all data about markets and companies, including but not limited to companies involved in banking, securities, and insurance.Regulation of Credit Default Swaps--Consistency and Transparency CDS are financial products that are not regulated by any authority and impose serious challenges to the ability to supervise this risk proactively without any prudential derivatives regulator or standard market regulation. We are aware of and support the recent efforts by the Federal Reserve Bank of New York to develop a common global framework for cooperation. There is a need to fill the regulatory gaps the CDS market has exposed. We have also learned there is a need for consistency and transparency in CDS contracts. The complexity of CDS contracts masked risks and weaknesses in the program that led to one type of CDS performing extremely poorly. The current regulatory means of measuring off-balance sheet risks do not fully capture the inherent risks of CDS. OTS believes standardization of CDS would provide more transparency to market participants and regulators. In the case of AIG, there was heavy reliance on rating agencies and in-house models to assess the risks associated with these extremely complicated and unregulated products. I believe that Congress should consider legislation to bring CDS under regulatory oversight, considering the disruption these instruments caused in the marketplace. Prudential supervision is needed to promote a better understanding of the risks and best practices to manage these risks, enhance transparency, and standardization of contracts and settlements. More and better regulatory tools are needed to bring all potential instruments that could cause a recurrence of our present problems under appropriate oversight and legal authority. A multiplicity of events led to the downfall of AIG. An understanding of the control weaknesses and events that transpired at AIG provides an opportunity to learn to identify weaknesses and strengthen regulatory oversight of complex financial products and companies. OTS has absorbed these lessons and has issued risk-focused guidance and policies to promote a more updated and responsive supervisory program. Thank you, Chairman Dodd, Ranking Member Shelby, and Members of the Committee, for the opportunity to testify on behalf of the OTS on the collapse of AIG. We look forward to working with the Committee to ensure that, in these challenging times, thrifts and consolidated holding companies operate in a safe and sound manner. ______ CHRG-110shrg50369--101 Mr. Bernanke," I think so. The housing market decline and the weakness in the credit markets were suggestive of---- Senator Bunning. Well, the weakness in the credit markets, Chairman Bernanke, were signaled last year, early in the year. I mean, it was not--it did not take a rocket scientist to figure that out. And I know with all the great economists that you have on the Federal Reserve and your members of the Federal Open Market Committee are a lot sharper than the people sitting up here at this table. And you had a big heads-up signal that the housing market was in the tank early last year. " CHRG-111hhrg52406--184 Mr. Plunkett," Good afternoon, Mr. Chairman, and members of the committee, and Ranking Member Bachus. My name is Travis Plunkett, and I am the legislative director at the Consumer Federation of America. I really appreciate the opportunity to speak with you again. CFA strongly supports creating a Federal consumer protection agency focused on credit and payment products because it targets the most significant underlying causes of the massive regulatory failures that have harmed millions of Americans. In particular, combining safety and soundness supervision with its focus on bank profitability in the same regulatory institution as consumer protection authority magnified an ideological predisposition or antiregulatory bias by Federal officials and contributed to an unwillingness to rein in abusive lending before it triggered the housing and economic crises. Structural flaws in the Federal regulatory system compromise the independence of banking regulators and encourage them to overlook, ignore, or minimize their mission to protect consumers. A consumer financial protection agency would correct many of the most significant structural flaws that exist, realigning the regulatory architecture to, first, put consumer protection at the center of financial services regulation; second, end regulatory arbitrage; and third, create a truly independent regulatory process. Towards that end, I want to talk about funding quickly. It should be a priority to provide the agency with a stable funding base that is sufficient to support robust enforcement and is not subject to political manipulation by regulated entities. Funding from a variety of sources, as well as a mix of these sources, should be considered, including congressional appropriations, user fees or industry assessments, filing fees, priced services, such as for compliance exams and transaction-based fees. Another authority that this agency should have that has been the subject of much discussion is the process for overseeing products, features, and services that are offered. Where credit products represent a significant risk to borrowers, we think this agency could require providers to file additional data and information to allow the agency to assess the fairness, sustainability, and transparency of products, features, and practices. As we have heard a lot of discussion about plain vanilla products that are determined to be fair, transparent, and sustainable should be presumptively in compliance and face less regulatory scrutiny and fewer restrictions. Those that are riskier need to have stronger oversight. That could include a variety of remedies related to increased regulatory requirements, including prohibition. And for those who think this is an unusual idea, let me just point out that Congress does this frequently and has recently done so regarding certain abusive credit card practices that consumers simply can't understand and that Congress has determined to be just outright abusive. We have been asked by the committee to consider whether this agency should have some jurisdiction over insurance as well. This is certainly an excellent question. With a few notable exceptions, State insurance consumer protections and market conduct examinations are generally very weak. CFA testified last month before Chairman Kanjorksi's subcommittee in support of bringing safety and soundness regulation under Federal control in part because effective systemic regulation of insurance, which we support, is not really possible unless the regulator has a thorough knowledge of and control over safety and soundness. However, consumer protection regulatory weaknesses that exist at the State level should be strengthened without undermining the excellent regulatory practices in a few States, such as the remarkably successful rate regulation regime in California. Any Federal efforts to assist insurance consumers must be as a supplement to, not a replacement for, consumer protection efforts by State insurance regulators. There are several things in our testimony that we throw out as possibilities for this agency regarding insurance regulation. Most significantly, given the core mission of the agency, which is to protect consumers in the credit markets, it makes a lot of sense to consider granting the agency minimum standards jurisdiction over insurance products that are central or ancillary to a credit transaction such as credit, title, mortgage and forced place insurance. " Mr. Gutierrez," [presiding] The time of the gentleman has expired. " FOMC20080109confcall--38 36,MS. PIANALTO.," Thank you, Mr. Chairman. I, too, am troubled by the weakness in the real economy data that we are seeing. Our Beige Book contacts confirm the weakness, and my business contacts to whom I have been talking report more weakness than they did before our December meeting. However, they are not flashing signals about a recession. Next week we will learn more about just how weak the fourth quarter was through the retail sales and industrial production releases for December. Next week we are also going to get the December CPI report. In my view, the October and November reports were very disappointing. In November, 60 percent of the CPI market basket prices increased at rates of 3 percent or greater. On learning of today's meeting, I was concerned about making a large policy move ahead of the December CPI report for fear that we would be damaging some of our credibility on price stability, so I did not want to make a move at today's meeting. However, I can support a 50 basis point reduction at our meeting at the end of the month if we are regarding that reduction--and regarding our cumulative policy actions--as just offsetting the decline in the equilibrium real rate and we are not being aggressively accommodative. That would be, in my view, appropriate policy given my concerns about inflation. But the public could interpret our actions as being aggressively accommodative and that we are downplaying inflation risks. So I hope, Mr. Chairman, that you will be able to communicate your