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 the interest of the economy, and we are working with banks to make sure they do that. I think that we are seeing improvement over time. We are seeing some stabilization in the terms and standards that banks are applying to borrowers. And I suspect we will see some continued improvement. But we understand that issue and we are trying as best we can to support bank lending through measures such as the TALF, which we already discussed. " CHRG-111hhrg58044--25 Mr. McRaith," Thank you. Chairman Gutierrez, Ranking Member Hensarling, and members of the subcommittee, thank you for inviting me to testify. I am Michael McRaith, director of Insurance in Illinois, and I serve as chairman of the Property and Casualty Committee for the National Association of Insurance Commissioners. Today, I offer the views of my fellow regulators on behalf of the NAIC. Thank you for your attention to the use of credit information in personal lines insurance. H.R. 5633, introduced and sponsored by the chairman last year, coincided with our own effort to scrutinize the use of insurance scores. As regulators, we do not fashion public policy. Those decisions are made by Congress and State legislatures. States view insurance scores from different perspectives. Some States have banned the use of credit information, others impose rate bans or prohibit use on renewal or allow only if credit information would reduce premium. Still others require only that credit not be the sole basis for an insurer's decision. In Illinois, unlike most States, our law requires only that insurers consider extraordinary life events and does not even recognize military deployment as an extraordinary event. In Illinois, an older gentleman from a small town wrote that he had paid cash for everything his whole life, car, farm land, etc. His handwritten note explained that he bought car insurance before the law required, never ate fancy meals or bought pricey clothes. He even added that he had been married 47 years to the same woman, but confronted a greater than 20 percent premium increase due to his thin file. Illinois law should be improved. For the NAIC, we applaud this committee's desire to move past the rhetoric of interested parties and toward a fully informed approach. To that same end, the NAIC held public hearings in 2009. Interested parties, insurers, actuaries, and insurance score vendors argued that insurance scores allow for more accurate underwriting and rating. Consumer representatives argued that credit-based insurance scores have a disparate impact on members of protected classes and are premised upon irrelevant if not inaccurate information. We heard in great length about the studies that support both positions. In our own States, insurers sell homeowner insurance in urban neighborhoods where homeowners were previously stretched to find affordable coverage. Insurers argue that credit-based insurance scores have facilitated that market change. Studies also indicate that individuals of racial and ethnic minority heritage are overrepresented in low credit score categories and that credit-based insurance scores discriminate on the basis of that heritage. Our national focus has turned. Rather than engage in that circular debate, we have undertaken a two-pronged strategy to assist policymakers. First, we are developing a standardized data call or detailed interrogatories for personal lines auto companies. This data call will target the impact of different factors upon rates paid by consumers: gender; marital status; age; and credit score, among others. This data will enable Congress and the States to measure the consumer and market impact of one State's law versus another's. Second, the NAIC is developing a model law to bring insurance score vendors within insurance regulator oversight. One panelist indicates in written testimony that those vendors are already subject to State regulator oversight, an assertion with which we largely agree. However, those same vendors argued the exact opposite before the NAIC, and we intend to eliminate the ambiguity. As digital information expands insurer access to consumer specific details, insurance regulators remain vigilant in protecting consumers against potentially abusive underwriting and rating practices. We are watchful for any underwriting or rating formula that may constitute a proxy for race, gender or other protected characteristics. Insurance must function as insurance. For the NAIC, we appreciate the chance to assist this subcommittee and pledge our continued support of your efforts. With our two-pronged approach, State regulators intend to offer reliable, fact-based information for Congress and the States. As our data call and model law development conclude, we will deliver the results to this committee and to Congress. Thank you for your attention. I look forward to your questions. [The prepared statement of Mr. McRaith can be found on page 81 of the appendix.] " CHRG-109shrg30354--51 Chairman Bernanke," I absolutely agree with your point, Senator. In fact, in my testimony before the Joint Economic Committee, I argued that at some point, a point which I did not specify, the Fed would have to get off this 25 basis point per meeting escalator and adopt a more flexible approach, possibly varying its pace of tightening, possibly taking a pause. That has been the practice in the past. That is the practice of the European Central Bank and the Bank of Japan today. They do not move at every meeting. They move based on the state of the economy and based on the pace at which they wish to tighten. So I did make that point. I think it is still relevant. But of course, we always look at this meeting by meeting, and we will be evaluating all options when we come to meet in August. Senator Sarbanes. This development in the housing market that I showed earlier, and the drop in the new housing starts, that is a 22 percent drop in a matter of months. Now the National Association of Home Builders, which obviously would be quite concerned about something of this sort, has written to Members of the Committee about this. And I understand that some forecasters say that this could result in a 1.5 percent drop in GDP. Now we have relied on the strong housing market to keep the economy up in recent times, and now this seems to indicate a deterioration in that position. Furthermore, in your statement when you talk about higher core inflation, you reference increase in residential rents, as well as the imputed rent on owner-occupied homes. Now the Association of Home Builders makes, it seems to me, a rather valid point in communicating with us about this measure, saying that the weakness in new housing increases the demand for rental housing. Therefore, the price of rental housing goes up and the imputed value of the owner's equivalent rent--which they are not actually paying, it is a statistical measure--that goes up. And therefore, the core inflation goes up. Then the reaction to the core inflation going up is to raise the interest rates in order to check what is perceived as an inflation problem. The raise in the interest rates intensifies this trend in the decline in new housing, available housing, greater demand for rental housing, a greater imputed value into the core inflation measure. And you have this vicious circle contributed to by the raised interest rates. That seems to me to have some validity, that observation. What is your reaction to that? " CHRG-111shrg56262--43 Mr. Davidson," Senator Gregg, certainly in the area of Fannie Mae and Freddie Mac, which is central to the mortgage-backed securities market---- Senator Gregg. Yes, I accept that. " Mr. Davidson," ----Congressional action is necessary. And then that would have a number of spillover effects, depending on how that process went, that may or may not require further Congressional action. Senator Gregg. Does anybody else have anything? You know, this does come down to underwriting. Everybody used that as an example of where the problem lies. Should we move toward a system like the Australians have, where you basically have to put a certain percent down--in Australia, I think it is 20 percent--then you have recourse on mortgages. Or should we continue with the system of the Congress telling everybody in America that they have a right to have a loan to buy a house, no matter whether they can pay it back or not, through the CRA? Or is there someplace in between? " CHRG-111shrg56376--102 Mr. Dugan," I generally think that is a daunting challenge to regulate the hundreds of thousands of different financial providers all on a safety and soundness basis. But I think the Administration would do so and have the authority to do so for consumer protection, as you suggested. It doesn't get at what really is, and was, a fundamental issue. To the extent they engage in very banklike functions and there is a safety and soundness issue, like an underwriting standard or downpayment requirements, I would argue that is not really a consumer protection function in its traditional sense---- Senator Warner. It almost goes to some of the comments Senator Bennett was making about making sure you have got skin in the game---- " FinancialCrisisReport--600 Investment banks can also act as “placement agents,” assisting those seeking to raise money through a private offering of securities by helping them design the securities, produce the offering materials, and market the new securities to investors. Placement agents are also registered broker-dealers. While public offerings of securities are required to be registered and filed with the SEC, private offerings are made to a limited number of investors and are exempt from SEC registration. In the securitization industry, RMBS securities are generally sold through public offerings, while CDO securities are generally sold through private placements. 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, an issuer selling new securities to potential investors has an affirmative duty to disclose material information that a reasonable investor would want to know. 2676 In addition, under securities law, a broker-dealer acting as an underwriter or placement agent is liable for any material misrepresentation or omission of material fact made in connection with a solicitation or sale of securities to an investor. 2677 The Supreme Court has held that a fact is material if there is a “substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.” 2678 The SEC has provided this additional guidance: “‘The question of materiality, it is universally agreed, is an objective one, involving the significance of an omitted or misrepresented fact to a reasonable investor.’ ‘[T]he reaction of individual investors is not determinative of materiality, since the standard is objective, not subjective.’ ‘[M]ateriality depends on the significance the reasonable investor would place on the withheld or misrepresented information.’ Although in general materiality is primarily a factual inquiry, ‘the question of materiality is to be resolved as a matter of law when the information is ‘so obviously important [or 2676 See, 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.”). 2677 See Sections 11 and 12 of Securities Act of 1933. See also Rule 10b-5 of the Securities Exchange Act of 1934. See also SEC v. Capital Gains Research Bureau, Inc. , 375 U.S. at 200 (“Failure to disclose material facts must be deemed fraud or deceit within its intended meaning, for, as the experience of the 1920’s and 1930’s amply reveals, the darkness and ignorance of commercial secrecy are the conditions upon which predatory practices best thrive.”). See also Goldman response to Subcommittee QFR, at PSI_QFR_GS0046. 2678 Basic v. Levinson , 485 U.S. 224, 231-32 (1988) (quoting TSC Industries, Inc. v. Northway, Inc. , 426 U.S. 438, 449 (1976)). unimportant] to an investor, that reasonable minds cannot differ on the question of materiality.’” 2679 CHRG-111shrg57320--397 Mr. Doerr," That is correct. It is consistent underwriting on both sides of the equation--for the portfolio loans, for the securitized loans. Senator Levin. Thank you both. Did you want to add anything? [No response.] Senator Levin. OK. Thank you. I appreciate your coming. OK. We are going to have a fourth panel. [Pause.] Senator Levin. Our final panel this afternoon: Sheila Bair, Chairman of the Federal Deposit Insurance Corporation; and John Bowman, Acting Director of the Office of Thrift Supervision. We are grateful not just for your being with us today, but for your voluntary, or involuntary, patience. I think you both know what our rules are, so under Rule VI, our witnesses, all of them, are sworn in. So we would ask you to please stand and raise your right hand. Do you solemnly swear that the testimony you are about to give to this Subcommittee will be the truth, the whole truth, and nothing but the truth, so help you, God? Ms. Bair. I do. " CHRG-111hhrg53240--76 Mr. Bachus," You know, there was no going into the banks and examining anything. But I know the State charter banks were examined for underwriting standards. One thing I ran into when I was advocating for subprime lending legislation in 2005, I would talk to some of the banks, the big banks, bank holding companies, and they would say, we don't do these subprime loans. And I found out later that was somewhat half true in that they all had nonbank affiliates who were making those loans hand over fist. But I don't think that the Fed did any audits or supervision of those nonbank affiliates, did they? Ms. Duke. I think the authority to do that kind of examination was a little unclear under Gramm-Leach-Bliley. However, we did conduct a pilot program within the last year where we went into nonbank subsidiaries jointly with the FTC, with the OTS, with State regulators, and did full compliance exams on those. And as a result of what we learned there, we are going to continue those examinations. " CHRG-111shrg52619--185 RESPONSE TO WRITTEN QUESTIONS OF SENATOR HUTCHISON FROM JOHN C. DUGANQ.1. Will each of you commit to do everything within your power to prevent performing loans from being called by lenders? Please outline the actions you plan to take.A.1. The OCC has and will continue to encourage bankers to work with borrowers and to meet the credit needs of credit-worthy borrowers. Ultimately, however, the decision about whether to call a particular loan is a business decision that a banker must make. Such decisions must be based on the specific facts and circumstances of the bank, including its overall risk profile and its relationship with the borrower. There has been a perception that examiners are requiring bankers to call or classify performing loans, resulting in what some have called a ``performing nonperforming loan.'' Let me be clear, examiners do not tell bankers to call or renegotiate a loan, nor will they direct bankers to classify a loan or borrowers who have the demonstrated ability to service their debts under reasonable repayment schedules. In an effort to clarify how examiners approach this issue, it is important to define the term ``performing loan.'' Some define performance as simply being contractually current on all principal and interest payments. In many cases this definition is sufficient for a particular credit relationship and accurately portrays the status of the loan. In other cases, however, being contractually current on payments can be a very misleading gauge of the credit risk embedded in the loan. This is especially the case where the loan's underwriting structure can mask credit weaknesses and obscure the fact that a borrower may be unable to meet the full terms of the loan. This phenomenon was vividly demonstrated in certain nontraditional rate residential mortgage products where a borrower may have been qualified at a low ``teaser'' rate or with interest-only payments, without regard as to whether they would be able to afford the loan once the rates or payments adjusted to a fully indexed rate or included principal repayments. Analysis of payment performance must consider under what terms the performance has been achieved. For example, in many acquisition, development and construction loans for residential developments, it is common for the loans to be structured with what is referred to as an ``interest reserve'' for the initial phase of the project. These interest reserves are established as part of the initial loan proceeds at the time the loan is funded and provide funds for interest payments as lots are being developed, with repayment of principal occurring as each lot or parcel is sold and released. However, if the development project stalls for any number of reasons, the interest will continue to be paid from the initial interest reserve even though the project is not generating any cash flows to repay loan principal. In such cases, the loan will be contractually current due to the interest payments being made from the reserves, but the repayment of principal is in jeopardy. We are seeing instances where projects such as these have completely stalled with lot sales significantly behind schedule or even nonexistent and the loan, including the interest reserve, is set to mature shortly. This is an example where a loan is contractually current, but is not performing as intended. ------ CHRG-111hhrg52261--87 Mr. Robinson," That is correct, Congressman. If there is a common thread that I could recommend that might answer some of these questions, it is, how broad a measure would be needed to cover all kinds of problems. It is answering a simple question like, Who underwrites the risk and who prices it? Because you could have somebody saying, Well, I thought the loan originator was. Well, I thought they were. Well, who is? Whether it is a credit default swap or a mortgage. And I think as we try to solve these issues--and there is no question that there are issues to be solved--that instead of perhaps picking a number to define too-big-to-fail, say, All right, you are big; what are your exposures and how much capital do you have to handle what statisticians would call the tail events--things that you don't think happen? And if they cannot answer those questions clearly and they perhaps have no idea, then that might aim you towards the real root cause of the issue. And that might be a good step, I would recommend. " FinancialCrisisInquiry--362 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 January 13, 2010 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. I remember being teased because at my shareholders’ meeting early in ‘07 somebody asked me what inning were we in and I said the seventh inning of the crisis. And of course it turned out not to be the seventh inning. It turned out to be the second inning. What was drought—and so what we were doing was we were creating processes. If you ask me do I wish we had done it? No—yes... FOMC20070321meeting--6 4,MR. DUDLEY.," Well, unfortunately, the information on the alt-A market is not very good. In fact, there is disagreement about exactly what an alt-A mortgage is. If you can’t define it, it’s pretty hard to measure. That is problem number one. A good way of thinking about the mortgage market is as a continuum of loan quality extending from, at the bottom, the worst underwritten subprime mortgages that are adjustable rate up to the conforming mortgages that we always associate with the GSEs, with alt-A somewhere in the middle. Obviously, to the extent that the housing market deteriorates and home prices don’t go up, there will be more strain on the alt-A market; but I don’t get a sense that we will see the kind of underwriting problems that we have seen in the subprime mortgage area. As of this date, we don’t see a lot of evidence of a significant problem in that area; but, again, we don’t have very good information, and we’ll have to wait and see." CHRG-111hhrg53241--31 The Chairman," Ms. Murguia. STATEMENT OF JANET MURGUIA, PRESIDENT AND CHIEF EXECUTIVE OFFICER, NATIONAL COUNCIL OF LA RAZA (NCLR) Ms. Murguia. Thank you. Good morning. My name is Janet Murguia, and I am president and CEO of the National Council of La Raza (NCLR). NCLR has been committed to improving the life opportunities of the Nation's 40 million Latinos for the last 4 decades, and I would just like to thank Chairman Frank and Ranking Member Bachus for inviting us to testify today. Our Latino families are experiencing record high foreclosures and mounting credit card debt. These are clear symptoms of weak oversight and gaps in consumer protections. Through our homeownership network, NCLR serves more than 38,000 home buyers and homeowners every year. But, these days, our counselors have shifted their focus from homeownership to foreclosure prevention. We are in the trenches every day fighting to save homes and build wealth in our community. The fact is, though, that our national banking system is failing communities of color. All Americans need access to bank accounts and credit to move up the economic ladder. A well-functioning system will put families on a path of financial security, not unwieldy debt. It will build wealth that future generations can rely on. I just want to make three points today. I want to highlight the major weaknesses in our current system, ways in which the Administration's proposal addresses those weaknesses, and just a couple of recommendations to strengthen the reforms. In regards to the current system, there is overwhelming evidence showing that minority borrowers pay more to access credit than their White peers. For example, Hispanic borrowers are twice as likely to receive high-cost mortgages. Latino credit card users are twice as likely as White cardholders to have interest rates over 20 percent. This trend is repeated among auto loans, bank accounts, and other financial services. This pattern of overpayment, abuse, and discrimination disrupts the financial stability of low-income and minority communities and impedes their improvement towards the middle class. Specifically, there are four ways the market fails our families: shopping for credit is nearly impossible; borrowers are still steered toward expensive products, even when they have good credit and high incomes; creditors trap borrowers in cycles of debt; and fraud and scams are rampant. NCLR applauds the broad reforms proposed by the Obama Administration. The market's breakdown has had a devastating impact that extends well beyond those initially harmed. As the proposed reforms make their way through Congress, there are four areas of particular importance to all communities of color: The missions of promoting access to credit and protecting borrowers are housed in the same regulatory agency. We agree. NCLR supports an independent regulator that will evaluate new financial products. These evaluations must be completed in light of credit needs of diverse communities. We want to make sure that we are holding all players in the market accountable. Deception, scams, and discrimination are present in all aspects of the market. Emphasizing simple, straightforward banking and credit products. This is an important part of this proposal, and we want to make sure that it is included. The fourth point is making enforcement a priority. The plan creates a meaningful way to analyze and respond to consumer complaints, protects private rights of action, and creates new tools for regulators to assess systemic risk. The concepts for promoting greater access to credit and increasing protections are not in conflict. Across the country, credit unions, community banks, and nonprofits are leaders in this area. They are creating alternatives to payday loans, offering free checking accounts, and using nontraditional credit information to underwrite loans. They do it while upholding highest standards of safety and soundness and generally offer prime pricing. I will just close with three recommendations to further strengthen the President's proposal. We strongly believe that we ought to create an Office of Fair Lending Compliance and Enforcement within the CFPA. Civil rights must be prioritized as part of the agency's formal structure. We ought to help consumers make smarter financial decisions. Go beyond the generic financial literacy and establish a federally funded financial counseling program. Improve data collection. Publicly available data, such as those available under HMDA, are valuable tools for holding financial institutions accountable. Communities of color were clearly targeted by lenders for inferior products, even when they had high incomes and good credit. Hispanic borrowers continue to face real barriers to accessing safe, fair, and affordable credit. We need strong regulators that allow borrowers fair and equal access to the banking system throughout their life cycle. Thank you, and I look forward to your questions. [The prepared statement of Ms. Murguia can be found on page 82 of the appendix.] " CHRG-111shrg62643--86 Mr. Bernanke," Well, the excess reserves, which is about $1 trillion held by the Federal Reserve, does not count--it is an asset. It does not count as capital. It is really a form of liquidity, and it helps to ensure that banks have all the access to liquid funds that they might need, and that it is another belt-and-suspender protection for the banking system. They have so far been reluctant to make use of those reserves, probably because they view the demand for credit as being weak or the quality of borrowers as being weak, or in some cases because they are uncertain about how much capital they will need in the longer term and are, therefore, being cautious about putting their capital to work. But capital reserves are different quantities. Senator Gregg. But they all reflect the strength of the system? " CHRG-111shrg57320--35 Mr. Thorson," I think almost any system, by definition, proper risk controls would say, yes, we can control that. So I guess to some degree, yes, you could say that. But the real-life examples are once you begin to institute those kind of policies and become much more lax, and especially in underwriting, which is really your safeguard, your final look before you do these packages, it is pretty hard to really understand what kind of a system you would put in place to control that. But definition-wise, yes. In the real world, probably not. Senator Coburn. And also the amount as relative to the risk of the risky instruments that you are procuring and selling. " CHRG-111hhrg55814--223 Secretary Geithner," Excellent questions, complicated questions and I won't be able to do them justice this quickly, but, let me make a quick attempt. If this set of authority and constraints had been in place ahead of this crisis, then you would have not have had AIG, you would not have had the world's largest investment banks, you would not have had firms like Countrywide and a bunch of other thrifts across the country, take on a level of risk that they could not manage. That would have been preventable. You would not have allowed a bunch of insurance companies to write a whole bunch of commitments in derivatives they did not have capital to support. That would have been enormously effective in limiting the risk, the build-up of pressures, that helped produce this crisis. You would not have let this terrible set of practices in mortgage underwriting, separate and lending in a bunch of other areas, get to the point they did. They would have been arrested more quickly. People would have been held to a level playing field with tougher requirements to constrain risk-taking. Now, firms will still make mistakes, even within a regime designed well like that. But if they do, then what this regime would allow for is us to take a firm, like Lehman, and have that put them out of existence, have the good businesses sold off, have them resolved, in a situation that would have caused less risk of broad panic and not put the position where you had millions of Americans, millions of investors, people who held pension funds, municipalities, counties across the country who invested money in money market funds that had funded Lehman. They would not have been exposed to that scale of losses and you would not have the extent of the panic you saw last fall, which did threaten the viability of a whole range of other institutions. In that case, what happened is, because the authority didn't exist, the government had to come in and do much more dramatic things, that created much greater risk of moral hazard, provided much greater protections to firms that should not have been exposed to those protections. And that's the basic rationale for this framework and that's what it would have provided. But, we will have firms in the future that make mistakes, we just don't want those mistakes to come at the expense of well-managed institutions and at the expense of the taxpayer. " CHRG-111hhrg55809--54 Mr. Bernanke," The Federal Reserve has taken this position. For a very long time, the Fed was focused on transparency and disclosures on the theory that if people could read the information, that they would make good decisions. But, for example, in our recent credit card work, which became the basis for a lot of the legislation here, we identified through consumer testing and other kinds of means that there were a number of practices and products and so on that did not benefit the consumer and which could not reasonably be understood by a typically educated consumer to understand the full implications of what that practice was. And based on that, we said that in some cases transparency is not enough, and we employed the Unfair or Deceptive Acts or Practices provisions simply to ban those practices. So I think, in situations where there is no benefit to the consumer and where disclosures are not adequate, there are grounds for banning a product or a practice. And the consumer agency or whomever is in charge would look at that, and the council could look at those thinks as well. Ms. Waters. I am very pleased to hear that. And I thank you very much. I yield back the balance of my time. " CHRG-110shrg38109--73 Chairman Bernanke," It also has some issues. Just to note one action we have taken recently, along with the other Federal banking agencies, we have issued guidance on nontraditional mortgages, mortgages that involve interest-only or option ARM's that may not be amortizing mortgages. We have emphasized to the lenders that they should be, first, very careful in their underwriting--that is, they should ensure that the borrower is equipped to deal with payment shock if interest rates go up, that they have sufficient income to meet higher payments; and, second, that disclosures are adequate so that the borrowers are fully informed about the nature of the contract that they are getting involved in. There are some loans that have been made that are not turning out well, and to the detriment of both the lenders and the borrowers. We will certainly be watching that carefully and trying to provide guidance and oversight to minimize that risk going forward. Senator Martinez. Thank you, Mr. Chairman. " FinancialCrisisReport--599 Market Maker. A “market maker” is typically a dealer in financial instruments that stands ready to buy and sell a particular financial instrument on a regular and continuous basis at a publicly quoted price. 2671 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 that security. 