thinking on this, as you have with us today, in some of your upcoming public statements. Thank you, Mr. Chairman. " CHRG-111hhrg72887--42 STATEMENT OF EILEEN HARRINGTON Ms. Harrington. Thank you, Chairman Rush. I am Eileen Harrington, the Director of the FTC's Bureau of Consumer Protection. I appreciate the opportunity to appear here today to discuss the Consumer Credit and Debt Protection Act and the FTC's role in protecting consumers of financial services. The Commission's views are set forth in the written testimony that we have submitted. My oral presentation and answers to your questions represent my own views. As we know, the current economic crisis continues to have a devastating effect on many consumers. Many are struggling to pay their bills, keep their homes, deal with abusive debt collectors, and maintain their credit ratings. Two months ago you asked the FTC to tell you what it has been doing to help consumers through this difficult time. We told you about how we have been using our tools, law enforcement, consumer education policy and research, to help protect consumers in financial distress from being taken advantage of by those who flout the law. When we came before you then, we recognized that we needed to do more, however, and we asked for your help. Your response, the Consumer Credit and Debt Protection Act, is directly on point. In particular, this bill would build on the new authority we obtained under the 2009 Omnibus Appropriations Act by enabling us to issue rules targeting the practices that caused the most harm to consumers in the broader credit and debt marketplace. Historically, the Commission has relied heavily on its law enforcement experience to inform its rulemakings undertaken under the Administrative Procedures Act with the express consent of Congress. This approach has served us well in the past, and will continue to do so here. Thus, in deciding which practices in the credit and debt market to target, we would rely on our casework to help identify any industrywide problems and pervasive consumer injury. The Consumer Credit and Debt Protection Act also would allow us to seek civil penalties against those who violate any such rules that the Commission issues in this area. This is significant because civil penalties deter would-be violators. The FTC strongly supports the enactment of this type of legislation. As you know, we are already using our new authority under the 2009 Omnibus Appropriations Act to develop new consumer protection regulations in the mortgage context. We expect these rules to address unfair and deceptive practices in mortgage lending, mortgage foreclosure rescue, mortgage loan modification, and mortgage servicing. The 2009 Omnibus Appropriations Act enhanced the Commission's ability to enforce these rules by allowing the FTC to obtain civil penalties against violators. Meanwhile, the Commission continues to vigorously enforce the FTC Act as well as other statutes and rules for which it has enforcement authority. In response to the current economic crisis, the FTC has intensified its focus on protecting consumers of financial services and has targeted particular illegal practices in mortgage advertising, lending and servicing. Let me give you two examples. This past Friday the Commission announced an enforcement action against Golden Empire Mortgage and its individual owner for alleged violations of the Equal Credit Opportunity Act and Regulation B. The Commission alleged that the defendants charged Hispanic consumers higher prices for mortgage loans than non-Hispanic white consumers. The FTC alleged that the credit characteristics or underwriting risk of the company's customers could not explain the differences in the prices charged. A second example. On April 6th, also since the last time we were here, the FTC joined with Treasury, HUD, the Department of Justice, and the Illinois attorney general to announce a coordinated crackdown on mortgage foreclosure rescue fraud. The Federal law enforcement component of that crackdown was done by the FTC. Although vigorous law enforcement is essential in providing more effective Federal oversight of the financial services sector, a broader legislative response may be appropriate here. Several bills have been introduced and proposals offered under which there would be some type of overall Federal regulator of financial services. There are differences in these bills and proposals to rationalize the oversight system, and there are numerous challenging issues that would have to be resolved to implement those concepts. Because of its unequaled comprehensive focus on consumer protection, its independence from providers of financial services, and its emphasis on vigorous law enforcement, we ask Congress to ensure that the FTC is considered as Congress moves forward in determining how to modify Federal consumer financial services. The Commission would be pleased to work with Congress and the subcommittee in developing and defining a new role for the FTC. Thank you for inviting the Commission to testify at this hearing. I would be pleased to answer any of your questions. " FinancialCrisisInquiry--691 ROSEN: Right. And that came through what I would say this—and it was unregulated. Almost every one of the institutions that made these loans, aggressive loans, have now been put out of business, bankrupt. I hope a number of people are going to go where they should, to jail that did the predatory lending. They’re mostly gone. But that came from that source. It wasn’t Fannie and Freddie who did it, primarily. It wasn’t the tax system being changed. I think it was these—I won’t say deceptive, but loans that looked too good to be true, and they were. Underwriting standards were—just disappeared. Low down payment loans became such a high portion of the market, low down payment meaning 100 percent, you know, loan, and so you’re asking for trouble when you do that. HOLTZ-EAKIN: Right. But—but my point is, is simply that, for years, our policymakers have been trying to get the homeownership rate to move. Suddenly it moves exactly the way they want. It’s hard to imagine them being upset with what they saw on the surface. CHRG-110shrg50416--27 Mr. Lockhart," Chairman Dodd, Senator Shelby, and members of the Committee, thank you for the opportunity to testify on the Federal Housing Finance Agency's response to the turmoil in the credit markets. I will begin by talking about our activities as the regulator of Fannie Mae, Freddie Mac, and the Federal Home Loan Banks, and then turn to TARP. There is no doubt that the mortgage market pendulum swung extremely widely toward easy credit, poor underwriting, risky mortgages, and even fraud. The market had to correct. But we need to prevent the pendulum from swinging too far in the other direction. Fannie Mae, Freddie Mac, and the 12 Federal Home Loan Banks have played a critical role in dampening that pendulum swing. In mid-2006, their market share of all new mortgage originations was less than 40 percent. With the demise of the private label mortgage-backed security market, their share is now 80 percent. On September 6th, FHFA placed Fannie Mae and Freddie Mac into conservatorship. Market conditions, compounded by a weak regulatory capital structure, meant that they were unable to fulfill their mission of providing stability, liquidity, and affordability to the mortgage market. A critical component of the conservatorship was the three Treasury facilities that were put in place. The most important one is a Senior Preferred Agreement, which ensures that the Enterprises always will have a positive net worth. These $100 billion each facilities, which have not been withdrawn on yet, are well over three times the statutory minimum capital requirements and last until all liabilities are paid off. Effectively, it is a government guarantee of their existing and future debt in mortgage-backed securities. Both can grow their portfolios by over $100 billion, which will further support the mortgage market, as will Treasury's mortgage-backed security purchase facility. Treasury has also provided the Enterprises and the Federal Home Loan Banks credit facilities to provide liquidity if needed. The Federal Home Loan Banks counter-cyclical capital structure has allowed them to play a critical role in supporting financial institutions and mortgage lending over the last year. Their secured advances to financial institutions have just reached $1 trillion, which is about 58 percent up from June of last year. The new legislation added the Enterprises affordable housing goals and mission enforcement to the responsibilities of the agency. I have instructed both CEOs to examine their underwriting standards and pricing. Earlier this month, Fannie Mae and Freddie Mac canceled a planned doubling of an adverse market delivery fee. I expect future changes to reflect both safe and sound business strategy and attentiveness to their mission. A critical component of stabilizing the mortgage market is assisting borrowers at risk of losing their homes by preventing foreclosures. Keeping people in their homes is critical, not only for the families and the neighborhoods, but for the overall housing market. Through August, the Enterprises have done $130,000 in loss mitigation activities, but they have to do a lot more. A more systematic approach to loan modifications is essential. Well before the conservatorship actions, we had asked the Enterprises to accelerate their loan modifications with features that included potential principal write downs and forbearance. We encouraged them to join the FDIC's IndyMac loan modification program. I expect loan modifications to be a priority, both as a matter of good business and supporting their mission. During this difficult time in our financial markets, the FHFA has been working with the Treasury, the Fed, the SEC, and the Federal banking agencies to monitor market conditions and coordinate regulatory activities. We have been assisting the Treasury Department as it develops ideas for the TARP. I also serve as a Director on the Financial Stability Oversight Board. Foreclosure mitigation is an important objective under the TARP program. The objective applies to all Federal agencies that hold troubled assets, including FHFA as conservator of Fannie Mae and Freddie Mac. In support of the TARP, and as a Federal property manager, FHFA will work to ensure the successes of these foreclosure minimization programs. In conclusion, FHFA and the housing GSEs have a critical role in returning the mortgage market to stability and preventing foreclosures. It will take time but I believe the many steps that have been taken will provide a much more solid foundation for creating a stable future for the mortgage markets and, most importantly, American homeowners, renters, workers, and investors. I look forward to working with the Committee and all of Congress in achieving this goal. Thank you. " fcic_final_report_full--12 Second, we clearly believe the crisis was a result of human mistakes, misjudg- ments, and misdeeds that resulted in systemic failures for which our nation has paid dearly. As you read this report, you will see that specific firms and individuals acted irresponsibly. Yet a crisis of this magnitude cannot be the work of a few bad actors, and such was not the case here. At the same time, the breadth of this crisis does not mean that “everyone is at fault”; many firms and individuals did not participate in the excesses that spawned disaster. We do place special responsibility with the public leaders charged with protecting our financial system, those entrusted to run our regulatory agencies, and the chief ex- ecutives of companies whose failures drove us to crisis. These individuals sought and accepted positions of significant responsibility and obligation. Tone at the top does matter and, in this instance, we were let down. No one said “no.” But as a nation, we must also accept responsibility for what we permitted to occur . Collectively, but certainly not unanimously, we acquiesced to or embraced a system, a set of policies and actions, that gave rise to our present predicament. * * * T HIS REPORT DESCRIBES THE EVENTS and the system that propelled our nation to- ward crisis. The complex machinery of our financial markets has many essential gears—some of which played a critical role as the crisis developed and deepened. Here we render our conclusions about specific components of the system that we be- lieve contributed significantly to the financial meltdown. • We conclude collapsing mortgage-lending standards and the mortgage securi- tization pipeline lit and spread the flame of contagion and crisis. When housing prices fell and mortgage borrowers defaulted, the lights began to dim on Wall Street. This report catalogues the corrosion of mortgage-lending standards and the securiti- zation pipeline that transported toxic mortgages from neighborhoods across Amer- ica to investors around the globe. Many mortgage lenders set the bar so low that lenders simply took eager borrow- ers’ qualifications on faith, often with a willful disregard for a borrower’s ability to pay. Nearly one-quarter of all mortgages made in the first half of  were interest- only loans. During the same year,  of “option ARM” loans originated by Coun- trywide and Washington Mutual had low- or no-documentation requirements. These trends were not secret. As irresponsible lending, including predatory and fraudulent practices, became more prevalent, the Federal Reserve and other regula- tors and authorities heard warnings from many quarters. Yet the Federal Reserve neglected its mission “to ensure the safety and soundness of the nation’s banking and financial system and to protect the credit rights of consumers.” It failed to build the retaining wall before it was too late. And the Office of the Comptroller of the Cur- rency and the Office of Thrift Supervision, caught up in turf wars, preempted state regulators from reining in abuses. FinancialCrisisReport--228 Neither OTS nor the FDIC saw preventing WaMu’s sale of high risk mortgages into U.S. securitization markets as part of its regulatory responsibilities. (d) Inflated CAMELS Ratings Still another possible explanation for OTS’ inaction may have been the overly positive CAMELS ratings it assigned WaMu. From 2004 until early 2008, WaMu held a 2 rating, which meant that it was “fundamentally sound,” had “satisfactory risk management,” and had “only moderate weaknesses that [were] within the board’s and management’s capability and willingness to correct.” 869 A lower CAMELS rating would have represented one of the strongest actions that OTS and the FDIC could have taken, because it would have required changes from WaMu. Both the Treasury and the FDIC Inspector General criticized the assignment of the 2 ratings as inaccurate and inappropriate, highlighting how those inflated ratings masked the true problems. 870 Treasury IG Thorson focused in particular on the 2 rating assigned to WaMu’s high risk home loans: “[W]e find it difficult to understand how OTS could assign WaMu a satisfactory asset quality 2-rating for so long. Assigning a satisfactory rating when conditions are not satisfactory sends a mixed and inappropriate supervisory message to the institution and its board. It is also contrary to the very purpose for which regulators use the CAMELS rating system.” 871 Inspector General Thorson also criticized the 2 rating assigned to WaMu’s management, which signaled “satisfactory performance by management and the Board of Directors and 867 10/7/2008 email from OTS examiner Thomas Constantine to OTS colleague Benjamin Franklin, Franklin_Benjamin-00034415_001, Hearing Exhibit 4/16-14. 868 See 3/5/2007 WAMU Examination “Review of Securitization,” OTSWME07-075 0000780-791 at 789 (data gathered from WaMu’s Market Risk Committee minutes, Dec. 2006 and Jan. 2007). 869 Thorson prepared statement at 7, April 16, 2010 Subcommittee Hearing at 107. 870 See, e.g., Treasury and FDIC IG Report at 16. 871 Thorson prepared statement at 10, April 16, 2010 Subcommittee Hearing at 110. See also id. at 8, April 16, 2010 Subcommittee Hearing at 108. satisfactory risk management practices.” 872 He noted that OTS gave management this positive rating until June 2008, despite the bank’s ongoing failure to correct the many deficiencies identified by OTS examiners and the fact that management problems at WaMu were longstanding. At the Subcommittee hearing, the FDIC Inspector General Rymer also criticized the 2 rating assigned to WaMu’s management: “[T]he management piece should be, in my view, downgraded if management has not demonstrated that it has built the adequate systems and control processes and governance processes to help manage problems when they eventually do occur in assets. … I find it difficult to understand why the management rating at a minimum was not lowered much earlier on.” 873 fcic_final_report_full--433 Some combination of the first two factors may apply in parts of the Sand States, but these don’t explain the nationwide increase in prices. The closely related and nationwide mortgage bubble was the largest and most sig- nificant manifestation of a more generalized credit bubble in the United States and Eu- rope. Mortgage rates were low relative to the risk of losses, and risky borrowers, who in the past would have been turned down, found it possible to obtain a mortgage.  In addition to the credit bubble, the proliferation of nontraditional mortgage products was a key cause of this surge in mortgage lending. Use of these products in- creased rapidly from the early part of the decade through . There was a steady deterioration in mortgage underwriting standards (enabled by securitizers that low- ered the credit quality of the mortgages they would accept, and credit rating agencies that overrated the subsequent securities and derivatives). There was a contemporane- ous increase in mortgages that required little to no documentation. As house prices rose, declining affordability would normally have constrained demand, but lenders and borrowers increasingly relied on nontraditional mortgage products to paper over this affordability issue. These mortgage products included interest-only adjustable rate mortgages (ARMs), pay-option ARMs that gave bor- rowers flexibility on the size of early monthly payments, and negative amortization products in which the initial payment did not even cover interest costs. These exotic mortgage products would often result in significant reductions in the initial monthly payment compared with even a standard ARM. Not surprisingly, they were the mortgages of choice for many lenders and borrowers focused on minimizing initial monthly payments. Fed Chairman Bernanke sums up the situation this way: “At some point, both lenders and borrowers became convinced that house prices would only go up. Bor- rowers chose, and were extended, mortgages that they could not be expected to serv- ice in the longer term. They were provided these loans on the expectation that accumulating home equity would soon allow refinancing into more sustainable mortgages. For a time, rising house prices became a self-fulfilling prophecy, but ulti- mately, further appreciation could not be sustained and house prices collapsed.”  