2672 Market makers do not keep the financial instruments they buy and sell in their own investment portfolio, but instead keep them in their sales portfolio or “trading book.” Market makers have among the most narrow disclosure obligations under federal securities law, since they typically 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. 2673 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. 2674 Underwriter and Placement Agent. Underwriters and placement agents have greater disclosure obligations than market makers, because in this role they are actively soliciting customers to buy new securities they have helped an issuer bring to market. When securities are offered to the public for sale, they are typically underwritten by one or more investment banks, each of which is a broker-dealer registered with the Financial Industry Regulatory Authority (FINRA). 2675 An underwriter is typically hired by the issuer of the new securities to help the issuer register the securities with the SEC and conduct a public offering of the securities. The underwriter typically 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. 2671 Section 3(a)(38) of the Securities Exchange Act of 1934 (“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; see also FINRA website, FAQs, “What Does a Market Maker Do?” http://finra.atgnow.com/finra/categoryBrowse.do. 2672 SEC website, http://www.sec.gov/answers/mktmaker.htm. 2673 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, (hereinafter “SEC Study on Investment Advisers and Broker-Dealers”). 2674 See Goldman response to Subcommittee QFR at PSI_QFR_GS0046. 2675 FINRA is the largest independent self-regulatory organization for securities firms doing business in the United States. FINRA has been delegated authority by the SEC and a number of securities exchanges to regulate the broker-dealer industry. Its stated mission is “to protect America’s investors by making sure the securities industry operates fairly and honestly.” See FINRA website, http://www.finra.org. CHRG-111hhrg54869--14 Mr. Volcker," Thank you, Mr. Chairman, and members of the committee. It has been a long time since I have been in the room. It is a familiar room, and I appreciate the opportunity because you are dealing with particularly important problems. Let me just say in a preliminary way, as you know, the President has said--as Mr. Geithner has said, if the market betters, the economy steadying, there has been some feeling of relaxation about some of these issues and some feeling of maybe just return to business as usual, return to making money, outside amounts of money, certain resistance to change. And from the comments that you have made, I am sure you will not respond to that by slowing down, but rather proceeding with all deliberate speed to get this right. It is really important. It is an incredibly complicated problem, and I want to concentrate on mainly the aspect that you have already emphasized. But before I do so, let me acknowledge that an awful lot of work is going on in various aspects by the regulatory agencies. They have taken important initiatives dealing with capital and liquidity, and they are working toward compensation practices. And I would point out it is relevant with the G-20 meeting that a lot of what needs to be done really does require a certain consistency internationally because these markets are global and that just adds another complication. You can't have capital requirements, for instance, for American banks that are way out of line of capital requirements elsewhere, to take an easy example. But that is an additional complication. But the central issue that I want to talk about really is what you have already said, moral hazard in financial markets. You know what that is all about. I don't have to explain it. But I would note that this is front and center because the active use of long-dormant emergency powers of the Federal Reserve together with extraordinary action by the Treasury and Congress to support non-bank institutions has extended this issue well beyond the world of commercial banking. ``Too-big-to-fail'' has been an issue in commercial banking; now it is an issue for finance generally. I think it raises very important substantive questions. It raises some administrative questions that I want to touch upon, too. It raise legal questions. And one of those questions is the role of the Federal Reserve, which I will return to. In dealing with that, I submitted a long statement which deals with all of this in more detail. Just to cut to the chase, you know, the Administration has set out a possible approach, which I feel somewhat resistant to or more than somewhat resistant because I think it does suffer from conceptual and practical difficulties. Now what they suggested is setting out a group of particular institutions that, in their judgment, would pose a systemic risk in the event of failure. I don't know what criteria would be used precisely in determining these institutions because the market changes, it is not always directly relevant to size. That in itself would be a great challenge. But I think it is fair to say that the great majority of systemically important institutions are today, and likely to be in the future, the mega-commercial banks. We are talking about in the center of things, the commercial banking problem. That is true here, that is true abroad, and in this case we already have an established safety net. The commercial banks that are at the heart of the problem are already subject to deposit insurance, central bank credit facilities, and other means of support. I have a little hobby of asking friends and acquaintances when they talk to me with experience in financial markets, I say, Now, outside of commercial banks, outside of insurance companies, which I would say parenthetically I hope better regulatory systems will be developed, maybe not as part of this legislation but next year. Apart from commercial banks and insurance companies, how many genuinely systemically important institutions do you think there are in the whole world, financial markets. I will tell you the answer I get consistently is somewhere between 5 and 25. The universe is not huge when you are talking about non-banking, non-insurance company, systemically important institutions. Now, if you extend this idea of developing a group of systemically important institutions for your own banks, then the moral hazards problem has obviously increased because the connotation is if they are systemically important, officially identified, they fall in the same category as banks, and the government better be especially alert to dealing with them in case of difficulty. Now, it does seem to me a better approach would be to confine the safety net to where it is, that is to commercial banking organizations. And as part of that organization now and even more so in the future, the banking supervisors would, I think, as a natural part of their responsibility, be especially attentive to the risks posed by the largest banking organizations. So they ought to have the discipline to insist upon best practice among those organizations, not just in the United States but generally worldwide by agreement. We have to agree to more adequate capital, responsible cooperation with other supervisory concerns, and leave it as ambiguous as you can as to whether government assistance would ever be provided in these emergency situations. Now that approach recognizes, I think, the reality that the commercial banks are the indispensable backbone of the financial system. Mr. Scott talked a bit about the importance of community banks, regional banks and credit. That is part of it. They also act as depository, they take care of the payment system, they offer investment advice, they maintain international financial flows. These are all essential services that justify a special sense of protection. Now, when you get to what are called capital market activity, a lot of trading, hedge funds, private equity funds, a lot of other activity, credit default swaps,CDOs, CDO squared, all that stuff, it is a different business. It is an impersonal position. It is a trading business, and it is useful. We need strong capital markets, but they are not the same as customer-related commercial banking functions and they do have substantial risks. Banking itself is risky enough. You add capital market operations to that, you are just compounding the risk. And I would note it is--they present conflicts of interest for customer relationships. When a bank is rendering advice and maybe investment advice to a company, it is rendering underwriting services and then it is turning around and creating in those same activities, does it bias the customer advice? Does it undercut the customer relationship? Is it consistent with the customer relationship? Those problems are enormously difficult, and I think demonstrably have been a big distraction for bank management and led to weaknesses in risk management practices. So I would say the logic of this situation is to prohibit the banking organizations, and by ``banking organizations,'' I am talking about the bank and its holding company and all of the related operations. I would prohibit them from sponsoring or capitalizing hedge funds, private equity funds, and I would have particularly strict supervision enforced by capital and collateral requirements toward proprietary trading in securities and derivatives. Now, how do you approach all of this and deal with the big nonbank that might get in trouble? That I think is where this resolution authority comes into play. Can we have a system, knowledge as to what we have with banks, a government authority can take over a failed or failing institution, manage that institution, try to find a merger partner if that is reasonable, force the end of the equity if there is no equity really left in the company, ask debt holders, negotiate with debt holders to exchange dept for equity to make the company solvent again, if that is possible. If none of that is possible, arrange an orderly liquidation. And none of that necessarily involves the injection of government money and taxpayer money but it provides an organized procedure for letting down what I hope is a very rare occurrence of the failure of a systemically important nonbank institution. Now who has all of this authority and how are the general regulatory and supervisory arrangements rejiggered, if at all, and I do think they do need some rejiggering. I would mention one aspect of that. The Treasury itself has correctly identified the need for what I call an overseer. Somebody, some organization that is responsible not just for individual institutions but responsible for surveying the whole financial system, identifying points of weakness, which may or may not lie in an individual institution. It may lie in new trading developments. But take two obvious examples. Who was alert to the rise of the subprime mortgage a few years ago? It may not have appeared to have presented a risk at the time for an individual institution, but it sure in its speed of increase and its weakness presented a risk to the whole system. Somebody should have been alerted to that. Who has been looking at credit default swaps and wondering whether they reach the point of creating a threat to the system? And the answer is basically nobody and not very well. And somebody should have that responsibility. The Treasury has been very eloquent on that point. They have suggested a kind of council or regulatory agency headed by the Treasury. I frankly don't think that is a very effective way to do it because getting a bunch of agencies together and getting to agreement on anything, and they all have their particular responsibilities, their particular constituencies are a very tough business. So if you do it that way you have to be a Treasury. You have to build up a new staff in the Treasury. The alternative is the Federal Reserve. I spent a lot of time in the Treasury so I am not particularly prejudiced of the Federal Reserve, I would argue, but I think this is a natural function for the Federal Reserve. I think consciously or unconsciously we have looked to the Federal Reserve. Whether the responsibility has been discharged effectively or not, there is a sense that the Federal Reserve is the agency, the major agency to be concerned with the whole financial market, and there is no doubt when you get in trouble, when anybody in the financial markets gets in real trouble they run to the Federal Reserve. The Federal Reserve has the authority, the money. It presumably has the experience and capabilities, and I think that simple fact ought to be recognized. It is a very important institution. It seems to be logical that they ought to be kind of assigned explicitly what I always thought they had implicitly, a kind of surveillance of a whole system. [The prepared statement of Mr. Volcker can be found on page 93 of the appendix.] " fcic_final_report_full--176 Countrywide, the nation’s largest mortgage lender at the time, had about , in- ternal referrals of potentially fraudulent activity in its mortgage business in , , in , and , in , according to Francisco San Pedro, the former senior vice president of special investigations at the company.  But it filed only  SARs in , , in , and , in .  Similarly, in examining Bank of America in , its lead bank regulator, the Of- fice of the Comptroller of the Currency (OCC), sampled  mortgages and found  with “quality assurance referrals” for suspicious activity for which no report had been filed with FinCEN. All  met the legal requirement for a filing. The OCC conse- quently required management to refine its processes to ensure that SARs were consis- tently filed.  Darcy Parmer, a former quality assurance and fraud analyst at Wells Fargo, the second largest mortgage lender from  through  and the largest in , told the Commission that “hundreds and hundreds and hundreds of fraud cases” that she knew were identified within Wells Fargo’s home equity loan division were not re- ported to FinCEN. And, she added, at least half the loans she flagged for fraud were nevertheless funded, over her objections.  Despite the underreporting, the jump in mortgage fraud drew attention. FinCEN in November  reported a -fold increase in SARs related to mortgage fraud be- tween  and . It noted that two-thirds of the loans being created were origi- nated by mortgage brokers who were not subject to any federal standard or oversight.  Swecker unsuccessfully asked legislators to compel all lenders to forward information about criminal fraud to regulators and law enforcement agencies.  Swecker attempted to gain more funding to combat mortgage fraud but was resis- ted. Swecker told the FCIC his funding requests were cut at either the director level at the FBI, at the Justice Department, or at the Office of Management and Budget. He called his struggle for more resources an “uphill slog.”  In , , SARs related to mortgage fraud were filed; in  there were ,. The number kept climbing, to , in , , in , and , in .  At the same time, top FBI officials, focusing on terrorist threats, reduced the agents assigned to white-collar crime from , in the  fiscal year to fewer than , by . That year, its mortgage fraud program had only  agents at any one time to review more than , SARs filed with FinCEN. In response to inquiries from the FCIC, the FBI said that to compensate for a lack of manpower, it had devel- oped “new and innovative methods to detect and combat mortgage fraud,” such as a computer application, created in , to detect property flipping.  CHRG-110shrg50409--38 Mr. Bernanke," Well, there is a general tightening in credit and tightening in underwriting standards, you know, related to this pullback from credit risk in general. It has affected different groups differentially. For example, prime corporate borrowers are still able to access the bond market and the loan market pretty effectively. Riskier firms, smaller firms, are having more difficulty accessing credit. I think that I would encourage banks to continue to make sound loans, and we at the Federal Reserve will not penalize banks that are making sound loans. We want them to extend credit. In assessing how to make a good loan to a business, certainly there are many factors, including financials and personal relationships and many other things, but the business plan is certainly an important part and one that a good bank lender would look at. Senator Allard. You have assumed, meaning the Fed has assumed, a great regulatory oversight authority recently here. Are you comfortable with that? And do you anticipate that you may even take on a greater regulatory role? " CHRG-111shrg51395--117 PREPARED STATEMENT OF JOHN C. COFFEE, JR. Adolf A. Berle Professor of Law, Columbia University Law School March 10, 2009 Enhancing Investor Protection and the Regulation of Securities Markets ``When the music stops, in terms of liquidity, things will get complicated. But as long as the music is playing, you've got to get up and dance. We're still dancing.'' ----Charles Prince, CEO of Citigroup Financial Times, July 2007 Chairman Dodd, Ranking Member Shelby, and Fellow Senators, I am pleased and honored to be invited to testify here today. We are rapidly approaching the first anniversary of the March 17, 2008, insolvency of Bear Stearns, the first of a series of epic financial collapses that have ushered in, at the least, a major recession. Let me take you back just one year ago when, on this date in 2008, the U.S. had five major investment banks that were independent of commercial banks and were thus primarily subject to the regulation of the Securities and Exchange Commission: Goldman Sachs, Merrill Lynch, Morgan Stanley, Lehman Brothers, and Bear Stearns. Today, one (Lehman) is insolvent; two (Merrill Lynch and Bear Stearns) were acquired on the brink of insolvency by commercial banks, with the Federal Reserve pushing the acquiring banks into hastily arranged ``shotgun'' marriages; and the remaining two (Goldman and Morgan Stanley) have converted into bank holding companies that are primarily regulated by the Federal Reserve. The only surviving investment banks not owned by larger commercial banks are relatively small boutiques (e.g., Lazard Freres). Given the total collapse of an entire class of institutions that were once envied globally for their entrepreneurial skill and creativity, the questions virtually ask themselves: Who failed? What went wrong? Although there are a host of candidates--the investment banks, themselves, mortgage loan originators, credit-rating agencies, the technology of asset-backed securitizations, unregulated trading in exotic new instruments (such as credit default swaps), etc.--this question is most pertinently asked of the SEC. Where did it err? In overview, 2008 witnessed two closely connected debacles: (1) the failure of a new financial technology (asset-backed securitizations), which grew exponentially until, after 2002, annual asset-backed securitizations exceeded the annual total volume of corporate bonds issued in the United States, \1\ and (2) the collapse of the major investment banks. In overview, it is clear that the collapse of the investment banks was precipitated by laxity in the asset-backed securitization market (for which the SEC arguably may bear some responsibility), but that this laxity began with the reckless behavior of many investment banks. Collectively, they raced like lemmings over the cliff by abandoning the usual principles of sound risk management both by (i) increasing their leverage dramatically after 2004, and (ii) abandoning diversification in pursuit of obsessive focus on high-profit securitizations. Although these firms were driven by intense competition and short-term oriented systems of executive compensation, their ability to race over the cliff depended on their ability to obtain regulatory exemptions from the SEC. Thus, as will be discussed, the SEC raced to deregulate. In 2005, it adopted Regulation AB (an acronym for ``Asset-Backed''), which simplified the registration of asset-backed securitizations without requiring significant due diligence or responsible verification of the essential facts. Even more importantly, in 2004, it introduced its Consolidated Supervised Entity Program (``CSE''), which allowed the major investment banks to determine their own capital adequacy and permissible leverage by designing their own credit risk models (to which the SEC deferred). Effectively, the SEC abandoned its long-standing ``net capital rule'' \2\ and deferred to a system of self-regulation for these firms, which largely permitted them to develop their own standards for capital adequacy.--------------------------------------------------------------------------- \1\ See John C. Coffee, Jr., Joel Seligman & Hillary Sale, SECURITIES REGULATION: Cases and Materials (10th ed. 2007) at 10. \2\ See Rule 15c3-1 (``Net Capital Requirements for Brokers and Dealers''), 17 CFR 240.15c3-1.--------------------------------------------------------------------------- For the future, it is less important to allocate culpability and blame than to determine what responsibilities the SEC can perform adequately. The recent evidence suggests that the SEC cannot easily or effectively handle the role of systemic risk regulator or even the more modest role of a prudential financial supervisor, and it may be more subject to capture on these issues than other agencies. This leads me to conclude (along with others) that the U.S. needs one systemic risk regulator who, among other tasks, would have responsibility for the capital adequacy and safety and soundness of all institutions that are too ``big to fail.'' \3\ The key advantage of a unified systemic risk regulator with jurisdiction over all large financial institutions is that it solves the critical problem of regulatory arbitrage. AIG, which has already cost U.S. taxpayers over $150 billion, presents the paradigm of this problem because it managed to issue billions in credit default swaps without becoming subject to regulation by any regulator at either the federal or state level.--------------------------------------------------------------------------- \3\ I have made this argument in greater detail in an article with Professor Hillary Sale, which will appear in the 75th Anniversary of the SEC volume of the Virginia Law Review. See Coffee and Sale, ``Redesigning the SEC: Does the Treasury Have a Better Idea?'' (available on the Social Science Research Network at http://ssrn.com/abstract=1309776).--------------------------------------------------------------------------- But one cannot stop with this simple prescription. The next question becomes what should be the relationship between such a systemic risk regulator and the SEC? Should the SEC simply be merged into it or subordinated to it? I will argue that it should not. Rather, the U.S. should instead follow a ``twin peaks'' structure (as the Treasury Department actually proposed in early 2008 before the current crisis crested) that assigns prudential supervision to one agency and consumer protection and transparency regulation to another. Around the globe, countries are today electing between a unified financial regulator (as typified by the Financial Services Authority (``FSA'') in the U.K.) and a ``twin peaks'' model (which both Australia and The Netherlands have followed). I will argue that the latter model is preferable because it deals better with serious conflict of interest problems and the differing cultures of securities and banking regulators. By culture, training, and professional orientation, banking regulators are focused on protecting bank solvency, and they historically have often regarded increased transparency as inimical to their interests, because full disclosure of a bank's problems might induce investors to withdraw deposits and credit. The result can sometimes be a conspiracy of silence between the regulator and the regulated to hide problems. In contrast, this is one area where the SEC's record is unblemished; it has always defended the principle that ``sunlight is the best disinfectant.'' Over the long-run, that is the sounder rule. If I am correct that a ``twin peaks'' model is superior, then Congress has to make clear the responsibilities of both agencies in any reform legislation in order to avoid predictable jurisdictional conflicts and to identify a procedure by which to mediate those disputes that are unavoidable.What Went Wrong? This section will begin with the problems in the mortgage loan market, then turn to the failure of credit-rating agencies, and finally examine the SEC's responsibility for the collapse of the major investment banks.The Great American Real Estate Bubble The earliest origins of the 2008 financial meltdown probably lie in deregulatory measures, taken by the U.S. Congress at the end of the 1990s, that placed some categories of derivatives and the parent companies of investment banks beyond effective regulation. \4\ Still, most accounts of the crisis start by describing the rapid inflation of a bubble in the U.S. housing market. Here, one must be careful. The term ``bubble'' can be a substitute for closer analysis and may carry a misleading connotation of inevitability. In truth, bubbles fall into two basic categories: those that are demand-driven and those that are supply-driven. The majority of bubbles fall into the former category, \5\ but the 2008 financial market meltdown was clearly a supply-driven bubble, \6\ fueled by the fact that mortgage loan originators came to realize that underwriters were willing to buy portfolios of mortgage loans for asset-backed securitizations without any serious investigation of the underlying collateral. With that recognition, loan originators' incentive to screen borrowers for creditworthiness dissipated, and a full blown ``moral hazard'' crisis was underway. \7\--------------------------------------------------------------------------- \4\ Interestingly, this same diagnosis was recently given by SEC Chairman Christopher Cox to this Committee. See Testimony of SEC Chairman Christopher Cox before the Committee on Banking, Housing and Urban Affairs, United States Senate, September 23, 2008. Perhaps defensively, Chairman Cox located the origins of the crisis in the failure of Congress to give the SEC jurisdiction over investment bank holding companies or over-the-counter derivatives (including credit default swaps), thereby creating a regulatory void. \5\ For example, the high-tech Internet bubble that burst in early 2000 was a demand-driven bubble. Investors simply overestimated the value of the Internet, and for a time initial public offerings of ``dot.com'' companies would trade at ridiculous and unsustainable multiples. But full disclosure was provided to investors and the SEC cannot be faulted in this bubble--unless one assigns it the very paternalistic responsibility of protecting investors from themselves. \6\ This is best evidenced by the work of two University of Chicago Business School professors discussed below. See Atif Mian and Amir Sufi, ``The Consequences of Mortgage Credit Expansion: Evidence from the 2007 Mortgage Default Crisis'', (http://ssrn.com/abstract=1072304) (May 2008). \7\ Interestingly, ``moral hazard'' problems also appear to have underlain the ``savings and loan'' crisis in the United States in the 1980s, which was the last great crisis involving financial institutions in the United States. For a survey of recent banking crises making this point, see Note, Anticipatory Regulation for the Management of Banking Crises, 38 Colum. J. L. & Soc. Probs. 251 (2005).--------------------------------------------------------------------------- The evidence is clear that, between 2001 and 2006, an extraordinary increase occurred in the supply of mortgage funds, with much of this increased supply being channeled into poorer communities in which previously there had been a high denial rate on mortgage loan applications. \8\ With an increased supply of mortgage credit, housing prices rose rapidly, as new buyers entered the market. But at the same time, a corresponding increase in mortgage debt relative to income levels in these same communities made these loans precarious. A study by University of Chicago Business School professors has found that two years after this period of increased mortgage availability began, a corresponding increase started in mortgage defaults--in exactly the same zip code areas where there had been a high previous rate of mortgage loan denials. \9\ This study determined that a one standard deviation in the supply of mortgages from 2001 to 2004 produced a one standard deviation increase thereafter in mortgage default rates. \10\--------------------------------------------------------------------------- \8\ See Mian and Sufi, supra note 6, at 11 to 13. \9\ Id. at 18-19. \10\ Id. at 19.--------------------------------------------------------------------------- Even more striking, however, was its finding that the rate of mortgage defaults was highest in those neighborhoods that had the highest rates of securitization. \11\ Not only did securitization correlate with a higher rate of default, but that rate of default was highest when the mortgages were sold by the loan originator to financial firms unaffiliated with the loan originator. \12\ Other researchers have reached a similar conclusion: conditional on its being actually securitized, a loan portfolio that was more likely to be securitized was found to default at a 20 percent higher rate than a similar risk profile loan portfolio that was less likely to be securitized. \13\ Why? The most plausible interpretation is that securitization adversely affected the incentives of lenders to screen their borrowers.--------------------------------------------------------------------------- \11\ Id. at 20-21. \12\ Id. \13\ See Benjamin J. Keys, Tanmoy K. Mukherjee, Amit Seru, and Vikrant Vig, ``Did Securitization Lead to Lax Screening? Evidence from Subprime Loans,'' (http://ssrn.com/abstract=1093137) (April, 2008). These authors conclude that securitization did result in ``lax screening.''