This explanation posits a relationship between the surge in housing prices and the surge in mortgage lending. There is not yet a consensus on which was the cause and which the effect. They appear to have been mutually reinforcing. In understanding the growth of nontraditional mortgages, it is also difficult to de- termine the relative importance of causal factors, but again we can at least list those that are important: • Nonbank mortgage lenders like New Century and Ameriquest flourished un- der ineffective regulatory regimes, especially at the state level. Weak disclosure standards and underwriting rules made it easy for irresponsible lenders to issue mortgages that would probably never be repaid. Federally regulated bank and thrift lenders, such as Countrywide, Wachovia, and Washington Mutual, had lenient regulatory oversight on mortgage origination as well. • Mortgage brokers were paid for new originations but did not ultimately bear the losses on poorly performing mortgages. Mortgage brokers therefore had an incentive to ignore negative information about borrowers. • Many borrowers neither understood the terms of their mortgage nor appreci- ated the risk that home values could fall significantly, while others borrowed too much and bought bigger houses than they could ever reasonably expect to afford. • All these factors were supplemented by government policies, many of which had been in effect for decades, that subsidized homeownership but created hid- den costs to taxpayers and the economy. Elected officials of both parties pushed housing subsidies too far. 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).--------------------------------------------------------------------------- ______ FOMC20080130meeting--341 339,MR. LACKER.," I am still confused. How much of these weaknesses would have been identified by an impartial observer in January 2006, say, without knowledge of what has happened since then? " CHRG-109hhrg31539--110 Mr. Bachus," And the fact that you are having to fight inflation is--part of that factor is a strong economy; is it not? If the economy was weak and unemployment was high, we wouldn't be having inflationary problems, would we? " CHRG-111shrg57320--360 Mr. Corston," That is correct. Senator Levin. Which is kind of, is it fair to say, heading towards a 3? Is that a fair summary? Is that some sort of weaknesses or concentrations which---- " 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-111shrg52619--182 RESPONSE TO WRITTEN QUESTIONS OF SENATOR REED FROM JOHN C. DUGANQ.1. It is clear that our current regulatory structure is in need of reform. At my subcommittee hearing on risk management, March 18, 2009, GAO pointed out that regulators often did not move swiftly enough to address problems they had identified in the risk management systems of large, complex financial institutions. My questions may be difficult, but please answer the following: If this lack of action is a persistent problem among the regulators, to what extent will changing the structure of our regulatory system really get at the issue? Along with changing the regulatory structure, how can Congress best ensure that regulators have clear responsibilities and authorities, and that they are accountable for exercising them ``effectively and aggressively''?A.1. As was discussed in Senior Deputy Comptroller Long's March 18th testimony before the Subcommittee on Securities, Insurance, and Investment, looking back on the events of the past two years, there are clearly things we may have done differently or sooner, but I do not believe our supervisory record indicates that there was a ``lack of action'' by the OCC. For example, we began alerting national banks to our concerns about increasingly liberal underwriting practices in certain loan products as early as 2003. Over the next few years, we progressively increased our scrutiny and responses, especially with regard to credit cards, residential mortgages, and commercial real estate loans even though the underlying ``fundamentals'' for these products and market segments were still robust. Throughout this period, our examiners were diligent in identifying risks and directing banks to take corrective action. Nonetheless, we and the industry initially underestimated the magnitude and severity of the disruptions that we have subsequently seen in the market and the rapidity at which these disruptions spilled over into the overall economy. In this regard, we concur with the GAO that regulators and large, complex banking institutions need to develop better stress test mechanisms that evaluate risks across the entire firm and that identify interconnected risks and potential tail events. We also agree that more transparency and capital is needed for certain off-balance sheet conduits and products that can amplify a bank's risk exposure. While changes to our regulatory system are warranted--especially in the area of systemic risk--I do not believe that fundamental changes are required to the structure for conducting banking supervision.Q.2. How do we overcome the problem that in the boom times no one wants to be the one stepping in to tell firms they have to limit their concentrations of risk or not trade certain risky products? What thought has been put into overcoming this problem for regulators overseeing the firms? Is this an issue that can be addressed through regulatory restructure efforts?A.2. A key issue for bankers and supervisors is determining when the accumulation of risks either within an individual firm or across the system has become too high, such that corrective or mitigating actions are needed. Knowing when and how to strike this balance is one of the most difficult jobs that supervisors face. Taking action too quickly can constrain economic growth and impede access to credit by credit-worthy borrowers. Waiting too long can result in an overhang of risk becoming embedded into banks that can lead to failure and, in the marketplace, that can lead to the types of dislocations we have seen over the past year. This need to balance supervisory actions, I believe, is fundamental to bank supervision and is not an issue that can be addressed through regulatory restructure--the same issue will face whatever entity or agency is ultimately charged with supervision. There are, however, actions that I believe we can and should take to help dampen some of the effects of business and economic cycles. First, as previously noted, I believe we need to insist that large institutions establish more rigorous and comprehensive stress tests that can identify risks that may be accumulating across various business and product lines. As we have seen, some senior bank managers thought they had avoided exposure to subprime residential mortgages by deliberately choosing not to originate such loans in the bank, only to find out after the fact that their investment banks affiliates had purchased subprime loans elsewhere. For smaller, community banks, we need to develop better screening mechanisms that we can use to help identify banks that are building up concentrations in a particular product line and where mitigating actions may be necessary. We have been doing just that for our smaller banks that may have significant commercial real estate exposures. We also need to ensure that banks have the ability to strengthen their loan loss reserves at an appropriate time in the credit cycle, as their potential future loans losses are increasing. A more forward-looking ``life of the loan'' or ``expected loss'' concept would allow provisions to incorporate losses expected over a more realistic time horizon, and would not be limited to losses incurred as of the balance sheet date, as under the current regime. Such a revision would help to dampen the decidedly pro-cyclical effect that the current rules are having today. This is an issue that I am actively engaged in through my role as Chairman of the Financial Stability Board's Working Group on Provisioning. Similarly, the Basel Committee on Bank Supervision recently announced an initiative to introduce standards that would promote the build up of capital buffers that can be drawn upon in periods of stress. Such a measure could also potentially serve as a buffer or governor to the build up of risk concentrations. There are additional measures we could consider, such as establishing absolute limits on the concentration a bank could have to a particular industry or market segment, similar to the loan limits we currently have for loans to an individual borrower. The benefits of such actions would need to be carefully weighed against the potential costs this may impose. For example, such a regime could result in a de facto regulatory allocation of credit away from various industries or markets. Such limits could also have a disproportionate affect on smaller, community banks whose portfolios by their very nature, tend to be concentrated in their local communities and, often, particular market segments such as commercial real estate.Q.3. As Mr. Tarullo and Mrs. Bair noted in their testimony, some financial institution failures emanated from institutions that were under federal regulation. While I agree that we need additional oversight over and information on unregulated financial institutions, I think we need to understand why so many regulated firms failed. Why is it the case that so many regulated entities failed, and many still remain struggling, if our regulators in fact stand as a safety net to rein in dangerous amounts of risk-taking?A.3. As alluded to in Governor Tarullo and Chairman Bair's testimonies, most of the prominent failures that have occurred and contributed to the current market disruption primarily involved systemically important firms that were not affiliated with an insured bank and were thus not overseen by the Federal Reserve or subject to the provisions of the Bank Holding Company Act. Although portions of these firms may have been subject to some form of oversight, they generally were not subject to the type or scope of consolidated supervision applied to banks and bank holding companies. Nonetheless, large national banking companies clearly have not been immune to the problems we have seen over the past eighteen months and several have needed active supervisory intervention or the assistance of the capital and funding programs instituted by the U.S. Treasury, Federal Reserve, and FDIC. As I noted in my previous answer, prior to the recent market disruptions our examiners had been identifying risks and risk management practices that needed corrective action and were working with bank management teams to ensure that such actions were being implemented. We were also directing our large banks to shore up their capital levels and during the eight month period from October 2007 through early June 2008, the largest national banking companies increased their capital and debt levels through public and private offerings by over $100 billion. I firmly believe that our actions that resulted in banks strengthening their underwriting standards, increasing their capital and reserves, and shoring up their liquidity were instrumental to the resilience that the national banking system as whole has shown during this period of unprecedented disruption in bank funding markets and significant credit losses. Indeed several of the largest national banks have served as a source of strength to the financial system by acquiring significant problem thrift institutions (i.e., Countrywide and Washington Mutual) and broker-dealer operations (i.e., Bear Stearns and Merrill Lynch). In addition, we worked to successfully resolve via acquisition by other national banks, two large national banks--National City and Wachovia--that faced severe funding pressures in the latter part of 2008. While both of these banks had adequate capital levels, they were unable to roll over their short term liabilities in the marketplace at a time when market perception and sentiment for many banking companies were under siege. Due to these funding pressures, both banks had to be taken over by companies with stronger capital and funding bases. As the breadth and depth of credit problems accelerated in late 2008, two other large banking companies, Citigroup and Bank of America, required additional financial assistance through Treasury's Asset Guarantee and Targeted Investment programs to help stabilize their financial condition. As part of the broader Supervisory Capital Assessment Program that the OCC, Federal Reserve, and FDIC recently conducted on the largest recipients of funds under the Treasury's Troubled Assets Relief Program, we are closely monitoring the adequacy of these firms' capital levels to withstand further adverse economic conditions and will be requiring them to submit capital plans to ensure that they have sufficient capital to weather such conditions. In almost all cases, our large national banking organizations are on track to meet any identified capital needs and have been able to raise private capital through the marketplace, a sign that investor confidence may be returning to these institutions. While the vast majority of national banks remain sound, many national banks will continue to face substantial credit losses as credit problems work through the banking system. In addition, until the capital and securitization markets are more fully restored, larger banks will continue to face potential liquidity pressures and funding constraints. As I have stated in previous testimonies, we do expect that the number of problem banks and bank failures will continue to increase for some time given current economic conditions. In problem bank situations, our efforts focus on developing a specific plan that takes into consideration the ability and willingness of management and the board to correct deficiencies in a timely manner and return the bank to a safe and sound condition. In most instances our efforts, coupled with the commitment of bank management, result in a successful rehabilitation of the bank. There will be cases, however, where the situation is of such significance that we will require the sale, merger, or liquidation of the bank, if possible. Where that is not possible, we will appoint the FDIC as receiver.Q.4. While we know that certain hedge funds, for example, have failed, have any of them contributed to systemic risk?A.4. The failure of certain hedge funds, while not by themselves systemically important (in contrast to the failure of Long Term Capital Management in 1998), led to a reduction in market liquidity as leveraged investors accelerated efforts to reduce exposures by selling assets. Given significant uncertainty over asset values, reflecting sharply reduced market liquidity, this unwinding of leveraged positions has put additional strains on the financial system and contributed to lack of investor confidence in the markets.Q.5. Given that some of the federal banking regulators have examiners on-site at banks, how did they not identify some of these problems we are facing today?A.5. At the outset, it is important to be clear that bank examiners do not have authority over the nonbank companies in a holding company. These nonbank firms were the source of many of the issues confronting large banking firms. With respect to banks, as noted above, we were identifying issues and taking actions to address problems that we were seeing in loan underwriting standards and other areas. At individual banks, we were directing banks to strengthen risk management and corporate governance practices and, at some institutions, were effecting changes in key managerial positions. Nonetheless, in retrospect, it is clear that we should have been more aggressive in addressing some of the practices and risks that were building up across the banking system during this period. For example, it is clear that we and many bank managers put too much reliance on the various credit enhancements used to support certain collateralized debt obligations and not enough emphasis on the quality of, and correlations across, the underlying assets supporting those obligations. Similarly, we were not sufficiently attuned to the systemic risk implications of the significant migration by large banks to an ``originate-to-distribute model'' for commercial and leveraged loan products. Under this model, banks originated a significant volume of loans with the express purpose of packaging and selling them to institutional investors who generally were willing to accept more liberal underwriting standards than the banks themselves would accept, in return for marginally higher yields. In the fall of 2007, when the risk appetite of investors changed dramatically (and at times for reasons not directly related to the exposures they held), banks were left with significant pipelines of loans that they needed to fund, thus exacerbating their funding and capital pressures. As has been well-documented, similar pressures were leading to relaxation of underwriting standards within the residential mortgage loan markets. While the preponderance of the subprime and ``Alt-A'' loans that have been most problematic were originated outside of the national banking system, the subsequent downward spiral in housing prices that these practices triggered have clearly affected all financial institutions, including national banks. ------ FinancialCrisisInquiry--314 DIMON: And I think the whole industry, you know, all of us just erode those losses. And I think economists will look at—and so I think you’ve seen the same