--------------------------------------------------------------------------- Such a conclusion should not surprise. It simply reflects the classic ``moral hazard'' problem that arises once loan originators did not bear the cost of default by their borrowers. As early as March, 2008, The President's Working Group on Financial Markets issued a ``Policy Statement on Financial Market Developments'' that explained the financial crisis as the product of five ``principal underlying causes of the turmoil in financial markets'': a breakdown in underwriting standards for subprime mortgages; a significant erosion of market discipline by those involved in the securitization process, including originators, underwriters, credit rating agencies, and global investors, related in part to failures to provide or obtain adequate risk disclosures; flaws in credit rating agencies' assessment of subprime residential mortgages . . . and other complex structured credit products, . . . risk management weaknesses at some large U.S. and European financial institutions; and regulatory policies, including capital and disclosure requirements, that failed to mitigate risk management weaknesses. \14\--------------------------------------------------------------------------- \14\ The President's Working Group on Financial Markets, ``Policy Statement on Financial Market Developments,'' at 1 (March 2008). Correct as the President's Working Group was in noting the connection between the decline of discipline in the mortgage loan origination market and a similar laxity among underwriters in the capital markets, it did not focus on the direction of the causality. Did mortgage loan originators fool or defraud investment bankers? Or did investment bankers signal to loan originators that they would buy whatever the loan originators had to sell? The available evidence tends to support the latter hypothesis: namely, that irresponsible lending in the mortgage market was a direct response to the capital markets' increasingly insatiable demand for financial assets to securitize. If underwriters were willing to rush deeply flawed asset-backed securitizations to the market, mortgage loan originators had no rational reason to resist them. The rapid deterioration in underwriting standards for subprime mortgage loans is revealed at a glance in the following table: \15\--------------------------------------------------------------------------- \15\ See Allen Ferrell, Jennifer Bethel and Gang Hu, Legal and Economic Issues in Litigation Arising from the 2007-2008 Credit Crisis (Harvard Law & Economics Discussion Paper No. 612, Harvard Law School Program in Risk Regulation Research Paper No. 08-5) at Table 4. Underwriting Standards in Subprime Home-Purchase Loans, 2001-2006---------------------------------------------------------------------------------------------------------------- Debt Year Low/No-Doc Payments/ Loan/Value ARM Share Interest- Share Income Only Share----------------------------------------------------------------------------------------------------------------2001...................................... 28.5% 39.7% 84.0% 73.8% 0.0%2002...................................... 38.6% 40.1% 84.4% 80.0% 2.3%2003...................................... 42.8% 40.5% 86.1% 80.1% 8.6%2004...................................... 45.2% 41.2% 84.9% 89.4% 27.3%2005...................................... 50.7% 41.8% 83.2% 93.3% 37.8%2006...................................... 50.8% 42.4% 83.4% 91.3% 22.8%----------------------------------------------------------------------------------------------------------------Source: Freddie Mac, obtained from the International Monetary Fund. The investment banks could not have missed that low document loans (also called ``liar loans'') rose from 28.5 percent to 50.8 percent over the 5 year interval between 2001 and 2006 or that ``interest only'' loans (on which there was no amortization of principal) similarly grew from 6 percent to 22.8 percent over this same interval. Thus, the real mystery is not why loan originators made unsound loans, but why underwriters bought them. Here, it seems clear that both investment and commercial banks saw high profits in securitizations and believed they could quickly sell on a global basis any securitized portfolio of loans that carried an investment grade rating. In addition, investment banks may have had a special reason to focus on securitizations: structured finance offered a level playing field where they could compete with commercial banks, whereas, as discussed later, commercial banks had inherent advantages at underwriting corporate debt and were gradually squeezing the independent investment banks out of this field. \16\ Consistent with this interpretation, anecdotal evidence suggests that due diligence efforts within the underwriting community slackened in asset-backed securitizations after 2000. \17\ Others have suggested that the SEC contributed to this decline by softening its disclosure and due diligence standards for asset-backed securitizations, \18\ in particular by adopting in 2005 Regulation AB, which covers the issuance of asset backed securities. \19\ From this perspective, relaxed discipline in both the private and public sectors overlapped to produce a disaster.--------------------------------------------------------------------------- \16\ See text and notes infra at notes 56 to 61. \17\ Investment banks formerly had relied on ``due diligence'' firms that they employed to determine whether the loans within a loan portfolio were within standard parameters. These firms would investigate and inform the underwriter as to the percentage of the loans that were ``exception'' loans (i.e., loans outside the investment bank's normal guidelines). Subsequent to 2000, the percentage of ``exception loans'' in portfolios securitized by these banks often rose from the former level of 25 percent to as high as 80 percent. Also, the underwriters scaled back the intensity of the investigations that they would authorize the ``due diligence'' firm to conduct, reducing from 30 percent to as few as 5 percent the number of loans in a portfolio that it was to check. See Vikas Bajaj & Jenny Anderson, ``Inquiry Focuses on Withholding of Data on Loans,'' N.Y. Times, January 12, 2008, at p. A-1. \18\ See Richard Mendales, ``Collateralized Explosive Devices: Why Securities Regulation Failed to Prevent the CDO Meltdown And How To Fix It'' (Working Paper 2008) at 36 (forthcoming in 2009, U. Ill. L. Rev.). \19\ See Securities Act Release No. 8518 (``Asset-Backed Securities'') (January 7, 2005, 79 FR 1506). Regulation AB codified a series of ``no action'' letters and established disclosures standards for all asset-backed securitizations. See 17 C.F.R. 229.1100-1123 (2005). Although it did not represent a sharp deregulatory break with the past, Regulation AB did reduce the due diligence obligation of underwriters by eliminating any need to assure that assets included in a securitized pool were adequately documented. See Mendales, supra note 18.---------------------------------------------------------------------------Credit Rating Agencies as Gatekeepers It has escaped almost no one's attention that the credit rating agencies bear much responsibility for the 2008 financial crisis, with the consensus view being that they inflated their ratings in the case of structured finance offerings. Many reasons have been given for their poor performance: (1) rating agencies faced no competition (because there are really only three major rating agencies); (2) they were not disciplined by the threat of liability (because credit rating agencies in the U.S. appear never to have been held liable and almost never to have settled a case with any financial payment); (3) they were granted a ``regulatory license'' by the SEC, which has made an investment grade rating from a rating agency that was recognized by the SEC a virtual precondition to the purchase of debt securities by many institutional investors; (4) they are not required to verify information (as auditors and securities analysts are), but rather simply express views as to the creditworthiness of the debt securities based on the assumed facts provided to them by the issuer. \20\ These factors all imply that credit rating agencies had less incentive than other gatekeepers to protect their reputational capital from injury. After all, if they face little risk that new entrants could enter their market to compete with them or that they could be successfully sued, they had less need to invest in developing their reputational capital or taking other precautions. All that was necessary was that they avoid the type of major scandal, such as that which destroyed Arthur Andersen & Co., the accounting firm, that had made it impossible for a reputable company to associate with them.--------------------------------------------------------------------------- \20\ For these and other explanations, see Coffee, GATEKEEPERS: The Professions and Corporate Governance (Oxford University Press, 2006), and Frank Partnoy, ``How and Why Credit Rating Agencies Are Not Like Other Gatekeepers'' (http://ssrn.com/abstract=900257) (May 2006).--------------------------------------------------------------------------- Much commentary has suggested that the credit rating agencies were compromised by their own business model, which was an ``issuer pays'' model under which nearly 90 percent of their revenues came from the companies they rated. \21\ Obviously, an ``issuer pays'' model creates a conflict of interest and considerable pressure to satisfy the issuer who paid them. Still, neither such a conflicted business model nor the other factors listed above can explain the dramatic deterioration in the performance of the rating agencies over the last decade. Both Moody's and Standard & Poor were in business before World War I and performed at least acceptably until the later 1990s. To account for their more recent decline in performance, one must point to more recent developments and not factors that long were present. Two such factors, each recent and complementary with the other, do provide a persuasive explanation for this deterioration: (1) the rise of structured finance and the change in relationships that it produced between the rating agencies and their clients; and (2) the appearance of serious competition within the ratings industry that challenged the long stable duopoly of Moody's and Standard & Poor's and that appears to have resulted in ratings inflation.--------------------------------------------------------------------------- \21\ See Partnoy, supra note 20.--------------------------------------------------------------------------- First, the last decade witnessed a meteoric growth in the volume and scale of structured finance offerings. One impact of this growth was that it turned the rating agencies from marginal, basically break-even enterprises into immensely profitable enterprises that rode the crest of the breaking wave of a new financial technology. Securitizations simply could not be sold without ``investment grade'' credit ratings from one or more of the Big Three rating agencies. Structured finance became the rating agencies' leading source of revenue. Indeed by 2006, structured finance accounted for 54.2 percent of Moody's revenues from its ratings business and 43.5 percent of its overall revenues. \22\ In addition, rating structured finance products generated much higher fees than rating similar amounts of corporate bonds. \23\ For example, rating a $350 million mortgage pool could justify a fee of $200,000 to $250,000, while rating a municipal bond of similar size justified only a fee of $50,000. \24\--------------------------------------------------------------------------- \22\ See In re Moody's Corporation Securities Litigation, 2009 U.S. Dist. LEXIS 13894 (S.D.N.Y. February 23, 2009) at *6 (also noting that Moody's grossed $1.635 billion from its ratings business in 2006). \23\ See Gretchen Morgenson, ``Debt Watchdogs: Tamed or Caught Napping?'' New York Times, December 7, 2008, at p. 1, 40. \24\ Id.--------------------------------------------------------------------------- Beyond simply the higher profitability of rating securitized transactions, there was one additional difference about structured finance that particularly compromised the rating agencies as gatekeepers. In the case of corporate bonds, the rating agencies rated thousands of companies, no one of which controlled any significant volume of business. No corporate issuer, however large, accounted for any significant share of Moody's or S&P's revenues. But with the rise of structured finance, the market became more concentrated. As a result, the major investment banks acquired considerable power over the rating agencies, because each of them had ``clout,'' bringing highly lucrative deals to the agencies on a virtually monthly basis. As the following chart shows, the top six underwriters controlled over 50 percent of the mortgage-backed securities underwriting market in 2007, and the top eleven underwriters each had more than 5 percent of the market and in total controlled roughly 80 percent of this very lucrative market on whom the rating agencies relied for a majority of their ratings revenue: \25\--------------------------------------------------------------------------- \25\ See Ferrell, Bethel, and Hu, supra note 15, at Table 2. For anecdotal evidence that ratings were changed at the demand of the investment banks, see Morgenson, supra note 23. MBS Underwriters in 2007-------------------------------------------------------------------------------------------------------------------------------------------------------- Proceed Amount + Rank Book Runner Number of Market Overallotment Sold in U.S. Offerings Share ($mill)--------------------------------------------------------------------------------------------------------------------------------------------------------1....................................................... Lehman Brothers 120 10.80% $100,1092....................................................... Bear Stearns & Co., Inc. 128 9.90% 91,6963....................................................... Morgan Stanley 92 8.20% 75,6274....................................................... JPMorgan 95 7.90% 73,2145....................................................... Credit Suis109 7.50% 69,5036....................................................... Bank of America Securities LLC 101 6.80% 62,7767....................................................... Deutsche Bank AG 85 6.20% 57,3378....................................................... Royal Bank of Scotland Group 74 5.80% 53,3529....................................................... Merrill Lynch 81 5.20% 48,40710...................................................... Goldman Sachs & Co. 60 5.10% 47,69611...................................................... Citigroup 95 5.00% 46,75412...................................................... UBS 74 4.30% 39,832-------------------------------------------------------------------------------------------------------------------------------------------------------- If the rise of structured finance was the first factor that compromised the credit rating agencies, the second factor was at least as important and had an even clearer empirical impact. Until the late 1990s, Moody's and Standard & Poor's shared a duopoly over the rating of U.S. corporate debt. But, over the last decade, a third agency, Fitch Ratings, grew as the result of a series of mergers and increased its U.S. market share from 10 percent to approximately a third of the market. \26\ The rise of Fitch challenged the established duopoly. What was the result? A Harvard Business School study has found three significant impacts: (1) the ratings issued by the two dominant rating agencies shifted significantly in the direction of higher ratings; (2) the correlation between bond yields and ratings fell, suggesting that under competitive pressure ratings less reflected the market's own judgment; and (3) the negative stock market reaction to bond rating downgrades increased, suggesting that a downgrade now conveyed worse news because the rated offering was falling to an even lower quality threshold than before. \27\ Their conclusions are vividly illustrated by one graph they provide that shows the correlation between grade inflation and higher competition:--------------------------------------------------------------------------- \26\ Bo Becker and Todd Milburn, ``Reputation and Competition: Evidence from the Credit Rating Industry,'' Harvard Business School, Working Paper No. 09-051 (2008) (http://ssrn.com/abstract =1278150) at p. 4. \27\ Id. at 17. CHRG-111shrg51303--139 Mr. Dinallo," Yes. I think that when you look at what happened historically, I think you see the worst form of moral hazard and the lack of any kind of retention of exposure in the underwriting process, which would be kind of a short story for the mortgage meltdown. But at the end, when people finally bought those securitized instruments, they went into the marketplace and thought that they were essentially safe because they had credit default insurance on those---- Senator Merkley. I just wanted to make sure I captured your comment correctly, that the credit default swaps were the great enabler of the major financial meltdown we are experiencing. " FinancialCrisisReport--390 At the same time, Mr. Sparks named David Lehman, a commercial mortgage backed securities trader, as the new head of the CDO Origination Desk. Shortly thereafter, Goldman dismantled the CDO Origination Desk and moved all remaining CDO securities to the SPG Trading Desk, where he was based. The SPG Trading Desk, which was a secondary trading desk and had little experience with underwriting, assumed responsibility for marketing the remaining unsold Goldman-originated CDO securities. The SPG Trading Desk’s lack of underwriting experience meant that it was less familiar with the obligations of underwriters and placement agents to disclose all material adverse interests to potential investors. The SPG Trading Desk worked with Goldman’s sales force to market the CDO securities. Goldman employed “hard sell” tactics, repeatedly urging its sales force to sell the CDO securities and target clients with limited CDO familiarity. 1580 After trying the Gameplan’s “targeted” client approach during May, June, and July 2007, the Mortgage Department switched back to issuing sales directives or “axes” to its entire sales force, including sales offices abroad. Axes on CDOs generally went out at weekly or monthly intervals, identified specific CDO securities as top sales priorities, and offered additional financial incentives for selling them. Despite the CDOs’ declining value, the sales force succeeded in selling some of the CDO securities, primarily to clients in Europe, Asia, Australia, and the Middle East, but was unable to sell all of them. The four CDOs that the Subcommittee examined illustrate a variety of conflict of interest issues related to how Goldman designed, marketed, and administered them. Hudson Mezzanine 2006-1. Hudson Mezzanine 2006-1 (Hudson 1) was a $2 billion synthetic CDO comprised of $1.2 billion in ABX assets from Goldman’s own inventory, and $800 million in single name CDS contracts on subprime RMBS and CDO securities that Goldman wanted to short. It was called a “mezzanine” CDO, because the referenced RMBS securities carried the riskier credit ratings of BBB or BBB-. Goldman used the CDO to transfer the risk associated with its ABX assets to investors that bought Hudson 1 securities. Goldman also took 100% of the short side of the CDO, which meant that it would profit if any of the Hudson securities lost value. In addition, Goldman exercised complete control over the CDO by playing virtually every key role in its establishment and administration, including the roles of underwriter, initial purchaser of the issued securities, senior swap counterparty, credit protection buyer, collateral put provider, and liquidation agent. 1579 5/19/2007 “Mortgages CDO Origination – Retained Positions & W arehouse Collateral, May 2007, ” Goldman presentation, GS MBS-E-010951926; 5/20/2007 email from Lee Alexander to Daniel Sparks, Donald M ullen, Lester Brafman, Michael Kaprelian, “Viniar Presentation - Updated, ” GS MBS-E-010965211 (attached file “Mortgages V4.ppt,” “Mortgages Department, May 2007, ” GS M BS-E-010965212). 1580 See discussions of Hudson, Anderson, Timberwolf, and Abacus sales efforts, below. CHRG-111hhrg48867--213 Mr. Plunkett," Congressman, we have heard this several times today, we have heard that we have strong regulation. I just want to correct the record. When it comes to consumer products, we have extremely weak regulation-- " CHRG-111hhrg56847--239 Mr. Bernanke," Again, I don't know what would have happened in the absence. I think it did add to jobs. It did help growth. And clearly we needed that help because the economy was in a very weak condition a year ago. " CHRG-111hhrg56776--181 Mr. Bernanke," If we are the consolidated supervisor, then it's our responsibility, and we need to do a good job to do that. But, of course, there are lots of things to look at. I have to say, in the case of Lehman, it was pretty clear that they were in weak condition, independent of this particular piece of accounting. " FOMC20070816confcall--17 15,MR. DUDLEY.," I think there has been some evidence of a modest uptick in credit cards and auto loans, but I don’t think you can characterize it as severe. I also would say it is in the early days. The really intense part of this market disruption has happened pretty recently. I would be surprised if you found anything showing up in real time. From an economic perspective, if I can put on my old economist hat for just a moment, I would say that the market disruption in terms of its macro consequences presumably will be felt mostly through the provision of mortgage credit in the nonconforming mortgage loan area—large mortgage loans, subprime mortgage loans, or alt-A mortgage loans. The sum of all those was a fairly significant portion of the mortgage market last year. Obviously, the depository institutions can take up some of the slack, but I think it’s probably pretty reasonable to think that mortgage credit availability and mortgage credit underwriting standards are going to be quite different this year than they were in 2006." FinancialCrisisReport--169 In addition, for institutions with assets of $10 billion or more, the FDIC had established a Large Insured Depository Institutions (LIDI) Program to assess and report on emerging risks that may pose a threat to the Deposit Insurance Fund. Under that program, the FDIC Dedicated Examiner and other FDIC regional case managers performed ongoing analysis of emerging risks within each covered institution and assigned it a quarterly risk rating, using a scale of A to E, with A being the best rating and E the worst. In addition, senior FDIC analysts within the Complex Financial Institutions Branch analyzed specific bank risks and developed supervisory strategies. If the FDIC viewed an institution as imposing an increasing risk to the Deposit Insurance Fund, it could perform one or more “special examinations” to take a closer look. C. Washington Mutual Examination History For the five-year period, from 2004 to 2008, OTS repeatedly identified significant problems with Washington Mutual’s lending practices, risk management, appraisal procedures, and issued securities, and requested corrective action. WaMu promised to correct the identified deficiencies, but failed to do so. OTS failed, in turn, to take enforcement action to ensure the corrections were made, until the bank began losing billions of dollars. OTS also resisted and at times impeded FDIC examination efforts at Washington Mutual. (1) Regulatory Challenges Related to Washington Mutual Washington Mutual was a larger and more complex financial institution than any other thrift overseen by OTS, and presented numerous regulatory challenges. By 2007, Washington Mutual had over $300 billion in assets, 43,000 employees, and over 2,300 branches in 15 states, including a securitization office on Wall Street, a massive loan portfolio, and several lines of business, including home loans, credit cards, and commercial real estate. Integration Issues. During the 1990s, as described in the prior chapter, WaMu embarked upon a strategy of growth through acquisition of smaller institutions, and over time became one of the largest mortgage lenders in the United States. One consequence of its acquisition strategy was that WaMu struggled with the logistical and managerial challenges of integrating a variety of lending platforms, information technology systems, staff, and policies into one system. OTS was concerned about and critical of WaMu’s integration efforts. In a 2004 Report on Examination (ROE), OTS wrote: “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.” 608 CHRG-111shrg57319--35 Mr. Cathcart," I had seen a number of internal audits prepared by Randy Melby's group that indicated significant control weaknesses. I was seeing reports that indicated poor performance of the securitized portion of Long Beach mortgages which put us in the lowest quartile of performance. And I believed that we had gaps in our controls associated with Long Beach. Senator Levin. And had there been a surge of loans that had to be repurchased as well? " CHRG-111hhrg54868--49 The Chairman," The gentlewoman from New York. Mrs. McCarthy of New York. Thank you, Mr. Chairman. I appreciate the hearings from this morning and this afternoon, and I appreciate the testimony that we have been hearing. This is a learning curve for a lot of people. Hopefully, a lot of people are watching this on TV so they can actually hear what went down over the past year. And to be very honest with you, it is a learning session for many Members. We sit here on the committee, but there are many Members who are sitting outside that really have no idea what we are talking about. These are difficult subjects. And if you are not in the financial world, it is extremely difficult for the average person to even pick this up. Now, I guess the questions that I want to go to, again, go to the Consumer Financial Protection Agency and what the rules and regulations are going to be. There are many who feel we definitely need something like this, and I am one of them. But we also want to make sure as we do this, we are not going to strangle those corporations that we are trying to help, so they are healthy. It is a fine line when you start to think about it. But I guess one of the things that I would like to have an answer--and I apologize if it was in the full context of your words--but how would a conflict between the agency and a regulatory be solved? And who is going to be on the top of that to make those decisions when you bring all these together? Ms. Bair. I think subprime is an example. Early on, when subprime expanded, it was viewed positively. Lenders that were making these loans were getting some plaudits in the media and elsewhere because they were broadening homeownership. As we saw later, these loans didn't perform, and they weren't serving anyone's interest because long-term, they weren't affordable. There can be differences in perspective on this, and you need synergies between the two. You need both perspectives to be able to evaluate a practice. This is one example of where a tool originally introduced in the nonbank sector spilled into banks. This tool, a type of mortgage product that was originally touted by those offering it as a way to expand homeownership, really ended up hurting a lot of people. But early on, nobody caught it on the safety and soundness side or the consumer protection side. This type of thing can happen in benign environments if a product appears to look good. With a low teaser rate, you can buy a house for a couple of years and figure it out later. Or you can have have a very low downpayment. Ultimately, we saw that did not work. In more benign times, you can get into a situation where a product that looks on the surface like it is going to be proconsumer is actually not. If you look deeper in terms of underwriting quality, it is not in the consumer's long-term interest and certainly not in the lender's long-term interest. " CHRG-111shrg55739--148 PREPARED STATEMENT OF JOHN C. COFFEE, Jr. Adolf A. Berle Professor of Law, Columbia University Law School August 5, 2009 Chairman Dodd, Ranking Member Shelby, and fellow Senators: I am honored to be back before this Committee to discuss the proposed ``Investor Protection Act of 2009'' and its provisions in Subtitle C (Improvement to the Regulation of Credit Rating Agencies). Frankly, I have Yogi Berra's sense of ``deja vu all over again'' in reviewing this legislation, because it borrows very heavily from legislation introduced earlier this year by Senator Reed, which he called the ``Rating Accountability and Transparency Enhancement Act of 2009.'' Senator Reed (and his staff) crafted an important and constructive piece of legislation, and the Administration has wisely adopted most of it. Nonetheless, there are two respects in which the Administration's proposals in my judgment fall short. Unless these two problems are better addressed, I am afraid that the current and unsatisfactory status quo will persist. Credit rating agencies are unlike the other major gatekeepers of the financial markets (e.g., accountants, investment banks, and securities analysts) in two critical respects: 1. Unlike other gatekeepers, the credit rating agencies do not perform due diligence or make its performance a precondition of their ratings. In contrast, accountants are, quite literally, bean counters who do conduct audits. But the credit rating agencies do not make any significant effort to verify the facts on which their models rely (as they freely conceded to this Committee in earlier testimony here). Rather, they simply accept the representations and data provided them by issuers, loan originators, and underwriters. The problem this presents is obvious and fundamental: no model, however well designed, can outperform its information inputs--``Garbage In-Garbage Out.'' Although the Administration's bill does address the need for due diligence, its current form (unlike the Reed bill) may actually discourage third party due diligence. Ultimately, unless the users of credit ratings believe that ratings are based on the real facts and not just a hypothetical set of facts, the credibility of ratings, particularly in the field of structured finance, will remain tarnished, and private housing finance in the U.S. will remain starved and underfunded because it will be denied access to the broader capital markets. 2. Credit rating agencies have long and uniquely been immune from liability to their users. Unlike accountants or investment banks, they have never been held liable. At the same time, because the ``issuer pays'' business model of the ratings agencies seems likely to persist (despite the creative efforts of many who have sought to develop a feasible ``user pays'' model), we have to face the simple reality that the rating agencies have a built-in bias: they are a watchdog paid by the entities they are expected to watch. Because the ratings agencies receive an estimated 90 percent of their revenues from issuers who are paying for their ratings, \1\ the agencies will predictably continue to have a strong desire to please the client who pays them. Moreover, the market for ratings has become more competitive, and the latest empirical research finds that, with greater competition, there has come an increased tendency to inflate ratings. \2\ This is predictable--unless there is some countervailing pressure on the gatekeeper. In the case of accountants and underwriters, there clearly is such countervailing pressure in the form of the threat of liability under the Federal securities laws. But that threat has never had any discernable impact on the credit rating agencies. Let me make clear that I do not want to subject credit rating agencies to class action litigation every time a rating proves to be inaccurate. Rather, the goal should be more modest: to use a litigation threat to induce the rating agencies not to remain willfully ignorant and to insist that due diligence be conducted and certified to them with regard to structured finance offerings.--------------------------------------------------------------------------- \1\ See, Frank Partnoy, ``How and Why Credit Rating Agencies Are Not Like Other Gatekeepers'', (http://ssrn.com/abstract=900257) (May 2006). \2\ See, Bo Becker and Todd J. Milbourn, ``Reputation and Competition: Evidence From the Credit Rating Industry'', (Harv. Bus. School Fin. Working Paper No. 09-051) (2008) (available at http://ssrn.com/abstract=1278150) (finding that the percentage of investment grade ratings went up and the percentage of noninvestment grade ratings went down after competition intensified in the industry, beginning in the late 1990s).