things I see—the low rates helped fuel it a little bit and maybe helped fuel a lot of housing speculation. And, you know, I’ve always looked at Fannie Mae and Freddie Mac as being part of the issue in how they grew over time. I don’t blame them for the bad behavior of our underwriter banks, but I do think they were part of the problem for the industry as a whole. CHRG-111shrg54789--104 Mr. Barr," Each agency would have responsibility for the mission assigned to it. The consumer protection agency would need to be sure that, say, disclosures are clear about a product or service, and the bank supervisory agency would have authority with respect to prudential supervision, underwriting standards, capital requirements, sort of core prudential supervisory matters. So a clear assignment of authority, clear assignment of responsibility and accountability to the Congress and to the American people for achieving those aims. Senator Reed. Thank you very much. Thank you, Mr. Chairman. " fcic_final_report_full--216 It had long been standard practice for CDO underwriters to sell some mezzanine tranches to other CDO managers. Even in the early days of ABS CDOs, these assets often contained a small percentage of mezzanine tranches of other CDOs; the rating agencies signed off on this practice when rating each deal. But reliance on them be- came heavier as the demand from traditional investors waned, as it had for the riskier tranches of mortgage-backed securities. The market came to call traditional investors the “real money,” to distinguish them from CDO managers who were buying tranches just to put them into their CDOs. Between  and , the typical amount a CDO could include of the tranches of other CDOs and still maintain its ratings grew from  to , according to the CDO manager Wing Chau.  According to data compiled by the FCIC, tranches from CDOs rose from an average of  of the collateral in mortgage-backed CDOs in  to  by . CDO-squared deals—those engi- neered primarily from the tranches of other CDOs—grew from  marketwide in  to  in  and  in . Merrill created and sold  of them.  Still, there are clear signs that few “real money” investors remained in the CDO market by late . Consider Merrill: for the  ABS CDOs that Merrill created and sold from the fourth quarter of  through August , nearly  of the mezza- nine tranches were purchased by CDO managers.  The pattern was similar for Chau: an FCIC analysis determined that  of the mezzanine tranches sold by the  CDOs managed by Chau were sold for inclusion into other CDOs.  An estimated  different CDO managers purchased tranches in Merrill’s Norma CDO. In the most extreme case found by the FCIC, CDO managers were the only purchasers of Mer- rill’s Neo CDO.  Marketwide, in  CDOs took in about  of the A tranches,  of the Aa tranches, and  of the Baa tranches issued by other CDOs, as rated by Moody’s. (Moody’s rating of Aaa is equivalent to S&P’s AAA, Aa to AA, Baa to BBB, and Ba to BB). In , those numbers were , , and , respectively.  Merrill and other investment banks simply created demand for CDOs by manufacturing new ones to buy the harder-to-sell portions of the old ones. As SEC attorneys told the FCIC, heading into  there was a Streetwide gentle- man’s agreement: you buy my BBB tranche and I’ll buy yours.  Merrill and its CDO managers were the biggest buyers of their own products. Merrill created and sold  CDOs from  to . All but  of these— CDOs—sold at least one tranche into another Merrill CDO. In Merrill’s deals, on av- erage,  of the collateral packed into the CDOs consisted of tranches of other CDOs that Merrill itself had created and sold. This was a relatively high percentage, but not the highest: for Citigroup, another big player in this market, the figure was . For UBS, it was just .  Managers defended the practice. Chau, who managed  CDOs created and sold by Merrill at Maxim Group and later Harding Advisory and had worked with Riccia- rdi at Prudential Securities in the early days of multisector CDOs, told the FCIC that plain mortgage-backed securities had become expensive in relation to their returns, even as the real estate market sagged. Because CDOs paid better returns than did similarly rated mortgage-backed securities, they were in demand, and that is why CDO managers packed their securities with other CDOs.  CHRG-110shrg46629--36 Chairman Bernanke," Once again, there is some reference to that in the subprime guidance, the idea being there that the loan should be underwritten at the fully indexed rate, that is that the rate once the adjustable resets have taken place. I should say though, particularly from the perspective of writing a rule, we are going to do our very best. But it is hard to put into a rule exactly what criteria one would use in order to decide whether a loan is affordable or not. But we are going to do our best. In particular, we are going to look at the question of underwriting to the fully indexed rate. And also, ask ourselves whether or not there can be guidelines in terms of demonstrated payment ability or demonstrated income that we related to the payments under the mortgage. Senator Brown. But there are some things, understanding the difficulty of writing a rule to conclude everything, but there are certainly some things, no doc loans, better disclosures, so people understand in readable large print, if you will, on the first page what this loan is going to cost, what their adjustable rate could be in worse case scenario. All of those absolutely could be included; right? " CHRG-111hhrg51592--33 Mr. Joynt," Thank you, Chairman Kanjorski, Ranking Member Garrett, and members of the committee. I would like to spend just a few minutes summarizing my prepared statement. Nearly 2 years has passed since the onset of the credit crisis. What began as stress focused on the global capital markets has evolved into a more severe economic slowdown. An array of factors have contributed to this, and these have been broadly analyzed by many market participants, the media, and within the policymaking and regulatory communities. During this time, the focus of Fitch Ratings has been on implementing initiatives that enhance the reliability and transparency of our ratings. More specifically, we are vigorously reviewing our analytical approaches and changing ratings to reflect the current risk profile of securities that we rate. In parallel, we have been introducing new policies and procedures, and updating existing ones, to reflect the evolving regulatory frameworks within which the credit rating agencies operate globally. I have provided details in my written statement, so I would like now to move on to the primary focus of today's hearing: where do we go from here? As this committee considers this important topic, we would like to offer some perspective on a number of the important issues. Transparency is a recurring theme in these discussions, and at Fitch, we are committed to being as transparent as possible in everything we do. But transparency also touches on issues beyond the strict control of rating agencies. All of Fitch's ratings, supporting rationale, and assumptions, and related methodologies, and a good portion of our research, are freely available to the market in real time, by definition, transparent. We do not believe that everyone should agree with all of our opinions, but we are committed to ensuring that the market has the opportunity to discuss them. Some market participants have noted that limits on the amount of information that is disclosed to the market by issuers and underwriters has made the market over-reliant on rating agencies, particularly for analysis and evaluation of structured securities. The argument follows that the market would benefit if additional information on structured securities were more broadly and readily available to investors, thereby enabling them to have access to the same information that mandated rating agencies have, in developing and maintaining our rating opinions. Fitch fully supports the concept of greater disclosure of such information. We also believe that responsibility for disclosing such information should rest fully with the issuers and the underwriters, and not just with the rating agencies. Quite simply, it's their information and their deals, so they should disclose that information. A related benefit of additional issuer disclosure is that it addresses the issue of rating shopping. Greater disclosure would enable non-mandated NRSROs to issue ratings on structured securities if they so choose, thus providing the market with greater variety of opinion, and an important check on perceived ratings inflation. The disclosure of additional information, however, is of questionable value of the accuracy and reliability of the information is suspect. That goes to the issue of due diligence. While rating agencies have taken a number of steps to increase our assessments of the quality of the information we are provided in assigning ratings, including adopting policies that we will not rate issues if we deem the quality of the information to be insufficient, due diligence is a specific and defined legal concept. The burden of due diligence belongs with issuers and underwriters. Congress ought not to hold rating agencies responsible for such due diligence, or requiring it from others. Rather, Congress should mandate that the SEC enact rules to require issuers and underwriters to perform such due diligence, make public the findings, and enforce the rules they enact. In terms of regulation more broadly, Fitch supports fair and balanced oversight and registration of credit rating agencies and believes the market will benefit from globally consistent rules for credit rating agencies that foster transparency, disclosure of ratings, and methodologies, and management of conflicts of interest. We also believe that all oversight requirements should be applied consistently and equally to all NRSROs. One theme in the discussion of additional regulation is the desire to impose some more accountability on rating agencies. Ultimately, the market imposes accountability for the reliability and performance of our ratings and research. That is, if the market no longer has sufficient confidence in the quality of our work, the value of Fitch's franchise will be diminished and our ability to continue to compete in the market will be impeded. While we understand and agree with the notion that we should be accountable for what we do, we disagree with the idea that the imposition of greater liability will achieve that. Some of the discussion on liability is based on misperceptions, and while those points are covered in my written statement, it's worth highlighting that the view that the rating agencies have no liability today is unfounded. Rating agencies, just like accountants, officers, directors, and securities analysts may be held liable for securities fraud, to the extent a rating agency intentionally or recklessly made a material misstatement or omission in connection with the purchase or sale of a security. Beyond the standard of existing securities law that applies to all, fundamentally, we struggle with the notion of what it is that we should be held liable for. Specifically, a credit rating is an opinion about future events, the likelihood of an issue or issuer that they will meet their credit obligations as they come due. Imposing a specific liability standard for failing to accurately predict the future, that in every case strikes us as an unwise approach. Congress also should consider the practical consequences of imposing additional liability. Expanded competition may be inhibited for smaller rating agencies by withdrawing from the NRO system to avoid specialized liability. All rating agencies may be motivated to provide low security ratings just to mitigate liability. In closing, Fitch has been and will continue to be constructively engaged with policymakers and regulators, as they and you consider ideas and questions about the oversight of credit rating agencies. We remain committed to enhancing the reliability and transparency of our ratings, and welcome all worthwhile ideas that aim to help us achieve that. Thank you. [The prepared statement of Mr. Joynt can be found on page 70 of the appendix.] " FinancialCrisisInquiry--108 BLANKFEIN: Good product that does—that creates the exposure that these professional investors are seeking. Right now you could buy—we would underwrite distressed product as long as we disclose it, help somebody move that distressed product off their balance sheet, and give it to somebody, a sophisticated investor, knowing what the product did would give them that exposure. CHAIRMAN ANGELIDES: But you were doing more than that. You were facilitating the market in which products were being offered in the consumer marketplace that were clearly... BLANKFEIN: Yes. CHAIRMAN ANGELIDES: ... deficient and unsustainable... BLANKFEIN: Yes. It had—yes. For sure it had that effect. By allowing that to turn over and by us giving the dollars back to the originators in exchange for the loans it allowed them to go out and originate more loans. So to that extent we were—played a part in making that market—all of us as syndicators doing what the capital markets do, which is give people access to capital. And so that was a role that... CHAIRMAN ANGELIDES: Well after Mr. Mack’s rather compelling statements about regulations recently, we cannot control ourselves, you have to step in and control the Street. Is this an argument for very tough regulation of products offered at the ground level because of the inability of the chain of securitization and the chain of private players to control the quality? CHRG-111hhrg67816--102 Mr. Leibowitz," Well, I think that is right and in some practices maybe deceptive as practiced by some companies whereas other companies may do them in a legitimate way. " FinancialCrisisReport--7 Despite identifying over 500 serious deficiencies in five years, OTS did not once, from 2004 to 2008, take a public enforcement action against Washington Mutual to correct its lending practices, nor did it lower the bank’s rating for safety and soundness. Only in 2008, as the bank incurred mounting losses, did OTS finally take two informal, nonpublic enforcement actions, requiring WaMu to agree to a “Board Resolution” in March and a “Memorandum of Understanding” in September, neither of which imposed sufficient changes to prevent the bank’s failure. OTS officials resisted calls by the FDIC, the bank’s backup regulator, for stronger measures and even impeded FDIC oversight efforts by at times denying FDIC examiners office space and access to bank records. Tensions between the two agencies remained high until the end. Two weeks before the bank was seized, the FDIC Chairman contacted WaMu directly to inform it that the FDIC was likely to have a ratings disagreement with OTS and downgrade the bank’s safety and soundness rating, and informed the OTS Director about that communication, prompting him to complain about the FDIC Chairman’s “audacity.” Hindered by a culture of deference to management, demoralized examiners, and agency infighting, OTS officials allowed the bank’s short term profits to excuse its risky practices and failed to evaluate the bank’s actions in the context of the U.S. financial system as a whole. Its narrow regulatory focus prevented OTS from analyzing or acknowledging until it was too late that WaMu’s practices could harm the broader economy. OTS’ failure to restrain Washington Mutual’s unsafe lending practices allowed high risk loans at the bank to proliferate, negatively impacting investors across the United States and around the world. Similar regulatory failings by other agencies involving other lenders repeated the problem on a broad scale. The result was a mortgage market saturated with risky loans, and financial institutions that were supposed to hold predominantly safe investments but instead held portfolios rife with high risk, poor quality mortgages. When those loans began defaulting in record numbers and mortgage related securities plummeted in value, financial institutions around the globe suffered hundreds of billions of dollars in losses, triggering an economic disaster. The regulatory failures that set the stage for those losses were a proximate cause of the financial crisis. (3) Inflated Credit Ratings: Case Study of Moody’s and Standard & Poor’s The next chapter examines how inflated credit ratings contributed to the financial crisis by masking the true risk of many mortgage related securities. Using case studies involving Moody’s Investors Service, Inc. (Moody’s) and Standard & Poor’s Financial Services LLC (S&P), the nation’s two largest credit rating agencies, the Subcommittee identified multiple problems responsible for the inaccurate ratings, including conflicts of interest that placed achieving market share and increased revenues ahead of ensuring accurate ratings. CHRG-111shrg51290--11 Mr. Bartlett," Thank you, Chairman Dodd and Ranking Member Shelby and members of the Committee. To start with the obvious, it is true that many consumers were harmed by the mortgage-lending practices that led to the current crisis, but what is even more true is that even more have been harmed by the crisis itself. The root causes of the crisis, to overly simplify, are twofold: One, mistaken policies and practices by many, but not all, not even most, financial services firms; and two, the failure of our fragmented financial regulatory system to identify and to prevent those practices and the systemic failures that resulted. This crisis illustrates the nexus, then, between consumer protection regulation and safety and soundness regulation. Safety and soundness, or prudential regulation, is the first line of defense for protecting consumers. It ensures that financial services firms are financially sound and further loans that borrowers can repay with their own income are healthy both for the borrower and for the lender. In turn, consumer protection regulation ensures that consumers are treated fairly. Put another way, safety and soundness and consumer protection are self-reinforcing, each strengthening the other. Given this nexus, we do not support, indeed, we oppose proposals to separate consumer protection regulation from safety and soundness regulation. Such a separation would significantly weaken both. An example, Mr. Chairman, in real