---------------------------------------------------------------------------I. The Disappearance of Due Diligence A rapid deterioration in underwriting standards for subprime mortgage loans occurred over a very short period, beginning around 2001. As the chart set forth below shows, low or no-document loans (also known in today's parlance as ``liar's loans'') rose from 28.5 percent in 2001 to 50.7 percent in 2005. \3\--------------------------------------------------------------------------- \3\ See, Allen Ferrell, Jennifer Bethel, and Gang Hu, ``Legal and Economic Issues in Litigation Arising From the 2007-2008 Credit Crisis'', (Harvard Law & Economics Discussion Paper No. 612, Harvard Law School Program in Risk Regulation Research Paper No. 08-5) at Table 4.Concomitantly, interest-only loans (on which no amortization of principal occurred) rose from 0 percent in 2001 to 37.8 percent in 2005. These changes should have prompted the ratings agencies to downgrade their ratings on securitizations based on such loans--but they didn't. As the housing bubble inflated, the ratings agencies slept. Two explanations are possible for their lack of response: (1) the ratings agencies willfully ignored this change, or (2) they managed not to learn about this decline, because issuers did not tell them and they made no independent inquiry. Prior to 2000, the ratings agencies did have a reliable source of information about the quality of the collateral in securitization pools. During this period prior to 2000, investment banks did considerable due diligence on asset-backed securitizations by outsourcing this task to specialized ``due diligence'' firms. These firms (of which Clayton Holdings, Inc. was probably the best known) would send squads of loan reviewers (sometimes a dozen or more) to sample the loans in a securitized portfolio, checking credit scores and documentation. But the intensity of this due diligence review declined over recent years. The Los Angeles Times quotes the CEO of Clayton Holdings to the effect that: Early in the decade, a securities firm might have asked Clayton to review 25 percent to 40 percent of the subprime loans in a pool, compared with typically 10 percent in 2006 . . . \4\--------------------------------------------------------------------------- \4\ See, E. Scott Reckard, ``Subprime Mortgage Watchdogs Kept on Leash; Loan Checkers Say Their Warnings of Risk Were Met With Indifference'', Los Angeles Times, March 17, 2008, at C-1.The President of a leading rival due diligence firm, the Bohan Group, ---------------------------------------------------------------------------made an even more revealing comparison: By contrast, loan buyers who kept the mortgages as an investment instead of packaging them into securities would have 50 percent to 100 percent of the loans examined, Bohan President Mark Hughes said. \5\--------------------------------------------------------------------------- \5\ Id.In short, lenders who retained the loans checked the borrowers carefully, but the investment banks decreased their investment in due diligence, making only an increasingly cursory effort as the bubble inflated. The actual loan reviewers employed by these firms also told the above-quoted Los Angeles Times reporter that supervisors in these firms would often change documentation in order to avoid ``red-flagging mortgages.'' These employees also report regularly encountering inflated documentation and ``liar's loans,'' but, even when they rejected loans, ``loan buyers often bought the rejected mortgages anyway.'' \6\ In short, even when the watchdog barked, no one at the investment banks truly paid attention, and no one told the rating agencies.--------------------------------------------------------------------------- \6\ Id.--------------------------------------------------------------------------- If mortgage-backed securitizations are again to become credible, ratings agencies must be able to distinguish (and verify) whether an asset pool consists mainly of ``liar's loans'' or is instead composed of loans made to creditworthy borrowers. This requires the restoration of due diligence--presumably by independent, third party due diligence firms. Both the Administration bill and the earlier Reed bill make an effort to restore due diligence, but the impact of the Administration's bill is uncertain and possibly even counterproductive. In proposed Section 932(s)(3)(D) (``Transparency of Credit Rating Methodologies and Information Reviewed''), the Administration bill requires disclosure of: whether and to what extent third party due diligence services have been utilized, and a description of the information that such thirty party reviewed in conducting due diligence services.Then, in Section 932(s)(5) (Due Diligence Services), the Administration bill requires that where third-party due diligence services are employed by a nationally recognized statistical rating organization or an issuer or underwriter, the firm providing the due diligence services shall provide to the [NRSRO] written certification of the due diligence, which shall be subject to review by the Commission. This makes great sense--except for the fact that it is optional. The issuer or underwriter (who will likely be the parties retaining and compensating the due diligence firm) may decide that it is easier not to retain such an outside firm than to have to describe its procedures and the information it reviewed and then provide a certification to the ratings agency. In full compliance with 932(s)(3)(D), it could answer that third party firms were not used. To make this appear more palatable, the underwriter might describe some internal review procedures that were followed by its own staff (which would not trigger any mandatory certification to the rating agency). In short, given the choice, issuers and underwriters might prefer the easier course of doing nothing, and thus the current opacity surrounding structured finance offerings would persist. To be sure, some rating agencies might insist on third party due diligence (at least for a period of time), but they might thereby place themselves at a competitive disadvantage and lose business until they gave in. How then can the use of third party due diligence be more effectively encouraged? One very feasible approach might be to focus on the users of credit ratings, for example by instructing mutual funds and other institutional investors that they could not rely on a rating issued by an NRSRO for purposes of their own need to comply with their own ``prudent man'' fiduciary obligations unless the ratings was explicitly based on third party due diligence. This would avoid any conceivable Constitutional issue, because Congress would not be mandating procedures for the NRSRO, but instead would be telling institutional investors what they needed to rely upon. To illustrate this approach, let me give two examples: Under current Rule 3a-7 under the Investment Company Act exempts fixed-income securities issued by a special purpose vehicle from the Investment Company Act if, at the time of sale, the securities are rated in one of four highest categories of investment quality by an NRSRO. \7\ Congress could simply instruct the SEC that such an exemption should also require that the requisite investment grade rating be based on third party due diligence that was certified to the rating agency pursuant to Section 932(s)(5). Similarly, Rule 2a-7 (``Money Market Funds'') under the same Act defines an ``Eligible Security'' as one that has a specified rating given by an NRSRO. \8\ If this rule required that the rating be based in addition on a due diligence certification, money market funds would be effectively required to demand that NRSROs receive such certifications. The attraction of this approach is that it does not mandate what the NRSRO must do, but instead tells the users of ratings what they must have. Effectively, issuers, underwriters and NRSROs would know that they had to use a due diligence firm to verify the critical information assumed by the rating agency's model in they intended to sell the offering to these institutions.--------------------------------------------------------------------------- \7\ See, 17 C.F.R. 270.3a-7. \8\ See, 17 C.F.R. 270.2a-7.--------------------------------------------------------------------------- A second approach to this same end could be achieved through the reformulation of liability rules, as next described.II. Using Liability To Compel Due Diligence The most serious failing in the proposed legislation is that it ducks the issue of enforcement and relies solely on SEC monitoring and disclosure. Even if we assume that the SEC will always be vigilant (which may be a heroic assumption after the Madoff debacle), the SEC is not given any clear authority to mandate due diligence. Moreover, over the last decade, we have seen the rating agencies behave in a manner that approached willful ignorance about changes in the credit environment that were clear to almost everyone else. Here, a balance must be struck. Ratings agencies appear never to have been held liable under the Federal securities laws. \9\ Even in the Enron litigation, a proceeding in which underwriters paid over $7 billion in settlements, the credit rating agencies escaped liability. \10\ Although it is not possible to be aware of every possible settlement in Federal or State court, recent surveys by legal scholars continue to reach this same conclusion. See, e.g., Frank Partnoy, Rethinking Regulation of Credit Rating Agencies: An Institutional Investor Perspective (Council of Institutional Investors White Paper April 2009) at 14-15; Kenneth Kettering,`` Securitization and Its Discontents: The Dynamics of Financial Product Development'', 29 Cardozo L. Rev. 1553, 1687-93 (2008); Arthur R. Pinto, ``Control and Responsibility of Credit Rating Agencies in the U.S.'', 54 Am. J. Comp. L. 341, 351-356 (2006). As a Congressional staff study found in 2002, the rating agencies that qualify as NRSROs are legislatively shielded from liability under the Federal securities laws. \11\ The First Amendment defense is only one of many defenses relied upon by the industry, and probably not the most important. Yet, although many tort law theories have been attempted by plaintiffs, ``the only common element . . . is that the rating agencies win.'' \12\ Since the 2006 legislation, the ratings industry now takes the position that that legislation preempted State tort law and thus precludes even fraud actions based on the common law. \13\ In short, while a settlement may have been paid somewhere in the recent flurry of litigation, the risk of liability for ratings agencies remains remote.--------------------------------------------------------------------------- \9\ Recently, a number of securities class actions have included rating agencies as defendants. In a few cases, Federal courts have refused to grant motions to dismiss sought by the ratings agency. See, e.g., In re Moody's Corp. Sec. Litig., 599 F. Supp. 2d 493 (S.D.N.Y. 2009); In re National Century Financial Enterprises Inc. Invest. Litig., 580 F. Supp. 2d 630 (S.D. Ohio 2008). But this simply means that the plaintiff has survived the first round in a long fight. My discussions with plaintiffs attorneys suggest that they see the underwriters as the ``deep pocket'' defendant in these cases and are not expecting significant contributions from the rating agencies, given the many legal obstacles to suing them. \10\ See, Newby v. Enron Corporation, 511 F. Supp. 2d 741, 815-817 (S.D. Tex. 2005). \11\ See, Staff of the S. Comm. on Governmental Affairs, 107 Cong., Report: Financial Oversight of Enron: The SEC and Private-Sector Watchdogs (Comm. Print Oct. 8, 2002) at 104-05. In particular, Rule 436(g) under the Securities Act of 1933 specifically exempts the ratings agencies from liability as an expert under Section 11 of that Act. \12\ See, Frank Partnoy, ``The Paradox of Credit Ratings'', In Ratings, Rating Agencies, and the Global Financial System, (Richard Levich, et al., eds. 2002) at 79; See, also First Equity Corp. v. Standard & Poor's Corp., 869 F.3d 175 (2d Cir. 1999) (rejecting common law theories under New York and Florida law). \13\ See, Section 15E(c)(2) of the Securities Exchange Act of 1934 (discussed infra), 15 U.S.C. 78o-7(c)(2).--------------------------------------------------------------------------- This does not mean, however, that we should seek to maximize liability. Clearly, the rating agencies cannot be insurers of credit quality and could conceivably be drowned under a sea of liability if the liability rules were greatly liberalized. Precisely for that reason, Senator Reed's bill struck a very sensible compromise in my judgment. It created a standard of liability for the rating agencies, but one with which they easily could comply (if they tried). Specifically, his bill contained a Section 4 (``State of Mind in Private Actions'') that permitted an action against a credit rating agency where: the complaint shall state with particularity facts giving rise to a strong inference that the [rating agency] knowingly or recklessly failed either to conduct a reasonable investigation of the rated security with respect to the factual elements relied upon by its own methodology for evaluating credit risk, or to obtain reasonable verification of such factual elements (which verification may be based on a sampling technique that does not amount to an audit) from other sources that it considered to be competent and that were independent of the issuer and underwriter.This language does not truly expose rating agencies to any serious risk of liability--at least if they either conduct a reasonable investigation themselves or obtain verification from others (such as a due diligence firm) that they reasonably believed to be competent and independent. Given the express certification requirement in the proposed legislation, this language could be picked up and incorporated into an updated revision of the above language in the Reed bill, so that a rating agency would be fully protected when it received such a certification from an independent due diligence firm that covered the basic factual elements in its model. Arguably, this entire liability provision could be limited to structured finance offerings, which is where the real problems lie. The case for this limited litigation threat is that it is unsafe and unsound to let rating agencies remain willfully ignorant. Over the last decade, they have essentially been issuing hypothetical ratings in structured finance transactions based on hypothetical assumed facts provided them by issuers and underwriters. Such conduct is inherently reckless; the damage that it caused is self-evident, and the proposed language would end this state of affairs (without creating anything approaching liability for negligence).III. Drafting Suggestions There are some ambiguities and inconsistencies in the draft bill that should be corrected: 1. First, there is a clear inconsistency between the amendment to Section 15E(c)(2), which would continue to state that: Notwithstanding any other provision of law, neither the Commission nor any State (or political subdivision thereof) may regulate the substance of credit ratings or the procedures and methodologies by which any [NRSRO] determines credit ratings.and proposed Section 932(r), which provides that: The Commission shall prescribe rules . . . with respect to the procedures and methodologies, including qualitative and quantitative models, used by [NRSROs] that require each [NRSRO] to . . .This conflict is dangerous, and it might be cured in part by stating in 15E(c)(2) that: ``except as otherwise specifically provided in this title, neither the Commission nor any State . . . may regulate . . . .'' Even more importantly, Congress should realize that, whatever it may have intended, the ratings industry is arguing in court that this language in Section 15E(c) also preempts common law claims for fraud and negligence. If Congress did not intend to preempt the common law, it should correct this looming misinterpretation and limits its preemption provision so that it does not reach the common law. If fraud can be proven under State law or Blue Sky statutes, such an action should not be preempted. 2. Under existing Section 15E(d), the SEC may censure, suspend (and now fine) an NRSRO for limited reasons only. The last and residual clause (Section 15E(d)(5)) says that such discipline or suspension may be invoked if the NRSRO ``fails to maintain adequate financial and managerial resources to consistently produce credit ratings with integrity.'' This is too high a standard and also too narrow a standard. With the revisions to be made by this legislation, an NRSRO will also be expected to maintain conflict of interest policies and to comply with the SEC's new procedural and disclosure rules under Sections 932 and 933. Hence, this Section should be broadened to read: (5) failed to (i) operate in substantial compliance with the rules promulgated by the Commission, (ii) maintain adequate financial and managerial resources to consistently produce credit ratings with integrity, or (iii) demonstrate sufficient competence or accuracy to justify continued reliance by investors upon its ratings.The last clause would also entitle the Commission to discipline, suspend, or revoke the registration of a ratings agency that was systematically inaccurate or inferior over a sustained period. An incompetent ratings agency does not merit tenure. 3. Proposed 934 requires the SEC to adopt rules requiring issuers to disclose ``preliminary credit ratings received'' from NRSROs. Because the term ``preliminary credit rating'' is not defined, this rule could be easily sidestepped if the NRSRO gave the issuer instead a general (or even a specific) description of how it would evaluate the issuer's credit, but not an actual or tentative rating. Hence, it would be advisable to broaden this section so that it required disclosure of ``preliminary credit ratings or any other assessment or information that informed the issuer of the likely range within which it would be rated or the likely outcome of the rating process.'' 4. If we want the ratings agency to rely on more than the facts provided by the issuer or underwriter, consideration should be given to expanding the required disclosures under 932(s)(3)(E). For example, the new form specified by that Section should require disclosure of: (E) a description of all relevant data, from whatever source learned or received, about any obligor, issuer, security, or money market instrument that was used and relied upon, or considered but not relied upon, for the purpose of determining the credit rating, indicating the source of such information;This is an admittedly broad provision, but aimed at making it more difficult for the rating agency to ignore information from third parties. 5. Consideration should be given to requiring the new compliance officer (which each NRSRO will be required to employ under this legislation) to provide any credible information that it learns indicating fraudulent or unlawful behavior to an appropriate law enforcement agency and/or the SEC. This is in effect a mandatory whistle-blowing provision, and exceptions could be created to cover circumstances when the compliance officer concluded that the information was false or unreliable. ______ CHRG-111shrg51290--67 The combination of easing credit standards and a growing economy resulted in a sharp increase in homeownership rates through 2004. As the credit quality of loans steadily grew worse over 2005 through 2007,\13\ however, the volume of unsustainable loans grew and homeownership rates dropped.\14\ (See Table 1).--------------------------------------------------------------------------- \13\ Subprime mortgage originated in 2005, 2006 and 2007 had successively worse default experiences than vintages in prior years. See Freddie Mac, Freddie Mac Update 19 (December 2008), available at www.freddiemac.com/investors/pdffiles/investor-presentation.pdf. \14\ See Jesse M. Abraham, Andrey Pavlov & Susan Wachter, Explaining the United States' Uniquely Bad Housing Market, XII Wharton Real Estate Rev. 24 (2008).--------------------------------------------------------------------------- Table 1. U.S. Homeownership Rates, by Year (U.S. Census Bureau) The explosion of nontraditional mortgage lending was timed to maintain securitization deal flows after traditional refinancings weakened in 2003. The major take-off in these products occurred in 2002, which coincided with the winding down of the huge increase in demand for mortgage securities through the refinance process. Coming out of the recession of 2001, interest rates fell and there was a massive securitization boom through refinancing that was fueled by low interest rates. The private-label securitization industry had grown in capacity and profits. But in 2003, rising interest rates ended the potential for refinancing at ever lower interest rates, leading to an increased need for another source of mortgages to maintain and grow the rate of securitization and the fees it generated. The ``solution'' was the expansion of the market through nontraditional mortgages, especially interest-only loans and option payment ARMs offering negative amortization. (See Figure 1 supra). This expansion of credit swept a larger portion of the population into the potential homeowner pool, driving up housing demand and prices, and consumer indebtedness. Indeed, consumer indebtedness grew so rapidly that between 1975 and 2007, total household debt soared from around 43 percent to nearly 100 percent of gross domestic product.\15\--------------------------------------------------------------------------- \15\ U.S. Federal Reserve Board, Bureau of Economic Analysis.--------------------------------------------------------------------------- The growth in nonprime mortgages was accomplished through market expansion of nontraditional mortgages and by qualifying more borrowing through easing of traditional lending terms. For example, while subprime mortgages were initially made as ``hard money'' loans with low loan-to-value ratios, by the height of their growth, combined loan-to-value ratios exceeded that of the far less risky prime market. (See Figure 3 supra). While the demand for riskier mortgages grew fueled by the need for product to securitize, the potential risk due to deteriorating lending standards also grew.B. Consumer Confusion If borrowers had been able to distinguish safe loans from highly risky loans, risky loans would not have crowded out the market. But numerous borrowers were not able to do so, for three distinct reasons. First, hybrid subprime ARMs, interest-only mortgages, and option payment ARMs were baffling in their complexity. Second, it was impossible to obtain binding price quotes early enough to permit meaningful comparison shopping in the nonprime market. Finally, borrowers usually did not know that mortgage brokers got higher compensation for steering them into risky loans. Hidden Risks--The arcane nature of hybrid ARMs, interest-only loans, and option payment ARMs often made informed consumer choice impossible. These products were highly complex instruments that presented an assortment of hidden risks to borrowers. Chief among those risks was payment shock--in other words, the risk that monthly payments would rise dramatically upon rate reset. These products presented greater potential payment shock than conventional ARMs, which had lower reset rates and manageable lifetime caps. Indeed, with these exotic ARMs, the only way interest rates could go was up. Many late vintage subprime hybrid ARMs had initial rate resets of 3 percentage points, resulting in increased monthly payments of 50 percent to 100 percent or more.\16\--------------------------------------------------------------------------- \16\ Statement of Sheila C. Bair, Chairman, Federal Deposit Insurance Corporation, on Strengthening the Economy: Foreclosure Prevention and Neighborhood Preservation, before the Committee on Banking, Housing and Urban Affairs, U.S. Senate, 538 Dirksen Senate Office Building, January 31, 2008, www.fdic.gov/news/news/speeches/chairman/spjan3108.html. --------------------------------------------------------------------------- For a borrower to grasp the potential payment shock on a hybrid, interest-only, or option payment ARM, he or she would need to understand all the moving parts of the mortgage, including the index, rate spread, initial rate cap, and lifetime rate cap. On top of that, the borrower would need to predict future interest rate movements and translate expected rate changes into changes in monthly payments. Interest-only ARMs and option payment ARMs had the added complication of potential deferred or negative amortization, which could cause the principal payments to grow. Finally, these loans were more likely to carry large prepayment penalties. To understand the effect of such a prepayment penalty, the borrower would have to use a formula to compute the penalty's size and then assess the likelihood of moving or refinancing during the penalty period.\17\ Truth-in-Lending Act disclosures did not require easy-to-understand disclosures about any of these risks.\18\--------------------------------------------------------------------------- \17\ Federal Reserve System, Truth in Lending, Part III: Final rule, official staff commentary, 73 Fed. Reg. 44522, 44524-25 (July 30, 2008); Federal Reserve System, Truth in Lending, Part II: Proposed rule; request for public comment, 73 Fed. Reg. 1672, 1674 (January 9, 2008). \18\ Patricia A. McCoy, Rethinking Disclosure in a World of Risk-Based Pricing, 44 Harv. J. Legis. 123 (2007), available at http://www.law.harvard.edu/students/orgs/jol/vol44_1/mccoy.pdf. --------------------------------------------------------------------------- Inability to Do Meaningful Comparison Shopping--The lack of binding rate quotes also hindered informed comparison-shopping in the nonprime market. Nonprime loans had many rates, not one, which varied according to the borrower's risk, the originator's compensation, the documentation level of the loan, and the naivety of the borrower. Between their complicated price structure and the wide variety of products, subprime loans were not standardized. Furthermore, it was impossible to obtain a binding price quote in the subprime market before submitting a loan application and paying a non-refundable fee. Rate locks were also a rarity in the subprime market. In too many cases, subprime lenders waited until the closing to unveil the true product and price for the loan, a practice that the Truth in Lending Act rules countenanced. These rules, promulgated by the Federal Reserve Board, helped foster rampant ``bait-and-switch'' schemes in the subprime market.\19\--------------------------------------------------------------------------- \19\ Id.; Federal Reserve System, Truth in Lending--Proposed rule; request for public comment, 73 Fed. Reg. 1672, 1675 (Jan. 9, 2008).--------------------------------------------------------------------------- As a result, deceptive advertising became a stock-in-trade of the nonprime market. Nonprime lenders and brokers did not advertise their prices to permit meaningful comparison-shopping. To the contrary, lenders treated their rate sheets--which listed their price points and pricing criteria--as proprietary secrets that were not to be disclosed to the mass consumer market. Subprime advertisements generally focused on fast approval and low initial monthly payments or interest rates, not on accurate prices. While the Federal Reserve exhorted people to comparison-shop for nonprime loans,\20\ in reality, comparison-shopping was futile. Nonprime lenders did not post prices, did not provide consumers with firm price quotes, and did not offer lock-in commitments as a general rule. Anyone who attempted to comparison-shop had to pay multiple application fees for the privilege and, even then, might not learn the actual price until the closing if the lender engaged in a bait-and-switch.--------------------------------------------------------------------------- \20\ See, e.g., Federal Reserve Board, Looking for the Best Mortgage, www.federalreserve.gov/pubs/mortgage/mortb_11.htm.--------------------------------------------------------------------------- As early as 1998, the Federal Reserve Board and the Department of Housing and Urban Development were aware that Truth in Lending Act disclosures did not come early enough in the nonprime market to allow meaningful comparison shopping. That year, the two agencies issued a report diagnosing the problem. In the report, HUD recommended changes to the Truth in Lending Act to require mortgage originators to provide binding price quotes before taking loan applications. The Federal Reserve Board dissented from the proposal, however, and it was never adopted.\21\ To this day, the Board has still not revamped Truth in Lending disclosures for closed-end mortgages.--------------------------------------------------------------------------- \21\ See Bd. of Governors of the Fed. Reserve Sys. & Dep't of Hous. & Urban Dev., Joint Report to the Congress, Concerning Reform to the Truth in Lending Act and the Real Estate Settlement Procedures Act, at 28-29, 39-42 (1998), available at www.federalreserve.gov/boarddocs/rptcongress/tila.pdf.--------------------------------------------------------------------------- Perverse Fee Incentives--Finally, many consumers were not aware that the compensation structure rewarded mortgage brokers for riskier loan products and higher interest rates. Mortgage brokers only got paid if they closed a loan. Furthermore, they were paid solely through upfront fees at closing, meaning that if a loan went bad, the losses would fall on the lender or investors, not the broker. In the most pernicious practice, lenders paid brokers thousands of dollars per loan in fees known as yield spread premiums (or YSPs) in exchange for loans saddling borrowers with steep prepayment penalties and higher interest rates than the borrowers qualified for, based on their incomes and credit scores. In sum, these three features--the ability to hide risk, thwart meaningful comparison-shopping, and reward steering--allowed lenders to entice unsuspecting borrowers into needlessly hazardous loans.C. The Crowd-Out Effect The ability to bury risky product features in fine print allowed irresponsible lenders to out-compete safe lenders. Low initial monthly payments were the most visible feature of hybrid ARMs, interest-only loans, and option payment ARMs. During the housing boom, lenders commonly touted these products based on low initial monthly payments while obscuring the back-end risks of those loans.\22\--------------------------------------------------------------------------- \22\ See, e.g., Julie Haviv & Emily Kaiser, Web lenders woo subprime borrowers despite crisis, Reuters (Apr. 22, 2007); E. Scott Reckard, Refinance pitches in sub-prime tone, Los Angeles Times, October 29, 2007.--------------------------------------------------------------------------- The ability to hide risks made it easy to out-compete lenders offered fixed-rate, fully amortizing loans. Other things being equal, the initial monthly payments on exotic ARMs were lower than on fixed-rate, amortizing loans. Furthermore, some nonprime lenders qualified borrowers solely at the low initial rate alone until the Federal Reserve Board finally banned that practice in July 2008.