time, today, a provision in the pending omnibus appropriations bill that would give State attorneys general the authority to enforce compliance with the Federal Truth in Lending Act illustrates this problem. It would create additional fragmented regulation, and attempting to separate safety and soundness and consumer protection would harm both. My testimony has been divided into two parts. First, I address what went wrong, and second, I address how to fix the problem. What went wrong? The proximate cause of the current financial crisis was the nationwide collapse of housing values. The root cause of the crisis are twofold. The first was a breakdown, as I said, in policies, practices, and processes at many, but not all financial services firms. Since 2007, admittedly long after all the horses were out of the barn and running around in the pasture, the industry identified and corrected those practices. Underwriting standards have been upgraded. Credit practices have been reviewed and recalibrated. Leverage has been reduced as firms were rebuilt. Capital incentives have been realigned. And some management teams have been replaced. The second underlying cause, though, is our overly complex and fragmented financial regulatory structure which still exists today as it existed during the ramp-up to the crisis. There are significant gaps in the financial regulatory system in which no one has regulatory jurisdiction. The system does not provide for sufficient coordination and cooperation among regulators and does not adequately monitor the potential for market failures or high-risk activities. So how to fix the problem? The Roundtable has developed over the course, literally, of 3 years a draft financial regulatory architecture that is intended to close those gaps, and our proposed architecture, which I submit for the record, has six key features. First, we propose to expand the membership of the President's Working Group on Financial Markets and rename it the Financial Markets Coordinating Council, but key, to give it statutory authority rather than merely executive branch authority. Second, to address systemic risk, we propose that the Federal Reserve Board be authorized as a market stability regulator. The Fed would be responsible for looking across the entire financial services sector to identify interconnections that could pose a risk to the entire financial system. Third, to reduce the gaps in regulation, we propose a consolidation of several existing Federal agencies, such as OCC and OTS, into a single national financial institutions regulator. The new agency would be a consolidated prudential and consumer protection agency for three broad sectors: Banking, securities, and insurance. The agency would issue national prudential and consumer protection standards for mortgage origination. Mortgage lenders, regardless of how they are organized, would be required to retain some of the risk for the loans they originate, also known as keeping some skin in the game, and likewise, mortgage borrowers, regardless of where they live or who their lender is, would be protected by the same safety and soundness and consumer standards. Fourth, we propose the creation of a national capital markets agency with the merger of the SEC and the Commodities Futures Trading Commission. And fifth, to protect depositors, policy holders, and investors, we propose that the Federal Deposit Insurance Corporation would be renamed the National Insurance Resolution Authority and that it manage insurance mechanisms for banking, depository institutions, but also federally chartered insurance companies and federally licensed broker dealers. Before I close, Mr. Chairman, I have also included in my testimony two other issues of importance to this Committee and the policymakers and the industry. One, lending by institutions that have received TARP funds is a subject of great comment around this table. And second, the impact of fair value accounting in illiquid markets. I have attached to my statement a series of tables that the Roundtable has compiled on lending by some of the nation's largest institutions. These tables are designed to set the record straight. The fact is that large financial services firms have increased their lending as a result of TARP capital. And second, fair value accounting continues to be of gargantuan concerns for the industry and should be for the public in general. We believe that the pro-cyclical effects of existing and past policies, which have not been changed, are unnecessarily exacerbating the crisis. We urge the Committee to take up this subject and deal with it. We thank you again for the opportunity to appear. I yield back. " fcic_final_report_full--53 SECURITIZATION AND DERIVATIVES CONTENTS Fannie Mae and Freddie Mac: “The whole army of lobbyists” ............................  Structured finance: “It wasn’t reducing the risk” ..................................................  The growth of derivatives: “By far the most significant event in finance during the past decade” ..................................................................  FANNIE MAE AND FREDDIE MAC: “THE WHOLE ARMY OF LOBBYISTS ” The crisis in the thrift industry created an opening for Fannie Mae and Freddie Mac, the two massive government-sponsored enterprises (GSEs) created by Congress to support the mortgage market. Fannie Mae (officially, the Federal National Mortgage Association) was chartered by the Reconstruction Finance Corporation during the Great Depression in  to buy mortgages insured by the Federal Housing Administration (FHA). The new gov- ernment agency was authorized to purchase mortgages that adhered to the FHA’s un- derwriting standards, thereby virtually guaranteeing the supply of mortgage credit that banks and thrifts could extend to homebuyers. Fannie Mae either held the mort- gages in its portfolio or, less often, resold them to thrifts, insurance companies, or other investors. After World War II, Fannie Mae got authority to buy home loans guaranteed by the Veterans Administration (VA) as well. This system worked well, but it had a weakness: Fannie Mae bought mortgages by borrowing. By , Fannie’s mortgage portfolio had grown to . billion and its debt weighed on the federal government.  To get Fannie’s debt off of the government’s balance sheet, the Johnson administration and Congress reorganized it as a publicly traded corporation and created a new government entity, Ginnie Mae (officially, the Government National Mortgage Association) to take over Fannie’s subsidized mort- gage programs and loan portfolio. Ginnie also began guaranteeing pools of FHA and VA mortgages. The new Fannie still purchased federally insured mortgages, but it was now a hybrid, a “government-sponsored enterprise.” Two years later, in , the thrifts persuaded Congress to charter a second GSE, Freddie Mac (officially, the Federal Home Loan Mortgage Corporation), to help the  thrifts sell their mortgages. The legislation also authorized Fannie and Freddie to buy “conventional” fixed-rate mortgages, which were not backed by the FHA or the VA. Conventional mortgages were stiff competition to FHA mortgages because borrow- ers could get them more quickly and with lower fees. Still, the conventional mort- gages did have to conform to the GSEs’ loan size limits and underwriting guidelines, such as debt-to-income and loan-to-value ratios. The GSEs purchased only these “conforming” mortgages. CHRG-111hhrg54868--42 Mr. Dugan," It is similar. We also did not have any rulewriting authority in this area. But we did have considerable examination and enforcement responsibilities with respect to the rules that were on the books, and we think we did a decent job with that. I would make one other very fundamental point, though. A number of the problems that caused the crisis, while consumer protection contributed to it, a big chunk of that was pure and simple underwriting problems. A big chunk of that was outside of the banking system. And we did not have any authority over that in terms of examining and supervising it, and even the rules that were adopted didn't apply to them. And so you had this uneven world where you had two different systems applying to the regulated and the unregulated, and that was a fundamental problem. " CHRG-111shrg57322--103 Mr. Sparks," Well, Senator, I was just saying that I had knowledge of it. I was not making a judgment about the practice. Senator Kaufman. Sure. What do you think about the practice? " CHRG-111shrg55117--15 Mr. Bernanke," Well, Mr. Chairman, I think the first order of business last fall was to avert essentially the collapse of the system, and that was a very important step and we did achieve that and the system now appears to be much more stable. It is still very challenged. Banks--some banks are still short of capital. Other banks are concerned about future losses. They are concerned about the weakness in the economy and the weakness of potential borrowers. So there are legitimate concerns that banks have. That being said, the Fed and the other bank regulators have been very clear that banks should be making loans to creditworthy borrowers, that it is in their interest, the banks' interest, as well as in