\23\--------------------------------------------------------------------------- \23\ In fall 2006, Federal regulators issued an interagency guidance advising option ARM lenders to qualify borrowers solely at the fully indexed rate. Nevertheless, Washington Mutual (WaMu) apparently continued to qualify applicants for option ARMs at the low, introductory rate alone until mid-2007. It was not until July 30, 2007 that WaMu finally updated its ``Bulk Seller Guide'' to require its correspondents to underwrite option ARMs and other ARMs at the fully indexed rate.--------------------------------------------------------------------------- Of course, many sophisticated customers recognized the dangers of these loans. That did not deter lenders from offering hazardous nontraditional ARMs, however. Instead, the ``one-sizefits-one'' nature of nonprime loans permitted lenders to discriminate by selling safer products to discerning customers and more lucrative, dangerous products to naive customers. Sadly, the consumers who were least well equipped in terms of experience and education to grasp arcane loan terms \24\ ended up with the most dangerous loans.--------------------------------------------------------------------------- \24\ Howard Lax, Michael Manti, Paul Raca & Peter Zorn, Subprime Lending: An Investigation of Economic Efficiency, 15 Housing Pol'y Debate 533, 552-554 (2004), http://www.fanniemaefoundation.org/programs/hpd/pdf/hpd_1503_Lax.pdf. --------------------------------------------------------------------------- In the meantime, lenders who offered safe products--such as fixed-rate prime loans--lost market share to lenders who peddled exotic ARMs with low starting payments. As conventional lenders came to realize that it didn't pay to compete on good products, those lenders expanded into the nonprime market as well.II. The Regulatory Story: Race to the Bottom Federal banking regulators added fuel to the crisis by allowing reckless loans to flourish. It is a basic tenet of banking law that banks should not extend credit without proof of ability to repay. Federal banking regulators \25\ had ample authority to enforce this tenet through safety and soundness supervision and through Federal consumer protection laws. Nevertheless, they refused to exercise their substantial powers of rulemaking, formal enforcement, and sanctions to crack down on the proliferation of poorly underwritten loans until it was too late. Their abdication allowed irresponsible loans to multiply. Furthermore, their green light to banks to invest in investment-grade subprime mortgage-backed securities and CDOs left the nation's largest banks struggling with toxic assets. These problems were a direct result of the country's fragmented system of financial regulation, which caused regulators to compete for turf.--------------------------------------------------------------------------- \25\ The four Federal banking regulators include the Federal Reserve System, which serves as the central bank and supervises State member banks; the Office of the Comptroller of the Currency, which oversees national banks; the Federal Deposit Insurance Corporation, which operates the Deposit Insurance Fund and regulates State nonmember banks; and the Office of Thrift Supervision, which supervises savings associations.---------------------------------------------------------------------------A. The Fragmented U.S. System of Mortgage Regulation In the United States, the home mortgage lending industry operates under a fragmented regulatory structure which varies according to entity.\26\ Banks and thrift institutions are regulated under Federal banking laws and a subset of those institutions--namely, national banks, Federal savings associations, and their subsidiaries--are exempt from State anti-predatory lending and credit laws by virtue of Federal preemption. In contrast, mortgage brokers and independent non-depository mortgage lenders escape Federal banking regulation but have to comply with all State laws in effect. Only State-chartered banks and thrifts in some states (a dwindling group) are subject to both sets of laws.--------------------------------------------------------------------------- \26\ This discussion is drawn from Patricia A. McCoy & Elizabeth Renuart, The Legal Infrastructure of Subprime and Nontraditional Mortgage Lending, in Borrowing to Live: Consumer and Mortgage Credit Revisited 110 (Nicolas P. Retsinas & Eric S. Belsky eds., Joint Center for Housing Studies of Harvard University & Brookings Institution Press, 2008).--------------------------------------------------------------------------- Under this dual system of regulation, depository institutions are subject to a variety of Federal examinations, including fair lending, Community Reinvestment Act, and safety and soundness examinations, but independent nondepository lenders are not. Similarly, banks and thrifts must comply with other provisions of the Community Reinvestment Act, including reporting requirements and merger review. Federally insured depository institutions must also meet minimum risk-based capital requirements and reserve requirements, unlike their independent non-depository counterparts. Some Federal laws applied to all mortgage originators. Otherwise, lenders could change their charter and form to shop for the friendliest regulatory scheme.B. Applicable Law Despite these differences in regulatory regimes, the Federal Reserve Board did have the power to prohibit reckless mortgages across the entire mortgage industry. The Board had this power by virtue of its authority to administer a Federal anti-predatory lending law known as ``HOEPA.''1. Federal Law Following deregulation of home mortgages in the early 1980's, disclosure became the most important type of Federal mortgage regulation. The Federal Truth in Lending Act (TILA),\27\ passed in 1968, mandates uniform disclosures regarding cost for home loans. Its companion law, the Federal Real Estate Settlement Procedures Act of 1974 (RESPA),\28\ requires similar standardized disclosures for settlement costs. Congress charged the Federal Reserve with administering TILA and the Department of Housing and Urban Development with administering RESPA.--------------------------------------------------------------------------- \27\ 15 U.S.C. 1601-1693r (2000). \28\ 12 U.S.C. 2601-2617 (2000).--------------------------------------------------------------------------- In 1994, Congress augmented TILA and RESPA by enacting the Home Ownership and Equity Protection Act (HOEPA).\29\ HOEPA was an early Federal anti-predatory lending law and prohibits specific abuses in the subprime mortgage market. HOEPA applies to all residential mortgage lenders and mortgage brokers, regardless of the type of entity.--------------------------------------------------------------------------- \29\ 15 U.S.C. 1601, 1602(aa), 1639(a)-(b).--------------------------------------------------------------------------- HOEPA has two important provisions. The first consists of HOEPA's high-cost loan provision,\30\ which regulates the high-cost refinance market. This provision seeks to eliminate abuses consisting of ``equity stripping.'' It is hobbled, however, by its extremely limited reach--covering only the most exorbitant subprime mortgages--and its inapplicability to home purchase loans, reverse mortgages, and open-end home equity lines of credit.\31\ Lenders learned to evade the high-cost loan provisions rather easily by slightly lowering the interest rates and fees on subprime loans below HOEPA's thresholds and by expanding into subprime purchase loans.--------------------------------------------------------------------------- \30\ 15 U.S.C. Sec. 1602(aa)(1)-(4); 12 C.F.R. 226.32(a)(1), (b)(1). \31\ 15 U.S.C. Sec. 1602(i), (w), (bb); 12 C.F.R. 226.32(a)(2) (1997); Edward M. Gramlich, Subprime Mortgages: America's Latest Boom and Bust 28 (Urban Institute Press, 2007).--------------------------------------------------------------------------- HOEPA also has a second major provision, which gives the Federal Reserve Board the authority to prohibit unfair or deceptive lending practices and refinance loans involving practices that are abusive or against the interest of the borrower.\32\ This provision is potentially broader than the high-cost loan provision, because it allows regulation of both the purchase and refinance markets, without regard to interest rates or fees. However, it was not self-activating. Instead, it depended on action by the Federal Reserve Board to implement the provision, which the Board did not take until July 2008.--------------------------------------------------------------------------- \32\ 15 U.S.C. 1639(l)(2).---------------------------------------------------------------------------2. State Law Before 2008, only the high-cost loan provision of HOEPA was in effect as a practical matter. This provision had a serious Achilles heel, consisting of its narrow coverage. Even though the Federal Reserve Board lowered the high-cost triggers of HOEPA effective in 2002, that provision still only applied to 1 percent of all subprime home loans.\33\--------------------------------------------------------------------------- \33\ Gramlich, supra note 31 (2007, p. 28).--------------------------------------------------------------------------- After 1994, it increasingly became evident that HOEPA was incapable of halting equity stripping and other sorts of subprime abuses. By the late 1990s, some cities and states were contending with rising foreclosures and some jurisdictions were contemplating regulating subprime loans on their own. Many states already had older statutes on the books regulating prepayment penalties and occasionally balloon clauses. These laws were relatively narrow, however, and did not address other types of new abuses that were surfacing in subprime loans. Consequently, in 1999, North Carolina became the first State to enact a comprehensive anti-predatory lending law.\34\ Soon, other states followed suit and passed anti-predatory lending laws of their own. These newer State laws implemented HOEPA's design but frequently expanded coverage or imposed stricter regulation on subprime loans. By year-end 2005, 29 States and the District of Columbia had enacted one of these ``mini-HOEPA'' laws. Some States also passed stricter disclosure laws or laws regulating mortgage brokers. By the end of 2005, only six States--Arizona, Delaware, Montana, North Dakota, Oregon, and South Dakota--lacked laws regulating prepayment penalties, balloon clauses, or mandatory arbitration clauses, all of which were associated with exploitative subprime loans.\35\--------------------------------------------------------------------------- \34\ N.C. Gen Stat. 24-1.1E (2000). \35\ See Raphael Bostic, Kathleen C. Engel, Patricia A. McCoy, Anthony Pennington-Cross & Susan Wachter, State and Local Anti-Predatory Lending Laws: The Effect of Legal Enforcement Mechanisms, 60 J. Econ. & Bus. 47-66 (2008), full working paper version available at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1005423. --------------------------------------------------------------------------- Critics, including some Federal banking regulators, have blamed the states for igniting the credit crisis through lax regulation. Certainly, there were states that were largely unregulated and there were states where mortgage regulation was weak. Mortgage brokers were loosely regulated in too many states. Similarly, the states never agreed on an effective, uniform system of mortgage regulation. Nevertheless, this criticism of the states disregards the hard-fought efforts by a growing number of states--which eventually grew to include the majority of states--to regulate abusive subprime loans within their borders. State attorneys general and State banking commissioners spearheaded some of the most important enforcement actions against deceptive mortgage lenders.\36\--------------------------------------------------------------------------- \36\ For instance, in 2002, State authorities in 44 states struck a settlement with Household Finance Corp. for $484 million in consumer restitution and changes in its lending practices following enforcement actions to redress alleged abusive subprime loans. Iowa Attorney General, States Settle With Household Finance: Up to $484 Million for Consumers (Oct. 11, 2002), available at www.iowa.gov/government/ag/latest_news/releases/oct_2002/Household_Chicago.html. In 2006, forty-nine states and the District of Columbia reached a $325 million settlement with Ameriquest Mortgage Company over alleged predatory lending practices. See, e.g., Press Release, Iowa Dep't of Justice, Miller: Ameriquest Will Pay $325 Million and Reform its Lending Practices (Jan. 23, 2006), available at http://www.state.ia.us/government/ag/latest_news/releases/jan_2006/Ameriquest_Iowa.html. ---------------------------------------------------------------------------C. The Ability to Shop For Hospitable Laws and Regulators State-chartered banks and thrifts and their subsidiaries had to comply with the State anti-predatory lending laws. So did independent nonbank lenders and mortgage brokers. For the better part of the housing boom, however, national banks, Federal savings associations, and their mortgage lending subsidiaries did not have to comply with the State anti-predatory lending laws due to Federal preemption rulings by their Federal regulators. This became a problem because Federal regulators did not replace the preempted State laws with strong Federal underwriting rules.1. Federal Preemption The states that enacted anti-predatory lending laws did not legislate in a vacuum. In 1996, the Federal regulator for thrift institutions--the Office of Thrift Supervision or OTS--promulgated a sweeping preemption rule declaring that henceforth Federal savings associations did not have to observe State lending laws.\37\ Initially, this rule had little practical effect because any State anti-predatory lending provisions on the books then were fairly narrow.\38\--------------------------------------------------------------------------- \37\ 12 C.F.R. 559.3(h), 560.2. \38\ Bostic et al., supra note 35; Office of Thrift Supervision, Responsible Alternative Mortgage Lending: Advance notice of proposed rulemaking, 65 Fed. Reg. 17811, 17814-16 (2000).--------------------------------------------------------------------------- Following adoption of the OTS preemption rule, Federal thrift institutions and their subsidiaries were relieved from having to comply with State consumer protection laws. That was not true, however, for national banks, State banks, State thrifts, and independent nonbank mortgage lenders and brokers. The stakes rose considerably starting in 1999, when North Carolina passed the first comprehensive State anti-predatory lending law. As State mini-HOEPA laws proliferated, national banks lobbied their regulator--a Federal agency known as the Office of the Comptroller of the Currency or OCC--to clothe them with the same Federal preemption as Federal savings associations. They succeeded and, in 2004, the OCC issued its own preemption rule banning the states from enforcing their laws impinging on real estate lending by national banks and their subsidiaries.\39\ In a companion rule, the OCC denied permission to the states to enforce their own laws that were not federally preempted--state lending discrimination laws are one example--against national banks and their subsidiaries. After a protracted court battle, the controversy ended up in the U.S. Supreme Court, which upheld the OCC preemption rule.\40\--------------------------------------------------------------------------- \39\ Office of the Comptroller of the Currency, Bank Activities and Operations; Final rule, 69 Fed. Reg. 1895 (2004) (codified at 12 C.F.R. 7.4000); Office of the Comptroller of the Currency, Bank Activities and Operations; Real Estate Lending and Appraisals; Final rule, 69 Fed. Reg. 1904 (2004) (codified at 12 C.F.R. 7.4007-7.4009, 34.4). National City Corporation, the parent of National City Bank, N.A., and a major subprime lender, spearheaded the campaign for OCC preemption. Predatory lending laws neutered, Atlanta Journal Constitution, Aug. 6, 2003. \40\ Watters v. Wachovia Bank, N.A., 550 U.S. 1 (2007); Arthur E. Wilmarth, Jr., The OCC's Preemption Rules Exceed the Agency's Authority and Present a Serious Threat to the Dual Banking System, 23 Ann. Rev. Banking & Finance Law 225 (2004). The Supreme Court recently granted certiorari to review the legality of the OCC visitorial powers rule. Cuomo v. Clearing House Ass'n, L.L.C.,__U.S.__, 129 S. Ct. 987 (2009). The OCC and the OTS left some areas of State law untouched, namely, State criminal law and State law regulating contracts, torts, homestead rights, debt collection, property, taxation, and zoning. Both agencies, though, reserved the right to declare that any State laws in those areas are preempted in the future. For fuller discussion, see. McCoy & Renuart, supra note 26.--------------------------------------------------------------------------- OTS and the OCC had institutional motives to grant Federal preemption to the institutions that they regulated. Both agencies depend almost exclusively on fees from their regulated entities for their operating budgets. Both were also eager to persuade State-chartered depository institutions to convert to a Federal charter. In addition, the OCC was aware that if national banks wanted Federal preemption badly enough, they might defect to the thrift charter to get it. Thus, the OCC had reason to placate national banks to keep them in its fold. Similarly, the OTS was concerned about the steady decline in thrift institutions. Federal preemption provided an inducement to thrift institutions to retain the Federal savings association charter.2. The Ability to Shop for the Most Permissive Laws As a result of Federal preemption, State anti-predatory lending laws applied to State-chartered depository institutions and independent nonbank lenders, but not to national banks, Federal savings associations, or their mortgage lending subsidiaries. The only anti-predatory lending provisions that national banks and federally chartered thrifts had to obey were HOEPA and agency pronouncements on subprime and nontraditional mortgage loans.\41\ Of these, HOEPA had extremely narrow scope. Meanwhile, agency guidances lacked the binding effect of rules and their content was not as strict as the stronger State laws.--------------------------------------------------------------------------- \41\ Board of Governors of the Federal Reserve System et al., Interagency Guidance on Subprime Lending (March 1, 1999); OCC, Abusive Lending Practices, Advisory Letter 2000-7 (July 25, 2000); OCC et al., Expanded Guidance for Subprime Lending Programs (Jan. 31, 2001); OCC, Avoiding Predatory and Abusive Lending Practices in Brokered and Purchased Loans, Advisory Letter 2003-3 (Feb. 21, 2003); OCC, Guidelines for National Banks to Guard Against Predatory and Abusive Lending Practices, Advisory Letter 2003-2 (Feb. 21, 2003); OCC, OCC Guidelines Establishing Standards for Residential Mortgage Lending Practices, 70 Fed. Reg. 6329 (2005); Department of the Treasury et al., Interagency Guidance on Nontraditional Mortgage Product Risks; Final guidance, 71 Fed. Reg. 58609 (2006); Department of the Treasury et al., Statement on Subprime Mortgage Lending; Final guidance, 72 Fed. Reg. 37569 (2007). Of course, these lenders, like all lenders, are subject to prosecution in cases of fraud. Lenders are also subject to the Federal Trade Commission Act, which prohibits unfair and deceptive acts and practices (UDAPs). However, Federal banking regulators were slow to propose rules to define and punish UDAP violations by banking companies in the mortgage lending area.--------------------------------------------------------------------------- This dual regulatory system allowed mortgage lender to play regulators off one another by threatening to change charters. Mortgage lenders are free to operate with or without depository institution charters. Similarly, depository institutions can choose between a State and Federal charter and between a thrift charter and a commercial bank charter. Each of these choices allows a lender to change regulators. A lender could escape a strict State law by switching to a Federal bank or thrift charter or by shifting its operations to a less regulated State. Similarly, a lender could escape a strict regulator by converting its charter to one with a more accommodating regulator. Countrywide, the nation's largest mortgage lender and a major subprime presence, took advantage of this system to change its regulator. One of its subsidiaries, Countrywide Home Loans, was supervised by the Federal Reserve. This subsidiary switched and became an OTS-regulated entity as of March 2007. That same month, Countrywide Bank, N.A., converted its charter from a national bank charter under OCC supervision to a Federal thrift charter under OTS supervision. Reportedly, OTS promised Countrywide's executives to be a ``less antagonistic'' regulator if Countrywide switched charters to OTS. Six months later, the regional deputy director of the OTS West Region, where Countrywide was headquartered, was promoted to division director. Some observers considered it a reward.\42\--------------------------------------------------------------------------- \42\ Richard B. Schmitt, Regulator takes heat over IndyMac, Los Angeles Times, Oct. 6, 2008; see also Binyamin Appelbaum & Ellen Nakashima, Regulator Played Advocate Over Enforcer, Washington Post, November 23, 2008.--------------------------------------------------------------------------- The result was a system in which lenders could shop for the loosest laws and enforcement. This shopping process, in turn, put pressure on regulators at all levels--state and local--to lower their standards or relax enforcement. What ensued was a regulatory race to the bottom.III. Regulatory Failure Federal preemption would not have been such a problem if Federal banking regulators had replaced State laws with tough rules and enforcement of their own. Those regulators had ample power to stop the deterioration in mortgage underwriting standards that mushroomed into a full-blown crisis. However, they refused to intervene in disastrous lending practices until it was too late. As a result, federally regulated lenders--as well as all lenders operating in states with weak regulation--were given carte blanche to loosen their lending standards free from meaningful regulatory intervention.A. The Federal Reserve Board The Federal Reserve Board had the statutory power, starting in 1994, to curb lax lending not only for depository institutions, but for all lenders across-the-board. It declined to exercise that power in any meaningful respect, however, until after the nonprime mortgage market collapsed. In the mortgage lending area, the Fed's supervisory process has three major parts and breakdowns were apparent in two out of the three. The only part that appeared to work well was the Fed's role as the primary Federal regulator for State-chartered banks that are members of the Federal Reserve System.\43\--------------------------------------------------------------------------- \43\ In general, these are community banks on the small side. In 2007 and 2008, only one failed bank--the tiny First Georgia Community Bank in Jackson, Georgia, with only $237.5 million in assets--was regulated by the Federal Reserve System. It is not clear whether the Fed's performance is explained by the strength of its examination process, the limited role of member banks in risky lending, the fact that State banks had to comply with State anti-predatory lending laws, or all three. In the following discussion on regulatory failure by the Federal Reserve Board, the OTS, and the OCC, the data regarding failed and near-failed banks and thrifts come from Federal bank regulatory and S.E.C. statistics, disclosures, press releases, and orders; rating agency reports; press releases and other web materials by the companies mentioned; statistics compiled by the American Banker; and financial press reports.--------------------------------------------------------------------------- As the second part of its supervisory duties, the Fed regulates nonbank mortgage lenders owned by bank holding companies but not owned directly or indirectly by banks or thrifts. During the housing boom, some of the largest subprime and Alt-A lenders were regulated by the Fed, including the top- and third-ranked subprime lenders in 2006, HSBC Finance and Countrywide Financial Corporation, and Wells Fargo Financial, Inc.\44\ The Fed's supervisory record with regard to these lenders was mixed. On one notable occasion, in 2004, the Fed levied a $70 million civil money penalty against CitiFinancial Credit Company and its parent holding company, Citigroup Inc., for subprime lending abuses.\45\ Apart from that, the Fed did not take public enforcement action against the nonbank lenders that it regulated. That may be because the Federal Reserve did not routinely examine the nonbank mortgage lending subsidiaries under its supervision, which the late Federal Reserve Board Governor Edward Gramlich revealed in 2007. Only then did the Fed kick off a ``pilot project'' to examine the nonbank lenders under its jurisdiction on a routine basis for loose underwriting and compliance with Federal consumer protection laws.\46\--------------------------------------------------------------------------- \44\ Data provided by American Banker, available at www.americanbanker.com. \45\ Federal Reserve, Citigroup Inc. New York, New York and Citifinancial Credit Company Baltimore, Maryland: Order to Cease and Desist and Order of Assessment of a Civil Money Penalty Issued Upon Consent, May 27, 2004. \46\ Edward M. Gramlich, Boom and Busts, The Case of Subprime Mortgages, Speech given August 31, 2007, Jackson Hole, Wyo., at symposium titled ``Housing, Housing Finance & Monetary Policy,'' sponsored by the Federal Reserve Bank of Kansas City, pp. 8-9, available at www.kansascityfed.org/publicat/sympos/2007/pdf/2007.09.04.gramlich.pdf; Speech by Governor Randall S. Kroszner At the National Bankers Association 80th Annual convention, Durham, North Carolina, October 11, 2007.--------------------------------------------------------------------------- Finally, the Board is responsible for administering most Federal consumer credit protection laws, including HOEPA. When former Governor Edward Gramlich served on the Fed, he urged then-Chairman Alan Greenspan to exercise the Fed's power to address unfair and deceptive loans under HOEPA. Greenspan refused, preferring instead to rely on non-binding statements and guidances.\47\ This reliance on statements and guidances had two disadvantages: one, major lenders routinely dismissed the guidances as mere ``suggestions'' and, two, guidances did not apply to independent nonbank mortgage lenders.--------------------------------------------------------------------------- \47\ House of Representatives, Committee on Oversight and Government Reform, ``The Financial Crisis and the Role of Federal Regulators, Preliminary Transcript'' 35, 37-38 (Oct. 23, 2008), available at http://oversight.house.gov/documents/20081024163819.pdf. Greenspan told the House Oversight Committee in 2008: Well, let's take the issue of unfair and deceptive practices, which is a fundamental concept to the whole predatory lending issue. The staff of the Federal Reserve . . . say[ ] how do they determine as a regulatory group what is unfair and deceptive? And the problem that they were concluding . . . was the issue of maybe 10 percent or so are self-evidently unfair and deceptive, but the vast majority would require a jury trial or other means to deal with it . . . Id. at 89.--------------------------------------------------------------------------- The Federal Reserve did not relent until July 2008, when under Chairman Ben Bernanke's leadership, it finally promulgated binding HOEPA regulations banning specific types of lax and abusive loans. Even then, the regulations were mostly limited to higher-priced mortgages, which the Board confined to first-lien loans of 1.5 percentage points or more above the average prime offer rate for a comparable transaction, and 3.5 percentage points for second-lien loans. Although shoddy nontraditional mortgages below those triggers had also contributed to the credit crisis, the rule left those loans--plus prime loans--mostly untouched.\48\--------------------------------------------------------------------------- \48\ Federal Reserve System, Truth in Lending: Final rule; official staff commentary, 73 Fed. Reg. 44522, 44536 (July 30, 2008). The Board set those triggers with the intention of covering the subprime market, but not the prime market. See id. at 44536-37.--------------------------------------------------------------------------- The rules, while badly needed, were too little and too late. On October 23, 2008, in testimony before the U.S. House of Representatives Oversight Committee, Greenspan admitted that ``those of us who have looked to the self-interest of lending institutions to protect shareholder's equity (myself especially) are in a state of shocked disbelief.'' House Oversight Committee Chairman Henry Waxman asked Greenspan whether ``your ideology pushed you to make decisions that you wish you had not made?'' Greenspan replied:\49\--------------------------------------------------------------------------- \49\ House of Representatives, Committee on Oversight and Government Reform, ``The Financial Crisis and the Role of Federal Regulators, Preliminary Transcript'' 36-37 (Oct. 23, 2008), available at http://oversight.house.gov/documents/20081024163819.pdf. Mr. GREENSPAN. . . . [Y]es, I found a flaw, I don't know how significant or permanent it is, but I have been very distressed by that fact . . . Chairman WAXMAN. You found a flaw? Mr. GREENSPAN. I found a flaw in the model that defines how the world works, so to speak. Chairman WAXMAN. In other words, you found that your view of the world, your ideology, was not right, it was not working. Mr. GREENSPAN. Precisely. That's precisely the reason I was shocked, because I had been going for 40 years or more with very considerable evidence that it was working exceptionally well.\50\ \50\ Testimony of Dr. Alan Greenspan before the House of Representatives Committee of Government Oversight and Reform, October 23, 2008, available at http://oversight.house.gov/documents/20081023100438.pdf.---------------------------------------------------------------------------B. Regulatory Lapses by the OCC and OTS Federal preemption might not have devolved into a banking crisis of systemic proportions had OTS and the OCC replaced State regulation for their regulated entities with a comprehensive set of binding rules prohibiting lax underwriting of home mortgages. Generally, in lieu of binding rules, Federal banking regulators, including the OCC and OTS, issued a series of ``soft law'' advisory letters and guidelines against predatory or unfair mortgage lending practices by insured depository institutions.\51\ Federal regulators disavowed binding rules during the run-up to the subprime crisis on grounds that the guidelines were more flexible and that the agencies enforced those guidelines through bank examinations and informal enforcement actions.\52\ Informal enforcement actions were usually limited to negotiated, voluntary agreements between regulators and the entities that they supervised, which made it easy for management to drag out negotiations to soften any restrictions and to bid for more time. Furthermore, examinations and informal enforcement are highly confidential, making it easy for a lax regulator to hide its tracks.--------------------------------------------------------------------------- \51\ See note 41 supra. \52\ Office of the Comptroller of the Currency, Bank Activities and Operations; Real Estate Lending and Appraisals; Final rule, 69 Fed. Reg. 1904 (2004).---------------------------------------------------------------------------1. The Office of Thrift Supervision Although OTS was the first agency to adopt Federal preemption, it managed to fly under the radar during the subprime boom, overshadowed by its larger sister agency, the OCC. After 2003, while commentators were busy berating the OCC preemption rule, OTS allowed the largest Federal savings associations to embark on an aggressive campaign of expansion through option payment ARMs, subprime loans, and low-documentation and no-documentation loans. Autopsies of failed depository institutions in 2007 and 2008 show that five of the seven biggest failures were OTS-regulated thrifts. Two other enormous thrifts during that period--Wachovia Mortgage, FSB and Countrywide Bank, FSB--were forced to arrange hasty takeovers by large bank holding companies to avoid failing. By December 31, 2008, thrifts totaling $355 billion in assets had failed in the previous sixteen months on OTS' watch. The reasons for the collapse of these thrifts evidence fundamental regulatory lapses by OTS. Almost all of the thrifts that failed in 2007 and 2008--and all of the larger ones--succumbed to massive levels of imprudent home loans. IndyMac Bank, FSB, which became the first major thrift institution to fail during the current crisis in July 2008, manufactured its demise by becoming the nation's top originator of low-documentation and no-documentation loans. These loans, which became known as ``liar's loans,'' infected both the subprime market and credit to borrowers with higher credit scores. By 2006 and 2007, over half of IndyMac's home purchase loans were subprime loans and IndyMac Bank approved up to half of those loans based on low or no documentation. Washington Mutual Bank, popularly known as ``WaMu,'' was the nation's largest thrift institution in 2008, with over $300 billion in assets. WaMu became the biggest U.S. depository institution in history to fail on September 25, 2008, in the wake of the Lehman Brothers bankruptcy. WaMu was so large that OTS examiners were stationed there permanently onsite. Nevertheless, from 2004 through 2006, despite the daily presence of the resident OTS inspectors, risky option ARMs, second mortgages, and subprime loans constituted over half of WaMu's real estate loans each year. By June 30, 2008, over one fourth of the subprime loans that WaMu originated in 2006 and 2007 were at least thirty days past due. Eventually, it came to light that WaMu's management had pressured its loan underwriters relentlessly to approve more and more exceptions to WaMu's underwriting standards in order to increase its fee revenue from loans.\53\--------------------------------------------------------------------------- \53\ Peter S. Goodman & Gretchen Morgenson, Saying Yes, WaMu Built Empire on Shaky Loans, N.Y. Times, Dec. 28, 2008.--------------------------------------------------------------------------- Downey Savings & Loan became the third largest depository institution to fail in 2008. Like WaMu, Downey had loaded up on option ARMs and subprime loans. When OTS finally had to put it into receivership, over half of Downey's total assets consisted of option ARMs and nonperforming loans accounted for over 15 percent of the thrift's total assets. In short, the three largest depository institution failures in 2007 and 2008 resulted from high concentrations of poorly underwritten loans, including low- and no-documentation ARMs (in the case of IndyMac) and option ARMs (in the case of WaMu and Downey) that were often only underwritten to the introductory rate instead of the fully indexed rate. During the housing bubble, OTS issued no binding rules to halt the proliferation by its largest regulated thrifts of option ARMs, subprime loans, and low- and no-documentation mortgages. Instead, OTS relied on oversight through guidances. IndyMac, WaMu, and Downey apparently treated the guidances as solely advisory, however, as evidenced by the fact that all three made substantial numbers of hazardous loans in late 2006 and in 2007 in direct disregard of an interagency guidance on nontraditional mortgages issued in the fall of 2006 and subscribed to by OTS that prescribed underwriting ARMs to the fully indexed rate.\54\--------------------------------------------------------------------------- \54\ Department of the Treasury et al., Interagency Guidance on Nontraditional Mortgage Product Risks; Final guidance, 71 Fed. Reg. 58609 (2006).--------------------------------------------------------------------------- The fact that all three institutions continued to make loans in violation of the guidance suggests that OTS examinations failed to result in enforcement of the guidance. Similarly, OTS fact sheets on the failures of all three institutions show that the agency consistently declined to institute timely formal enforcement proceedings against those thrifts prohibiting the lending practices that resulted in their demise. In sum, OTS supervision of residential mortgage risks was confined to ``light touch'' regulation in the form of examinations, nonbinding guidances, and occasional informal agreements that ultimately did not work.2. The Office of the Comptroller of the Currency The OCC has asserted that national banks made only 10 percent of subprime loans in 2006. But this assertion fails to mention that national banks moved aggressively into Alt-A low-documentation and no-documentation loans during the housing boom.\55\ This mattered a lot, because the biggest national banks are considered ``too big to fail'' and pose systemic risk on a scale unmatched by independent nonbank lenders. We might not be debating the nationalization of Citibank and Bank of America today had the OCC stopped them from expanding into toxic mortgages, bonds, and SIVs.--------------------------------------------------------------------------- \55\ Testimony by John C. Dugan, Comptroller, before the Senate Committee on Banking, Housing, and Urban Affairs, March 4, 2008.--------------------------------------------------------------------------- Like OTS, ``light touch'' regulation was apparent at the OCC. Unlike OTS, the OCC did promulgate one rule, in 2004, prohibiting mortgages to borrower who could not afford to repay. However, the rule was vague in design and execution, allowing lax lending to proliferate at national banks and their mortgage lending subsidiaries through 2007. Despite the 2004 rule, through 2007, large national banks continued to make large quantities of poorly underwritten subprime loans and low- and no-documentation loans. In 2006, for example, fully 62.6 percent of the first-lien home purchase mortgages made by National City Bank, N.A., and its subsidiary, First Franklin Mortgage, were higher-priced subprime loans. Starting in the third quarter of 2007, National City Corporation reported five straight quarters of net losses, largely due to those subprime loans. Just as with WaMu, the Lehman Brothers bankruptcy ignited a silent run by depositors and pushed National City Bank to the brink of collapse. Only a shotgun marriage with PNC Financial Services Group in October 2008 saved the bank from FDIC receivership. The five largest U.S. banks in 2005 were all national banks and too big to fail. They too made heavy inroads into low- and no-documentation loans. The top-ranked Bank of America, N.A., had a thriving stated-income and no-documentation loan program which it only halted in August 2007, when the market for private-label mortgage-backed securities dried up. Bank of America securitized most of those loans, which may be why the OCC tolerated such lax underwriting practices. Similarly, in 2006, the OCC overrode public protests about a ``substantial volume'' of no-documentation loans by JPMorgan Chase Bank, N.A., the second largest bank in 2005, on grounds that the bank had adequate ``checks and balances'' in place to manage those loans. Citibank, N.A., was the third largest U.S. bank in 2005. In September 2007, the OCC approved Citibank's purchase of the disreputable subprime lender Argent Mortgage, even though subprime securitizations had slowed to a trickle. Citibank thereupon announced to the press that its new subsidiary--christened ``Citi Residential Lending''--would specialize in nonprime loans, including reduced documentation loans. But not long after, by early May 2008 after Bear Stearns narrowly escaped failure, Citibank was forced to admit defeat and dismantle Citi Residential's lending operations. The fourth largest U.S. bank in 2005, Wachovia Bank, N.A., originated low- and no-documentation loans through its two mortgage subsidiaries. Wachovia Bank originated such large quantities of these loans--termed Alt-A loans--that by the first half of 2007, Wachovia Bank was the twelfth largest Alt-A lender in the country. These loans performed so poorly that between December 31, 2006 and September 30, 2008, the bank's ratio of net write-offs on its closed-end home loans to its total outstanding loans jumped 2400 percent. Concomitantly, the bank's parent company, Wachovia Corporation, was reported its first quarterly loss in years due to rising defaults on option ARMs made by Wachovia Mortgage, FSB, and its Golden West predecessor. Public concern over Wachovia's loan losses triggered a silent run on Wachovia Bank in late September 2008, following Lehman Brothers' failure. To avoid receivership, the FDIC brokered a hasty sale of Wachovia to Wells Fargo after Wells Fargo outbid Citigroup for the privilege. Wells Fargo Bank, N.A., was in better financial shape than Wachovia, but it too made large quantities of subprime and reduced documentation loans. In 2006, over 23 percent of the bank's first-lien refinance mortgages were high-cost subprime loans. Wells Fargo Bank also securitized substantial numbers of low- and no-documentation mortgages in its Alt-A pools. In 2007, a Wells Fargo prospectus for one of those pools stated that Wells Fargo had relaxed its underwriting standards in mid-2005 and did not verify whether the mortgage brokers who had originated the weakest loans in that loan pool complied with its underwriting standards before closing. Not long after, as of July 25, 2008, 22.77 percent of the loans in that loan pool were past due or in default. As the Wells Fargo story suggests, the OCC depended on voluntary risk management by national banks, not regulation of loan terms and practices, to contain the risk of improvident loans. A speech by the then-Acting Comptroller, Julie Williams, confirmed as much. In 2005, Comptroller Williams, in a speech to risk managers at banks, coached them on how to ``manage'' the risks of no-doc loans through debt collection, higher reserves, and prompt loss recognition. Securitization was another risk management device favored by the OCC. Three years later, in 2008, the Treasury Department's Inspector General issued a report that was critical of the OCC's supervision of risky loans.\56\ Among other things, the Inspector General criticized the OCC for not instituting formal enforcement actions while lending problems were still manageable in size. In his written response to the Inspector General, the Comptroller, John Dugan, conceded that ``there were shortcomings in our execution of our supervisory process'' and ordered OCC examiners to start initiating formal enforcement actions on a timely basis.\57\--------------------------------------------------------------------------- \56\ Office of Inspector General, Department of the Treasury, ``Safety and Soundness: Material Loss Review of ANB Financial, National Association'' (OIG-09-013, Nov. 25, 2008). \57\ Id.--------------------------------------------------------------------------- The OCC's record of supervision and enforcement during the subprime boom reveals many of the same problems that culminated in regulatory failure by OTS. Like OTS, the OCC usually shunned formal enforcement actions in favor of examinations and informal enforcement. Neither of these supervisory tools obtained compliance with the OCC's 2004 rule prohibiting loans to borrowers who could not repay. Although the OCC supplemented that rule later on with more detailed guidances, some of the largest national banks and their subsidiaries apparently decided that they could ignore the guidances, judging from their lax lending in late 2006 and in 2007. The OCC's emphasis on managing credit risk through securitization, reserves, and loss recognition, instead of through product regulation, likely encouraged that laissez faire attitude by national banks.C. Judging by the Results: Loan Performance By Charter OCC and OTS regulators have argued that their agencies offer ``comprehensive'' supervision resulting in lower default rates on residential mortgages. The evidence shows otherwise. Data from the Federal Deposit Insurance Corporation show that among depository institutions, Federal thrift institutions had the worst default rate for one-to-four family residential mortgages from 2006 through 2008. (See Figure 5). Figure 5. Total Performance of Residential Mortgages by Depository Institution Lenders CHRG-111shrg51395--108 Mr. Silvers," Only that one of the reasons why this discussion has become sort of hard to follow or hard to understand is because the concept of a principles-based system became code, became a code word for a weak regulatory system. " CHRG-111shrg57320--377 Mr. Corston," Asset quality. Weak asset quality. It brought on the liquidity problems. Senator Levin. And that lack of sufficient capital was something that reflected embedded losses in their asset portfolio? " FinancialCrisisReport--156 Ban on Stated Income Loans. Multiple witnesses at the Subcommittee’s April 16, 2010 hearing on the role of bank regulators expressed support for banning stated income loans. The FDIC Chairman Sheila Bair testified: “We are opposed to stated income. … We think you should document income.” 581 When asked for his opinion of stated income loans, the FDIC Inspector General Jon Rymer responded: “I do not think they should be allowed,” 582 stressing the fraud risk: “I really can see no practical reason from a banker’s perspective or a lender’s perspective to encourage that. … That is just, to me, an opportunity to essentially encourage fraud.” 583 Treasury Inspector General Eric Thorson also criticized stated income loans, explaining: “[T]he 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.” 584 Even the former head of OTS called stated income loans an “anathema” and expressed regret that OTS had allowed them. 585 The Dodd-Frank Act essentially bans stated income loans by establishing minimum standards for residential mortgages in Title XIV of the law. Section 1411 establishes a new Section 129C of the Truth in Lending Act (TILA) prohibiting lenders from issuing a residential mortgage without first conducting a “good faith and reasonable” determination, based upon “verified and documented information,” that a borrower has a “reasonable ability to repay the loan” and all applicable taxes, insurance, and assessments. Subsection 129C(a)(4) states the lender “shall verify” the borrower’s income and assets by reviewing the borrower’s W-2 tax form, tax returns, payroll receipts, financial institution records, or “other third-party documents that provide reasonably reliable evidence” of the borrower’s income or assets. In addition, Section 1412 of the Dodd-Frank Act adds a new Subsection 129C(b) to TILA establishing a new category of “qualified mortgages” eligible for more favorable treatment under federal law. It states that, in all “qualified mortgages,” the “income and financial resources” of the borrower must be “verified and documented.” These statutory requirements, by prohibiting lenders from issuing a residential mortgage without first verifying the borrower’s income and assets, essentially put an end to stated income loans. 586 581 April 16, 2010 Subcommittee Hearing at 88. 582 Id. at 27. 583 Id. at 15. 584 Id. 585 Id. at 42, 142. 586 The Federal Reserve is charged with issuing regulations to implement Section 1411. Federal Reserve regulations issued in July 2008, under the authority of the Home Ownership and Equity Protection Act (HOEPA) of 1994, which took effect in October 2009, already require lenders issuing certain high cost mortgages to verify a borrower’s ability to repay the loan. 73 Fed. Reg. 147, at 44543 (7/30/2008). Since the Dodd-Frank Act applies to all types of CHRG-111hhrg48874--16 Mr. Polakoff," Good morning, Chairman Frank, Ranking Member Bachus, and members of the committee. Thank you for the opportunity to testify on behalf of OTS on finding the right balance between ensuring safety and soundness of U.S. financial institutions and ensuring that adequate credit is available to creditworthy consumers and businesses. Available credit and prudent lending are both critical to our Nation and its economic wellbeing. Neither one can be sacrificed at the expense of the other, so striking the proper balance is key. I understand why executives of financial institutions feel they are receiving mixed messages from regulators. We want our regulated institutions to lend, but we want them to lend in a safe and sound manner. I would like to make three points about why lending has declined: number one, the need for prudent underwriting. During the recent housing boom, credit was extended to too many borrowers who lacked the ability to repay their loans. For home mortgages, some consumers received loans based on introductory teaser rates, unfounded expectations that home prices would continue to skyrocket, inflated income figures, or other underwriting practices that were not as prudent as they should have been. Given this recent history, some tightening in credit is expected and needed. Number two, the need for additional capital and loan loss reserves. Financial institutions are adding to their loan loss reserves and augmenting capital to ensure an acceptable risk profile. These actions strain an institution's ability to lend, but they are necessary due to a deterioration in asset quality and increases in delinquencies and charge-offs for mortgages, credit cards, and other types of lending. Number three, declines in consumer confidence and demand for loans. Because of the recession, many consumers are reluctant to borrow for homes, cars, or other major purchases. In large part, they are hesitant to spend money on anything beyond daily necessities. Also, rising job losses are making some would-be borrowers unable to qualify for loans. Steep slides in the stock market have reduced many consumers' ability to make downpayments for home loans and drain consumers' financial strength. Dropping home prices are cutting into home equity. In reaction to their declining financial net worth, many consumers are trying to shore-up their finances by spending less and saving more. Given these forces, the challenges ensuring that the pendulum does not swing too far by restricting credit availability to an unhealthy level, I would like to offer four suggestions for easing the credit crunch: Number one: Prioritize Federal assistance. Government programs such as TARP could prioritize assistance for institutions that show a willingness to be active lenders. The OTS is already collecting information from thrifts applying for TARP money on how they plan to use the funds. As you know, the OTS makes TARP recommendations to the Treasury Department. The Treasury makes the final decision. Number two: Explore ways to meet institutions' liquidity needs. Credit availability is key to the lending operations of banks and thrifts. The Federal Government has already taken significant steps to bolster liquidity through programs such as the Capital Purchase Program under TARP, the Commercial Paper Funding Facility, the Temporary Liquidity Guarantee Program, and the Term Asset-backed Securities Loan Facility. Number three: Use the power of supervisory guidance. For OTS-regulated thrifts, total loan originations and purchases declined about 11 percent from 2007 to 2008. However, several categories of loans, such as consumer and commercial business loans, and non-residential and multi-family mortgages increased during this period. The OTS and the other Federal banking regulators issued an ``Inter-agency Statement on Meeting the Needs of Creditworthy Borrowers'' in November 2008. It may be too soon to judge the effectiveness of the statement. And, number four: Employ countercyclical regulation. Regulators should consider issuing requirements that are countercyclical, such as lowering loan to value ratios during economic upswings. Conversely, in difficult economic times, when home prices are not appreciating, regulators could permit loan to value ratios to rise, thereby making home loans available. Also, regulators could require financial institutions to build their capital and loan lost reserve during good economic times, making them better positioned to make resources available for lending when times are tough. Thank you, Mr. Chairman. I look forward to answering your questions. [The prepared statement of Mr. Polakoff can be found on page 163 of the appendix.] " CHRG-111hhrg51591--48 Mr. Harrington," The idea there is probably more germane to some forms of anti-competitive regulation that exists at the State level regarding prices and price controls and restrictions on underwriting and rate classification, where if you had some sort of a passport system where an insurer could apply to a State to get its primary license from the State and perhaps be subject to solvency regulation in all States that it does business, but that it would be regulated regarding rates and perhaps market conduct or other non-solvency issues by the rules and the State that it gets its primary. And the notion then would be that companies could choose to go where there was a more competitive environment on those dimensions, and consumers would be able to choose accordingly, subject to adequate disclosure about the nature of a regulation about a particular company. " fcic_final_report_full--460 Over the next 15 years, HUD consistently enhanced and enlarged the AH goals. In the GSE Act, Congress had initially specified that 30 percent of the GSEs’ mortgage purchases meet the AH goals. This was increased to 42 percent in 1995, and 50 percent in 2000. By 2008, the main LMI goal was 56 percent, and a special affordable subgoal had been added requiring that 27 percent of the loans acquired by the GSEs be made to borrowers who were at or below 80 percent of area median income (AMI). Table 10, page 510, shows that Fannie and Freddie met the goals in almost every year between 1996 and 2008. There is very little data available concerning Fannie and Freddie’s acquisitions of subprime and Alt-A loans in the early 1990s, so it is diffi cult to estimate the GSEs’ year-by-year acquisitions of these loans immediately after the AH goals went into effect. However, Pinto estimates the total value of these purchases at approximately $4.1 trillion (see Table 7, page 504). As shown in Table 1, page 456, on June 30, 2008, immediately prior to the onset of the financial crisis, the GSEs held or had guaranteed 12 million subprime and Alt-A loans. This was 37 percent of their total mortgage exposure of 32 million loans, which in turn was approximately 58 percent of the 55 million mortgages outstanding in the U.S. on that date. Fannie and Freddie, accordingly, were by far the dominant players in the U.S. mortgage market before the financial crisis and their underwriting standards largely set the standards for the rest of the mortgage financing industry. The Community Reinvestment Act . In 1995, the regulations under the Community Reinvestment Act (CRA) 10 were tightened. As initially adopted in 1977, the CRA and its associated regulations required only that insured banks and S&Ls reach out to low-income borrowers in communities they served. The new regulations, made effective in 1995, for the first time required insured banks and S&Ls to demonstrate that they were actually making loans in low-income communities and to low-income borrowers. 11 A qualifying CRA loan was one made to a borrower at or below 80 percent of the AMI, and thus was similar to the loans that Fannie and Freddie were required to buy under HUD’s AH goals. In 2007, the National Community Reinvestment Coalition (NCRC), an umbrella organization for community activist organizations, reported that between 1997 and 2007 banks that were seeking regulatory approval for mergers committed in agreements with community groups to make over $4.5 trillion in CRA loans. 12 A substantial portion of these commitments appear to have been converted into mortgage loans, and thus would have contributed substantially to the number of subprime and other high risk loans outstanding in 2008. For this reason, they deserved Commission investigation and analysis. Unfortunately, as outlined in Part III, this was not done. Accordingly, the GSE Act put Fannie and Freddie, FHA, and the banks that were seeking CRA loans into competition for the same mortgages—loans to borrowers at or below the applicable AMI. HUD’s Best Practices Initiative . In 1994, HUD added another group to this list when it set up a “Best Practices Initiative,” to which 117 members of the Mortgage 10 Pub.L. 95-128, Title VIII of the Housing and Community Development Act of 1977, 91 Stat. 1147, 12 U.S.C. § 2901 et seq. 11 12 http://www.fdic.gov/regulations/laws/rules/2000-6500.html. See http://www.community-wealth.org/_pdfs/articles-publications/cdfis/report-silver-brown.pdf . 455 CHRG-111hhrg50289--55 Mr. Luetkemeyer," Okay. One of the questions that has been posed to me with regard to the TARP funds is initially they were supposed to be for the banks that were in trouble, for the institutions that were in trouble, and as I have seen the funds dispersed, it seems like it has gone to more and more institutions that are not in trouble. And in fact, I have found that some of the banks were asked to take the money so that they would go out and buy other banks rather than actually absorb weak assets. Have you seen or heard of instances like that or are you aware that we have an opportunity maybe to help a weak bank with the TARP funds that we have not taken advantage of? Ms. Blankenship. As I understand from Treasury Secretary Geithner was present at one of our meetings several weeks ago, and he indicated that there would be an initiative for some of the perhaps returned TARP funds to go to some of the banks that had applied and perhaps had missed the deadline or did not qualify the first time around. I think just from my experience I am hearing that a lot of smaller community banks have opted not necessarily to use that program because of the regulatory burden associated with it, and typically those banks are well capitalized. We did not use it. We would have considered possibly using it, and I think there are some opportunities for an additional program perhaps that would fund M&A activity of, say, a strong community bank to acquire a weak or a failing community bank with the assistance, but I do not know that under the current program a lot of banks would be willing to accept the terms associated with that. But I think you could take those TARP funds and perhaps look at another initiative if you wanted to look at the M&A. " CHRG-111hhrg53248--53 Secretary Geithner," I agree that, as you saw in the model line insurance companies and in AIG, one of the things at the center of this crisis was you had entities that were not only insurance companies with no Federal oversight of any meaningful level writing dramatically large commitments for credit protection with no meaningful levels of capital against that, and that is something we can't afford to allow to happen in the future. So I think the framework that we proposed, which largely models on something you proposed, to begin the process of putting in place a Federal level oversight entity, it will be very important. But, of course, our job is not just to deal with the last war, but to make sure that we are putting in place something that is going to capture those weaknesses and vulnerabilities more quickly in the future. But I think you are hiding one particular example of the weakness of our current framework. " CHRG-111hhrg56776--138 Mr. Bernanke," Credit cards, for example. We have banned a number of practices, like double-cycle billing, for example. If there are practices which serve no good business purpose, and which the consumer cannot understand, there is no reason to allow them. Ms. Waters. Yes. " FinancialCrisisReport--195 As part of their review of Washington Mutual, the Treasury and the FDIC Inspectors General determined that, over a five-year period, 2004-2008, OTS examiners identified a total of over 540 criticisms, observations, and recommendations related to WaMu operations. 737 At the Subcommittee hearing, when asked whether those 540 findings constituted “serious criticisms” of the bank, Treasury IG Eric Thorson responded: “Absolutely.” 738 The FDIC Inspector General, Jon Rymer, agreed: “[T]he 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.” 739 As WaMu accumulated hundreds of infractions from OTS, longstanding problems with asset quality in the bank’s portfolio continued. While some observers have blamed WaMu’s failure on its liquidity troubles in late 2008, years of unresolved problems festered below the surface. The consequences of WaMu’s failure to address its underwriting problems, risk concentrations, risk layering, and other problems were exponential increases in its loss rates. The FDIC later calculated the loss rates for several WaMu products. In WaMu’s held-for- investment Option ARM portfolio, delinquency rates nearly doubled every year, rising from 0.48% at the end of 2005 to 0.90% a year later, to 2.63% at year end 2007, and up to 4.63% by June 30, 2008. 740 In its subprime portfolio, its delinquency rate increased from 7.39% in 2005 to 25.20% in June 2008. 741 The delinquency rate in its HELOC portfolio rose from 0.58% in 2005 to 4.00% in June 2008. 742 As a result, net charge-offs for WaMu’s Option ARM portfolio rose from $15 million at year end 2005 to $37 million in 2006, to $147 million in 2007, and to $777 million by June 2008. 743 HELOC net charge-offs likewise increased, rising from $21 million in 2005, to $23 million in 2006, to $424 million in 2007, and to $1.19 billion by June 2008. 744 Subprime net charge-offs expanded even more rapidly, rising from $47 million in 2005, to $134 million in 2006, to $550 million in 2007, and $956 million by June 2008. 745 To account for these losses, WaMu’s loss provisions jumped from $218 million in 2006 to over $2 billion in 2007, and an additional $6 billion by June 2008. 746 737 Id. at 20. See also IG Report at 28. 738 April 16, 2010 Subcommittee Hearing at 17. 739 Id. at 18. 740 See FDIC Complaint Against WaMu Executives at ¶ 79. 741 Id. 742 Id. 743 Id. at ¶ 81. 744 Id. 745 Id. 746 Id. at ¶ 82. CHRG-111hhrg54867--165 Mr. Watt," Thank you, Mr. Chairman. I hope my colleagues will support that bill when it comes to a vote. Actually, we passed it by voice vote, so you all are not even going to vote on it, the Defense Production Act Reauthorization. Mr. Secretary, my good friend, Mr. Lucas, was talking about practical considerations, and I am kind of into practical considerations, too. And I have been looking at this Consumer Financial Protection Agency proposal and how we got to where we are on account of a practical basis. It seems to me that we gave the Fed and the FDIC and the other regulators substantial consumer protection authority. Each one of them had consumer protection authority. But we also gave them an expectation, a mandate, just like the consumer protection ``mandate'' that we gave them to assure the safety and soundness of financial institutions. And I guess my question to you is, you have been in one of these agencies. You came out of one of these agencies. You were with the Federal Reserve. If I look at you and tell you that your obligation is to assure the safety and soundness of the institutions that you have responsibility to regulate and I look at you and I say, okay, I am also going to give you the authority to do consumer protection, tell me, just as a practical consideration, practical consideration, which one of those things are you going to do come crunch time? " CHRG-111shrg55739--77 Mr. Joynt," Thank you, Senator Reed, Senator Shelby, Members of the Committee. Thank you for the opportunity to appear at the hearing today. I would like to spend a few minutes summarizing my prepared statement. While overall macroeconomic conditions remain difficult, it seems the period of the most intense market stress has passed. This is due to both a variety of Government initiatives here and abroad aimed at restoring financial market stability as well as actions taken by companies individually to shore up their balance sheets and reduce risk. Having said that, important sectors in the fixed-income markets remain effectively closed, and certain asset classes, such as commercial mortgage-backed securities, are experiencing greater performance strain on their underlying assets. During this time, the focus of Fitch Ratings has been on implementing a broad range of initiatives that enhance the reliability and transparency of our opinions and related analytics. More specifically, our primary focus is on vigorously reviewing our analytical approaches and changing ratings to reflect the current risk profile of the securities that we rate. In many cases, that continues to generate significant numbers of downgrades in structured securities, but also affects other sectors, such as banks and insurance. We are releasing our updated ratings and research transparently and publicly, and we are communicating directly with the market the latest information and analysis that we have. In parallel, we have been introducing a range of new policies and procedures--and updating existing ones--to reflect the evolving regulatory frameworks within which credit rating agencies operate globally. In each of these areas, we have been as transparent as possible, broadly engaging with all market participants, including policy makers and regulators. I am happy to expand on these topics as we proceed. That said, the focus of today's hearing is clearly on where do we go forward from here. Senator Reed has introduced a bill, which we are happy to speak to. The House held a hearing in May. The SEC, I think, considered important new rules at their roundtable discussion in April. There is a Treasury proposal that we will speak about, and also outside the U.S., we have been in discussions with the EU, and they have recently enacted a registration and oversight system as well that applies to rating agencies. As this Committee considers these topics, we would like to offer our perspective on several important issues. Let me reiterate that we are committed to engaging on all of these matters in a thoughtful, balanced, constructive, and non-self-serving manner. At the same time, some perceptions and proposals continue to circulate that could use clarification. Transparency is a recurring theme of the discussions about rating agencies, and at Fitch, we are committed to being as transparent in everything we do. 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. We do not believe that everyone should agree with all of our opinions, but we are committed to ensuring 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 overreliant 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 made broadly and readily available to all investors, thereby enabling them to have access to the same information as mandated rating agencies in developing their own thinking and research. Fitch fully supports the concept of greater disclosure of such information. We also believe that responsibility for disclosing that information should rest with issuers and underwriters. It is their transactions, and they should be disclosing all the pertinent information to all investors. A related benefit of additional issuer disclosure is that it addresses the issue of rating shopping. Greater disclosure would enable nonmandated NRSROs to issue ratings on structured securities if they so choose, providing the market with a greater variety of opinion and an important check on perceived ratings inflation. Discussion of additional information is of questionable value without accuracy and reliability of the information. That goes to this question of due diligence. We have taken, rating agencies, a number of steps to increase our assessments of the quality of the information that we are provided with, and we have adopted policies that we will not rate issues if we deem the quality of the information to be insufficient. The burden of due diligence, in my opinion, though, belongs with issuers and underwriters. Congress should mandate that the SEC enact rules that require issuers and underwriters to perform such due diligence and make public their findings and enforce the rules that 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. We believe that oversight requirements should be applied consistently and equally to all NRSROs. One theme in the discussion of additional regulation is the desire to impose more accountability on rating agencies. While ultimately the market imposes accountability for our ratings, for the reliability and performance of our ratings and our research, if the market does not have confidence in us, the value of Fitch's franchise will be diminished. 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. Rating agencies today, like accountants and officers and directors and securities analysts, may be held liable for securities fraud to the extent rating agencies intentionally or recklessly make material misstatements or omissions. Beyond the standard of existing securities law that applies to all fundamentally, we struggle with the notion of what it is we should be liable for. Specifically a credit rating is an opinion about future events, and the likelihood of an issuer that he might meet his credit obligations. Imposing a specific liability standard for failing to accurately predict the future strikes us as an unwise approach. Congress should also consider some practical consequences of imposing additional liability. They were mentioned earlier. Expanded competition might be inhibited from smaller agencies, but that may be addressed. All rating agencies also may be motivated to just try to provide the lowest securities ratings just to mitigate liability, which does not encourage accuracy. I see I am past my time. Senator Reed. Thank you very much, Mr. Joynt. Let me also say that all your statements will be made part of the record, and if you would like to summarize them, that is perfectly fine. And the statements of the Members will be made part of the record. Mr. Gellert, please. STATEMENT OF JAMES H. GELLERT, PRESIDENT AND CHIEF EXECUTIVE CHRG-111hhrg53234--228 Mr. Mishkin," And I think that one of my concerns has been that if we go down the route of worrying about the big picture and then don't do anything, that we are actually in a situation which not only means institutions can get in trouble, and we can't do anything about them, but also we are in a very weak position to get them to fix things because we have no ammunition. " CHRG-111hhrg54867--113 Secretary Geithner," I think it is actually kind of simple and stark, and if we understand one thing, I think we understand that. To say it simply, where there were rules, they were weak and enforced, but there were large parts of the system without rules. And that is not a tenable balance for any system. " FOMC20070816confcall--8 6,MR. HOENIG.," Yes. I just have a question for Bill. Can you elaborate on your comment about the effects and the perceptions of weak backstops on some of the issuers? I didn’t quite catch it, and I’d like to know a little more, if you don’t mind." FOMC20080430meeting--95 93,MR. ROSENGREN.," Thank you, Mr. Chairman. Without judgmental adjustments, the Boston Fed forecast is somewhat more optimistic than the Greenbook. As in the Greenbook, our GDP is weak in the first half of this year, though neither of the first two quarters actually turns negative. Our slightly more optimistic forecast assumes that consumption and business fixed investment are weak, but not as weak as in the Greenbook, and then the fiscal and monetary stimuli are sufficient for the economy to pick up in the second half of this year. In a sense, the Greenbook represents another mode in the forecast distribution with probability roughly equal to our forecast. The big risk to our forecast is that the financial turmoil and housing price declines, which are not fully reflected in the Boston model, result in a greater drag on the economy. Such an outcome would largely close the gap between the Greenbook and our forecast. In short, the downside risks to our forecast are appreciable. With a monetary policy assumption similar to the Greenbook's, we have core PCE below 2 percent in 2009, but the unemployment rate remains well above the NAIRU even at the end of 2010. If we sought to keep inflation below 2 percent but did not want an extended period in which the unemployment rate was above the NAIRU, our model would require more easing than currently assumed in the Greenbook. Since the last meeting, the economic data have remained weak. Private payroll employment declined by approximately 100,000 jobs on average over the past three months, and the unemployment rate increased 0.3 percentage point. In addition, the labor market weakness was widespread across industries. Such labor market weakness is likely to aggravate an already troubling housing story. To date, falling housing prices have disproportionately affected subprime borrowers and those who purchased securitized products. However, if housing prices continue to decline rapidly, that will begin to affect more prime borrowers and a wide array of financial institutions. Smaller financial institutions that were largely unaffected by the financial turmoil last August are beginning to see increases in delinquencies, and those with outsized exposures in construction loans are now experiencing significant duress. Commercial real estate loans are also now experiencing increased delinquencies. Like the Greenbook, I am concerned that commercial real estate may be the next sector to experience problems. However, the biggest concern remains that rising delinquencies and falling housing prices cause a much higher rate of mortgage defaults than we have experienced historically. Should these mounting problems become more pronounced, we are likely to see credit availability for small- and medium-sized businesses affected. That sector has not to date been significantly affected by the financial turmoil. Many financial indicators have improved since the last meeting, as was highlighted in Bill's report. The stock market has moved up. Many credit spreads have narrowed. Treasury securities and repurchase agreements are trading in more-normal ranges, and credit default swaps for many financial firms have improved. Nonetheless, several ominous trends remain in financial markets. The LIBOR�OIS spread has widened, so borrowers tied to LIBOR rates have seen those rates rise more than 25 basis points since the last meeting. Similarly, the TAF stop-out rate in the last three auctions was higher than the primary credit rate, providing another indicator that banks remain in need of dollar term funds. Finally, the asset-backed commercial paper market is once again experiencing difficulties. Rates on asset-backed commercial paper have been rising, and there is a risk that more of the paper will end up on bank balance sheets. Higher food and energy prices are both a drag on the economy and a cause for concern with inflation. But despite the extended sequence of supply shocks, I do not see evidence that inflation expectations are no longer anchored. Labor markets do not indicate that the commodity price increases are causing wage pressures, and such pressures are even less likely if the unemployment rate continues to increase. Many of the financial indicators of inflation, such as the five-year-forward rate, have fallen significantly from their peaks earlier this year. Finally, core PCE over the past year has been 2 percent, and most econometric-based forecasts expect that the weakness we are experiencing should result in core and total PCE inflation at or below 2 percent next year. Overall, the downside risks to demand that I listed in the outset seem the more compelling cause for concern. Thank you. " FinancialCrisisReport--193 The memorandum identified several matters that required resolution prior to a WaMu purchase of Long Beach, including the establishment of pre- and post-funding loan quality reviews that were already in place at the bank. The memorandum also stated that Long Beach management had “worked diligently to improve its operation and correct significant deficiencies … reported in prior years,” and observed, “there is definitely a new attitude and culture.” 724 OTS continued to review Long Beach’s lending practices and found additional deficiencies throughout the year. Those deficiencies included errors in loan calculations of debt- to-income ratios, lack of documentation to support the reasonableness of borrower income on stated income loans, and lack of explanation of a borrower’s ability to handle payment shock on loans with rising interest rates. 725 OTS also determined that Long Beach’s newly created portfolio of subprime loans “had attributes that could result in higher risk” than WaMu’s existing subprime loan portfolio. 726 Nevertheless, in December 2005, OTS examiners wrote that, even though Long Beach was “engaged in a high-risk lending activity and we are not yet fully satisfied with its practices,” they recommended approving WaMu’s purchase of the company with certain conditions. 727 Those conditions included WaMu’s reconsidering its high risk lending concentration limits, including “stated income loans with low FICOs and high LTV ratios”; WaMu’s assurance that Long Beach would comply with certain loan guidance; a WaMu commitment to continue to bring down its loan exception and error rates; and a WaMu commitment to ensure its Enterprise Risk Management division would provide a “countervailing balance” to “imprudent” desires to expand Long Beach’s subprime lending. 728 About the same time as this memorandum was completed, OTS learned that, during the fourth quarter of 2005, Long Beach had been required to repurchase tens of millions of dollars of loans it had sold to third parties due to early payment defaults. 729 By December, this unexpected wave of repurchases had overwhelmed Long Beach’s repurchase reserves, leading to a reserve shortfall of nearly $75 million. Altogether in the second half of 2005, Long Beach had to repurchase loans with about $837 million in unpaid principal, and incurred a net loss of about 724 Id. See also 5/19/2005 OTS email, “LBMC Fair Lending,” OTSWMS05-005 0002002, Hearing Exhibit 4/16-20 (“I would not … feel comfortable with their moving [Long Beach] under the thrift without some conditions”). 725 See 12/21/2005 OTS internal memorandum by OTS examiners to OTS Deputy Regional Director Darrel Dochow, OTSWMS06-007 0001009-16, Hearing Exhibit 4/16-31. 726 Id. at OTSWMS06-007 0001011. 727 See 12/21/2005 OTS internal memorandum by OTS examiners to OTS Deputy Regional Director Darrel Dochow, OTSWMS06-007 0001009-16, Hearing Exhibit 4/16-31. 728 Id. at OTSWMS06-007 0001015-16. 729 See 10/3/2005 OTS Report of Examination, OTSWMS06-010 0002530, Hearing Exhibit 4/16-94 [Sealed Exhibit] (noting that, after a field visit to Long Beach that concluded in December 2005, OTS learned that loan repurchases had surged: “Subsequent to our on-site field visit, management informed us that loan repurchases had increased considerably. … Management indicated that approximately $0.6 billion in loans were repurchased during the fourth quarter of 2005 out of approximately $13.2 billion in total whole loan sales. The gross financial impact at December 31, 2005, was $72.3 million.”); 1/20/2006 email from Darrel Dochow to Michael Finn and others, with chart, OTSWMS06-007 0001020 to 1021 (describing Long Beach repurchases). $107 million. 730 In response, its auditor, Deloitte and Touche, cited Long Beach for a CHRG-111shrg52966--71 PREPARED STATEMENT OF ROGER T. COLE Director, Division of Banking Supervision and Regulation Board of Governors of the Federal Reserve System March 18, 2009 Chairman Reed, Ranking Member Bunning and members of the Subcommittee, it is my pleasure to appear today to discuss the state of risk management in the banking industry and steps taken by Federal Reserve supervisors to address risk management shortcomings at banking organizations. In my testimony, I will describe the vigorous and concerted steps the Federal Reserve has taken and is taking to rectify the risk management weaknesses revealed by the current financial crisis. I will also describe actions we are taking internally to improve supervisory practices and apply supervisory lessons learned. This includes a process spearheaded by Federal Reserve Vice Chairman Donald Kohn to systematically identify key lessons revealed by recent events and to implement corresponding recommendations. Because this crisis is ongoing, our review is ongoing.Background The Federal Reserve has supervisory and regulatory authority over a range of financial institutions and activities. It works with other Federal and State supervisory authorities to ensure the safety and soundness of the banking industry, foster the stability of the financial system, and provide for fair and equitable treatment of consumers in their financial transactions. The Federal Reserve is not the primary Federal supervisor for the majority of commercial bank assets. Rather, it is the consolidated supervisor of bank holding companies, including financial holding companies, and conducts inspections of all of those institutions. As I describe below, we have recently enhanced our supervisory processes on consolidated supervision to make them more effective and efficient. The primary purpose of inspections is to ensure that the holding company and its nonbank subsidiaries do not pose a threat to the soundness of the company's depository institutions. In fulfilling this role, the Federal Reserve is required to rely to the fullest extent possible on information and analysis provided by the appropriate supervisory authority of the company's bank, securities, or insurance subsidiaries. The Federal Reserve is also the primary Federal supervisor of State-member banks, sharing supervisory responsibilities with State supervisory agencies. In this role, Federal Reserve supervisory staff regularly conduct onsite examinations and offsite monitoring to ensure the soundness of supervised State member banks. The Federal Reserve is involved in both regulation--establishing the rules within which banking organizations must operate--and supervision--ensuring that banking organizations abide by those rules and remain, overall, in safe and sound condition. A key aspect of the supervisory process is evaluating risk management practices, in addition to assessing the financial condition of supervised institutions. Since rules and regulations in many cases cannot reasonably prescribe the exact practices each individual bank should use for risk management, supervisors design policies and guidance that expand upon requirements set in rules and regulations and establish expectations for the range of acceptable practices. Supervisors rely extensively on these policies and guidance as they conduct examinations and to assign supervisory ratings. We are all aware that the U.S. financial system is experiencing unprecedented disruptions that have emerged with unusual speed. The principal cause of the current financial crisis and economic slowdown was the collapse of the global credit boom and the ensuing problems at financial institutions, triggered by the end of the housing expansion in the United States and other countries. 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. For example, following the September 11, 2001, terrorist attacks, we took steps to improve clearing and settlement processes, business continuity for critical financial market activities, and compliance with Bank Secrecy Act, anti-money laundering, and sanctions requirements. Other areas of focus pertained to credit card subprime lending, the growth in leveraged lending, credit risk management practices for home equity lending, counterparty credit risk related to hedge funds, and effective accounting controls after the fall of Enron. These are examples in which the Federal Reserve took aggressive action with a number of financial institutions, demonstrating that effective supervision can bring about material improvements in risk management and compliance practices at supervised institutions. In addition, the Federal Reserve, working with the other U.S. banking agencies, issued several pieces of supervisory guidance before the onset of the recent crisis--taking action on nontraditional mortgages, commercial real estate, home equity lending, complex structured financial transactions, and subprime lending--to highlight emerging risks and point bankers to prudential risk management practices they should follow. Moreover, we identified a number of potential issues and concerns and communicated those concerns to the industry through the guidance and through our supervisory activities.Supervisory Actions to Improve Risk Management Practices In testimony last June, Vice Chairman Kohn outlined the immediate supervisory actions taken by the Federal Reserve to identify risk management deficiencies at supervised firms related to the current crisis and bring about the necessary corrective steps. We are continuing and expanding those actions. While additional work is necessary, we are seeing progress at supervised institutions toward rectifying issues identified amid the ongoing turmoil in the financial markets. We are also devoting considerable effort to requiring bankers to look not just at risks from the past but also to have a good understanding of their risks going forward. The Federal Reserve has been actively engaged in a number of efforts to understand and document the risk management lapses and shortcomings at major financial institutions revealed during the current crisis. In fact, the Federal Reserve Bank of New York organized and leads the Senior Supervisors Group (SSG), which published a report last March on risk management practices at major international firms.\1\ I do not plan to summarize the findings of the SSG report and similar public reports, since others from the Federal Reserve have already done so.\2\ But I would like to describe some of the next steps being taken by the SSG.--------------------------------------------------------------------------- \1\ Senior Supervisors Group (2008). ``Observations on Risk Management Practices during the Recent Market Turbulence'' March 6, www.newyorkfed.org/newsevents/news/banking/2008/SSG_Risk_Mgt_doc_final.pdf. \2\ President's Working Group on Financial Markets (2008), ``Policy Statement on Financial Market Developments,'' March 13, www.treas.gov/press/releases/reports/pwgpolicystatemktturmoil_03122008.pdf. Financial Stability Forum (2008), ``Report of the Financial Stability Forum on Enhancing Market and Institutional Resilience,'' April 7, www.fsforum.org/publications/FSF_Report_to_G7_11_April.pdf.--------------------------------------------------------------------------- A key initiative of the Federal Reserve and other supervisors since the issuance of the March 2008 SSG report has been to assess the response of the industry to the observations and recommendations on the need to enhance key risk management practices. The work of the SSG has been helpful, both in complementing our evaluation of risk management practices at individual firms and in our discussions with bankers and their directors. It is also providing perspective on how each individual firm's risk management performance compares with that of a broad cross-section of global financial services firms. The continuation of the SSG process requires key firms to conduct self-assessments that are to be shared with the organization's board of directors and serve to highlight progress in addressing gaps in risk management practices and identify areas where additional efforts are still needed. Our supervisory staff is currently in the process of reviewing the firms' self assessments, but we note thus far that in many areas progress has been made to improve risk management practices. We plan to incorporate the results of these reviews into our future examination work to validate management assertions. The next portion of my remarks describes the supervisory actions we have been taking in the areas of liquidity risk management, capital planning and capital adequacy, firm-wide risk identification, residential lending, counterparty credit risk, and commercial real estate. In all of these areas we are moving vigorously to address the weaknesses at financial institutions that have been revealed by the crisis.Liquidity risk management Since the beginning of the crisis, we have been working diligently to bring about needed improvements in institutions' liquidity risk management practices. One lesson learned in this crisis is that several key sources of liquidity may not be available in a crisis. For example, Bear Stearns collapsed in part because it could not obtain liquidity even on a basis fully secured by high-quality collateral, such as U.S. Government securities. Others have found that back-up lines of credit are not made available for use when most needed by the borrower. These lessons have heightened our concern about liquidity and improved our approach to evaluating liquidity plans of banking organizations. Along with our U.S. supervisory colleagues, we are monitoring the major firms' liquidity positions on a daily basis, and are discussing key market developments and our supervisory views with the firms' senior management. We also are conducting additional analysis of firms' liquidity positions to examine the impact various scenarios may have on their liquidity and funding profiles. We use this ongoing analysis along with findings from examinations to ensure that liquidity and funding risk management and contingency funding plans are sufficiently robust and that the institutions are prepared to address various stress scenarios. We are aggressively challenging those assumptions in firms' contingency funding plans that may be unrealistic. Our supervisory efforts require firms to consider the potential impact of both disruptions in the overall funding markets and idiosyncratic funding difficulties. We are also requiring more rigor in the assessment of all expected and unexpected funding uses and needs. Firms are also being required to consider the respective risks of reliance on wholesale funding and retail funding, as well as the risks associated with off-balance sheet contingencies. These efforts include steps to require banks to consider the potential impact on liquidity that arises from firms' actions to protect their reputation, such as an unplanned increase in assets requiring funding that would arise with support given to money market funds and other financial vehicles where no contractual obligation exists. These efforts also pertain to steps banks must take to prepare for situations in which even collateralized funding may not be readily available because of market disruptions or concern about the health of a borrowing institution. As a result of these efforts, supervised institutions have significantly improved their liquidity risk management practices, and have taken steps to stabilize and improve their funding sources as market conditions permit. In conducting work on liquidity risk management, we have used established supervisory guidance on liquidity risk management as well as updated guidelines on liquidity risk management issued by the Basel Committee on Banking Supervision last September--a process in which the Federal Reserve played a lead role. So that supervisory expectations for U.S. depository institutions are aligned with these international principles, the U.S. banking agencies plan to update their own interagency guidance on liquidity risk management practices in the near future. The new guidance will emphasize the need for institutions of all sizes to conduct meaningful cash-flow forecasts of their funding needs in both normal and stressed conditions and to ensure that they have an adequately diversified funding base and a cushion of liquid assets to mitigate stressful market conditions. Our supervisory efforts at individual institutions and the issuance of new liquidity risk management guidance come on top of broader Federal Reserve efforts outside of the supervision function to improve liquidity in financial markets, such as introduction of the Term Auction Facility and the Term Asset-Backed Securities Loan Facility.Capital planning and capital adequacy Our supervisory activities for capital planning and capital adequacy are similar to those for liquidity. We have been closely monitoring firms' capital levels relative to their risk exposures, in conjunction with reviewing projections for earnings and asset quality and discussing our evaluations with senior management. We have been engaged in our own analysis of loss scenarios to anticipate institutions' future capital needs, analysis that includes the potential for losses from a range of sources as well as assumption of assets currently held off balance sheet. We have been discussing our analysis with bankers and requiring their own internal analyses to reflect a broad range of scenarios and to capture stress environments that could impair solvency. As a result, banking organizations have taken a number of steps to strengthen their capital positions, including raising substantial amounts of capital from private sources in 2007 and 2008. We have stepped up our efforts to evaluate firms' capital planning and to bring about improvements where they are needed. For instance, we recently issued guidance to our examination staff--which was also distributed to supervised institutions--on the declaration and payment of dividends, capital repurchases, and capital redemptions in the context of capital planning processes. We are forcefully requiring institutions to retain strong capital buffers-above the levels prescribed by minimum regulatory requirements--not only to weather the immediate environment but also to remain viable over the medium and long term. Our efforts related to capital planning and capital adequacy are embodied in the interagency supervisory capital assessment process, which began in February. We are conducting assessments of selected banking institutions' capital adequacy, based on certain macroeconomic scenarios. For this assessment, we are carefully evaluating the forecasts submitted by each financial institution to ensure they are appropriate, consistent with the firm's underlying portfolio performance, and reflective of each entity's particular business activities and risk profile. The assessment of capital under the two macroeconomic scenarios being used in the capital assessment program will permit supervisors to ascertain whether institutions' capital buffers over the regulatory capital minimum are appropriate under more severe but plausible scenarios. Federal Reserve supervisors have been engaged over the past few years in evaluating firms' internal processes to assess overall capital adequacy as set forth in existing Federal Reserve supervisory guidance. A portion of that work has focused on how firms use economic capital practices to assess overall capital needs. We have communicated our findings to firms individually, which included their need to improve some key practices, and demanded corrective actions. We also presented our overall findings to a broad portion of the financial industry at a System-sponsored outreach meeting last fall that served to underscore the importance of our message.Firm-wide risk identification and compliance risk management One of the most important aspects of good risk management is risk identification. This is a particularly challenging exercise because some practices, each of which appears to present low risk on its own, may combine to create unexpectedly high risk. For example, in the current crisis, practices in mortgage lending--which historically has been seen as a very low-risk activity--have become distorted and, consequently riskier, as they have been fueled by another activity that was designed to reduce risk to lenders--the sale of mortgage assets to investors outside the financial industry. Since the onset of the crisis, we have been working with supervised institutions to improve their risk identification practices where needed, such as by helping identify interconnected risks. These improvements include a better understanding of risks facing the entire organization, such as interdependencies among risks and concentrations of exposures. One of the key lessons learned has been the need for timely and effective communication about risks, and many of our previously mentioned efforts pertaining to capital and liquidity are designed to ensure that management and boards of directors understand the linkages within the firm and how various events might impact the balance sheet and funding of an organization. We have demanded that institutions address more serious risk management deficiencies so that risk management is appropriately independent, that incentives are properly aligned, and that management information systems (MIS) produce comprehensive, accurate, and timely information. In our 2006 guidance on nontraditional mortgage products, we recognized that poor risk management practices related to retail products and services could have serious effects on the profitability of financial institutions and the economy; in other words, there could be a relationship between consumer protection and financial soundness. For example, consumer abuses in the subprime mortgage lending market were a contributing cause to the current mortgage market problems. Here, too, we are requiring improvements. The Federal Reserve issued guidance on compliance risk management programs to emphasize the need for effective firm-wide compliance risk management and oversight at large, complex banking organizations. This guidance is particularly applicable to compliance risks, including its application to consumer protection, that transcend business lines, legal entities, and jurisdictions of operation.Residential lending Financial institutions are still facing significant challenges in the residential mortgage market, particularly given the rising level of defaults and foreclosures and the lack of liquidity for private label mortgage-backed securities. Therefore, we will continue to focus on the adequacy of institutions' risk management practices, including their underwriting standards, and re-emphasize the importance of a lender's assessment of a borrower's ability to repay the loan. Toward that end, we are requiring institutions to maintain risk management practices that more effectively identify, monitor, and control the risks associated with their mortgage lending activity and that more adequately address lessons learned from recent events. In addition to efforts on the safety and soundness front, last year we finalized amendments to the rules under the Home Ownership and Equity Protection Act (HOEPA). These amendments establish sweeping new regulatory protections for consumers in the residential mortgage market. Our goal throughout this process has been to protect borrowers from practices that are unfair or deceptive and to preserve the availability of credit from responsible mortgage lenders. The Board believes that these regulations, which apply to all mortgage lenders, not just banks, will better protect consumers from a range of unfair or deceptive mortgage lending and advertising practices that have been the source of considerable concern and criticism. Given escalating mortgage foreclosures, we have urged regulated institutions to establish systematic, proactive, and streamlined mortgage loan modification protocols and to review troubled loans using these protocols. We expect an institution (acting either in the role of lender or servicer) to determine, before proceeding to foreclosure, whether a loan modification will enhance the net present value of the loan, and whether loans currently in foreclosure have been subject to such analysis. Such practices are not only consistent with sound risk management but are also in the long-term interests of borrowers, lenders, investors, and servicers. We are encouraging regulated institutions, through government programs, to pursue modifications that result in mortgages that borrowers will be able to sustain over the remaining maturity of their loan. In this regard, just recently the Federal Reserve joined with other financial supervisors to encourage all of the institutions we supervise to participate in the Treasury Department's Home Affordable loan modification program, which was established under the Troubled Assets Relief Program.\3\ Our examiners are closely monitoring loan modification efforts of institutions we supervise.--------------------------------------------------------------------------- \3\ See http://www.Federalreserve.gov/newsevents/press/bcreg/20090304a.htm.---------------------------------------------------------------------------Counterparty credit risk The Federal Reserve has been concerned about counterparty credit risk for some time, and has focused on requiring the industry to have effective risk management practices in place to deal with risks associated with transacting with hedge funds, for example, and other key counterparties. This focus includes assessing the overall quality of MIS for counterparty credit risk and ensuring that limits are complied with and exceptions appropriately reviewed. As the crisis has unfolded, we have intensified our monitoring of counterparty credit risk. Supervisors are analyzing management reports and, in some cases, are having daily conversations with management about ongoing issues and important developments. This process has allowed us to understand key linkages and exposures across the financial system as specific counterparties experience stress during the current market environment. Federal Reserve supervisors now collect information on the counterparty credit exposures of major institutions on a weekly and monthly basis, and have enhanced their methods of assessing this exposure. Within counterparty credit risk, issues surrounding the credit default swap (CDS) market have been particularly pertinent. As various Federal Reserve officials have noted in past testimony to congressional committees and in other public statements, regulators have, for several years, been addressing issues surrounding the over-the-counter (OTC) derivatives market in general and the CDS market in particular. Since September 2005, an international group of supervisors, under the leadership of the Federal Reserve Bank of New York, has been working with dealers and other market participants to strengthen arrangements for processing, clearing, and settling OTC derivatives. An early focus of this process was on CDS. This emphasis includes promoting such steps as greater use of electronic-confirmation platforms, adoption of a protocol that requires participants to request counterparty consent before assigning trades to a third party, and creation of a contract repository that maintains an electronic record of CDS trades. More recently, and in response to the recommendations of the President's Working Group on Financial Markets and the Financial Stability Forum, supervisors are working to bring about further improvements to the OTC derivatives market infrastructure. With respect to credit derivatives, this agenda includes: (1) further increasing standardization and automation; (2) incorporating an auction-based cash settlement mechanism into standard documentation; (3) reducing the volume of outstanding CDS contracts; and (4) developing well-designed central counterparty services to reduce systemic risks. The most important potential change in the infrastructure for credit derivatives is the creation of one or more central counterparties (CCPs) for CDS. The Federal Reserve supports CCP clearing of CDS because, if properly designed and managed, CCPs can reduce risks to market participants and to the financial system. In addition to clearing CDS through CCPs, the Federal Reserve believes that exchange trading of sufficiently standardized contracts by banks and other market participants can increase market liquidity and transparency, and thus should be encouraged. In a major step toward achieving that goal, the Federal Reserve Board, on March 4, 2009, approved the application by ICE US Trust LLC (ICE Trust) to become a member of the Federal Reserve System. ICE Trust intends to provide central counterparty services for certain credit default swap contracts.Commercial real estate For some time, the Federal Reserve has been focused on commercial real estate (CRE) exposures. For background, as part of our onsite supervision of banking organizations in the early 2000s, we began to observe rising CRE concentrations. Given the central role that CRE lending played in the banking problems of the late 1980s and early 1990s, we led an interagency effort to issue supervisory guidance on CRE concentrations. In the 2006 guidance on CRE, we emphasized our concern that some institutions' strategic- and capital-planning processes did not adequately acknowledge the risks from their CRE concentrations. We stated that stress testing and similar exercises were necessary for institutions to identify the impact of potential CRE shocks on earnings and capital, especially the impact from credit concentrations. Because weaker housing markets and deteriorating economic conditions have clearly impaired the quality of CRE loans at supervised banking organizations, we have redoubled our supervisory efforts in regard to this segment. These efforts include monitoring carefully the impact that declining collateral values may have on CRE exposures as well as assessing the extent to which banks have been complying with the interagency CRE guidance. We found, through horizontal reviews and other examinations, that some institutions would benefit from additional and better stress testing and could improve their understanding of how concentrations--both single-name and sectoral/geographical concentrations--can impact capital levels during shocks. We have also implemented additional examiner training so that our supervisory staff is equipped to deal with more serious CRE problems at banking organizations as they arise, and have enhanced our outreach to key real estate market participants and obtained additional market data sources to help support our supervisory activities. As a result of our supervisory work, risk management practices related to CRE are improving, including risk identification and measurement. To sum up our efforts to improve banks' risk management, we are looking at all of the areas mentioned above--both on an individual and collective basis--as well as other areas to ensure that all institutions have their risk management practices at satisfactory levels. More generally, where we have not seen appropriate progress, we are aggressively downgrading supervisory ratings and using our enforcement tools.Supervisory Lessons Learned Having just described many of the steps being taken by Federal Reserve supervisors to address risk management deficiencies in the banking industry, I would now like to turn briefly to our internal efforts to improve our own supervisory practices. The current crisis has helped us to recognize areas in which we, like the banking industry, can improve. Since last year, Vice Chairman Kohn has led a System-wide effort to identify lessons learned and to develop recommendations for potential improvements to supervisory practices. To benefit from multiple perspectives in these efforts, this internal process is drawing on staff from around the System. For example, we have formed System-wide groups, led by Board members and Reserve Bank Presidents, to address the identified issues in areas such as policies and guidance, the execution of supervisory responsibilities, and structure and governance. Each group is reviewing identified lessons learned, assessing the effectiveness of recent initiatives to rectify issues, and developing additional recommendations. We will leverage these group recommendations to arrive at an overall set of enhancements that will be implemented in concert. As you know, we are also meeting with Members of the Congress and other government bodies, including the Government Accountability Office, to consult on lessons learned and to hear additional suggestions for improving our practices. One immediate example of enhancements relates to System-wide efforts for forward-looking risk identification efforts. Building on previous System-wide efforts to provide perspectives on existing and emerging risks, the Federal Reserve has recently augmented its process to disseminate risk information to all the Reserve Banks. That process is one way we are ensuring that risks are identified in a consistent manner across the System by leveraging the collective insights of Federal Reserve supervisory staff. We are also using our internal risk reporting to help establish supervisory priorities, contribute to examination planning and scoping, and track issues for proper correction. Additionally, we are reviewing staffing levels and expertise so that we have the appropriate resources, including for proper risk identification, to address not just the challenges of the current environment but also those over the longer term. We have concluded that there is opportunity to improve our communication of supervisory and regulatory policies, guidance, and expectations to those we regulate. This includes more frequently updating our rules and regulations and more quickly issuing guidance as new risks and concerns are identified. For instance, we are reviewing the area of capital adequacy, including treatment of market risk exposures as well as exposures related to securitizations and counterparty credit risk. We are taking extra steps to ensure that as potential areas of risk are identified or new issues emerge, policies and guidance address those areas in an appropriate and timely manner. And we will increase our efforts to ensure that, for global banks, our policy and guidance responses are coordinated, to the extent possible, with those developed in other countries. One of the Federal Reserve's latest enhancements related to guidance, a project begun before the onset of the crisis, was the issuance of supervisory guidance on consolidated supervision. This guidance is intended to assist our examination staff as they carry out supervision of banking institutions, particularly large, complex firms with multiple legal entities, and to provide some clarity to bankers about our areas of supervisory focus. Importantly, the guidance is designed to calibrate supervisory objectives and activities to the systemic significance of the institutions and the complexity of their regulatory structures. The guidance provides more explicit expectations for supervisory staff on the importance of understanding and validating the effectiveness of the banking organization's corporate governance, risk management, and internal controls that are in place to oversee and manage risks across the organization. Our assessment of nonbank activities is an important part of our supervisory process to understand the linkages between depository and nondepository subsidiaries, and their effects on the overall risks of the organization. In addition to issues related to general risk management at nonbank subsidiaries, the consolidated supervision guidance addresses potential issues related to consumer compliance. In this regard, in 2007 and 2008 the Board collaborated with other U.S. and State government agencies to launch a cooperative pilot project aimed at expanding consumer protection compliance reviews at selected nondepository lenders with significant subprime mortgage operations. This interagency initiative has clarified jurisdictional issues and improved information-sharing among the participating agencies, along with furthering its overarching goal of preventing abusive and fraudulent lending while ensuring that consumers retain access to beneficial credit. As stated earlier, there were numerous cases in which the U.S. banking agencies developed policies and guidance for emerging risks and issues that warranted the industry's attention, such as in the areas of nontraditional mortgages, home equity lending, and complex structured financial transactions. It is important that regulatory policies and guidance continue to be applied to firms in ways that allow for different business models and that do not squelch innovation. However, when bankers are particularly confident, when the industry and others are especially vocal about the costs of regulatory burden and international competitiveness, and when supervisors cannot yet cite recognized losses or writedowns, we must have even firmer resolve to hold firms accountable for prudent risk management practices. It is particularly important, in such cases, that our supervisory communications are very forceful and clear, directed at senior management and boards of directors so that matters are given proper attention and resolved to our satisfaction. With respect to consumer protection matters, we have an even greater understanding that reviews of consumer compliance records of nonbank subsidiaries of bank holding companies can aid in confirming the level of risk that these entities assume, and that they assist in identifying appropriate supervisory action. Our consumer compliance division is currently developing a program to further the work that was begun in the interagency pilot discussed earlier. In addition to these points, it is important to note that we have learned lessons and taken action on important aspects of our consumer protection program, which I believe others from the Federal Reserve have discussed with the Congress. In addition, we must further enhance our ability to develop clear and timely analysis of the interconnections among both regulated and unregulated institutions, and among institutions and markets, and the potential for these linkages and interrelationships to adversely affect banking organizations and the financial system. In many ways, the Federal Reserve is well positioned to meet this challenge. In this regard, the current crisis has, in our view, demonstrated the ways in which the Federal Reserve's consolidated supervision role closely complements our other central bank responsibilities, including the objectives of fostering financial stability and deterring or managing financial crises. The information, expertise, and powers derived from our supervisory authority enhance the Federal Reserve's ability to help reduce the likelihood of financial crises, and to work with the Treasury Department and other U.S. and foreign authorities to manage such crises should they occur. Indeed, the enhanced consolidated supervision guidance that the Federal Reserve issued in 2008 explicitly outlines the process by which we will use information obtained in the course of supervising financial institutions--as well as information and analysis obtained through relationships with other supervisors and other sources--to identify potential vulnerabilities across financial institutions. It will also help us identify areas of supervisory focus that might further the Federal Reserve's knowledge of markets and counterparties and their linkages to banking organizations and the potential implications for financial stability. A final supervisory lesson applies to the structure of the U.S. regulatory system, an issue that the Congress, the Federal Reserve, and others have already raised. While we have strong, cooperative relationships with other relevant bank supervisors and functional regulators, there are obvious gaps and operational challenges in the regulation and supervision of the overall U.S. financial system. This is an issue that the Federal Reserve has been studying for some time, and we look forward to providing support to the Congress and the Administration as they consider regulatory reform. In a recent speech, Chairman Bernanke introduced some ideas to improve the oversight of the U.S. financial system, including the oversight of nonbank entities. He stated that no matter what the future regulatory structure in the United States, there should be strong consolidated supervision of all systemically important banking and nonbanking financial institutions. Finally, Mr. Chairman, 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 the 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. ______ CHRG-111shrg55739--31 Chairman Dodd," Thank you very much. Senator Reed. Senator Reed. Well, thank you very much, Mr. Chairman. Thank you, Mr. Secretary. The issue that Chairman Dodd raised with respect to due diligence is embroached by the second panel, Professor Coffee and Mr. Joynt on behalf of Fitch. One suggests that we instruct--Professor Coffee--neutral clients and other institutional investors that they cannot rely on ratings to meet their fiduciary obligations unless there was, in fact, third-party due diligence. Mr. Fitch's approach is to ensure that the issuers and underwriters perform such due diligence. Do you have a position with respect to these two views or another view? " FinancialCrisisReport--157 Restrictions on Negative Amortization Loans. Witnesses at the Subcommittee’s April 16 hearing also criticized WaMu’s heavy reliance on Option ARM loans. These loans provided borrowers with a low initial interest rate, which was followed at a later time by a higher variable rate. Borrowers were generally qualified for the loans by assuming they would pay the lower rather than the higher rate. In addition, borrowers were allowed to select one of four types of monthly payments, including a “minimum payment” that was less than the interest and principal owed on the loan. If the borrower selected the minimum payment, the unpaid interest was added to the unpaid loan principal, which meant that the loan debt could increase rather than decrease over time, resulting in negative amortization. At the Subcommittee hearing, the FDIC Inspector General Jon Rymer warned that negative amortization loans are “extraordinarily risky” for both borrowers and banks. 587 The FDIC Chairman Sheila Bair testified: “We are opposed to teaser rate underwriting. You need to underwrite at the fully indexed rate. 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.” 588 The Dodd-Frank Act does not ban negatively amortizing loans, but does impose new restrictions on them. Section 1411 amends TILA by adding a new Section 129C(6) that requires, for any residential mortgage that allows a borrower “to defer the repayment of any principal or interest,” that the lender vet potential borrowers based upon the borrower’s ability to make monthly loan payments on a fully amortizing schedule – meaning a schedule in which the loan would be fully repaid by the end of the loan period – instead of evaluating the borrower’s ability to make payments at an initial teaser rate or in some amount that is less than the amount required at a fully amortized rate. The law also requires the lender, when qualifying a borrower, to “take into consideration any balance increase that may accrue from any negative amortization provision.” This provision essentially codifies the provisions in the 2006 Nontraditional Mortgage Guidance regarding qualification of borrowers for negatively amortizing loans. In addition, Section 1414 of the Dodd-Frank Act adds a new Section 129C(c) to TILA prohibiting lenders from issuing a mortgage with negative amortization without providing certain disclosures to the borrower prior to the loan. The lender is required to provide the borrower with an explanation of negative amortization in a manner prescribed by regulation as well as describe its impact, for example, how it can lead to an increase in the loan’s outstanding principal balance. In the case of a first-time home buyer, the lender must also obtain documentation that the home buyer received homeownership counseling from a HUD-certified organization or counselor. Finally, Section 1412 of the Dodd-Frank Act, establishing the new favored category of “qualified mortgages,” states those mortgages cannot negatively amortize. mortgage loans, the Federal Reserve is expected to issue revised regulations during 2011, expanding the verification requirement to all mortgage loans. 587 April 16, 2010 Subcommittee Hearing at 16. 588 Id. at 88. CHRG-111shrg57320--189 Mr. Dochow," I can tell you that it was standard practice that those loans were made, and that to the extent they were sold into the secondary market without recourse, or even with recourse--we focused on the recourse, quite frankly. Senator Kaufman. Sure. You didn't focus on the riskiness of the loans? " CHRG-110hhrg44901--101 Mr. Scott," I have two points. Your answer on the economic stimulus package, how good was it, is it good, and given the weakness of the economic forecast, wouldn't it make sense perhaps to extend another round of that economic stimulus package to get some checks more directly into the hands of the American people? " CHRG-111hhrg74090--183 Mr. Radanovich," Can you describe a scenario where the duplicative regulatory authorities allowed by this Act's weak preemption provision might actually prevent consumers from access to valuable financial services? This is the State preemption issue where you would have 51 different---- " FOMC20060920meeting--155 153,CHAIRMAN BERNANKE., That is a good practice. [Laughter] fcic_final_report_full--523 Freddie Mac. As noted earlier, in its limited review of the role of the GSEs in the financial crisis, the Commission spent most of its time and staff resources on a review of Fannie Mae, and for that reason this dissent focuses primarily on documents received from Fannie. However, things were not substantially different at Freddie Mac. In a document dated June 4, 2009, entitled “Cost of Freddie Mac’s Affordable Housing Mission,” a report to the Business Risk Committee, of the Board of Directors, 136 several points were made that show the experience of Freddie was no different than Fannie’s: • Our housing goals compliance required little direct subsidy prior to 2003, but since then subsidies have averaged $200 million per year. • Higher credit risk mortgages disproportionately tend to be goal-qualifying. Targeted affordable lending generally requires ‘accepting’ substantially higher credit risk. • We charge more for targeted (and baseline) affordable single-family loans, but not enough to fully offset their higher incremental risk. • Goal-qualifying single-family loans accounted for the disproportionate share of our 2008 realized losses that was predicted by our models. (slide 2) • In 2007 Freddie Mac failed two subgoals, but compliance was subsequently deemed infeasible by the regulator due to economic conditions. In 2008 Freddie Mac failed six goals and subgoals, five of which were deemed infeasible. No enforcement action was taken regarding the sixth missed goal because of our financial condition. (slide 3) • Goal-qualifying loans tend to be higher risk. Lower household income correlates with various risk factors such as less wealth, less employment stability, higher loan-to-value ratios, or lower credit scores. (slide 7) • Targeted affordable loans have much higher expected default probabilities... Over one-half of targeted affordable loans have higher expected default probabilities than the highest 5% of non-goal-qualifying loans. (Slide 8) The use of the affordable housing goals to force a reduction in the GSEs’ underwriting standards was a major policy error committed by HUD in two successive administrations, and must be recognized as such if we are ever to understand what caused the financial crisis. Ultimately, the AH goals extended the housing bubble, infused it with weak and high risk NTMs, caused the insolvency of Fannie and Freddie, and—together with other elements of U.S. housing policy—was the principal cause of the financial crisis itself. When Congress enacted the Housing and Economic Recovery Act of 2008 (HERA), it transferred the responsibility for administering the affordable housing goals from HUD to FHFA. In 2010, FHFA modified and simplified the AH goals, and eliminated one of their most troubling elements. As Fannie had noted, if the AH goals exceed the number of goals-eligible borrowers in the market, they were being forced to allocate credit, taking it from the middle class and providing it to low- income borrowers. In effect, there was a conflict between their mission to advance affordable housing and their mission to maintain a liquid secondary mortgage 136 Freddie Mac, “Cost of Freddie Mac’s Affordable Housing Mission,” Business Risk Committee, Board of Directors, June 4, 2009. 519 market for most mortgages in the U.S. The new FHFA rule does not require the GSEs to purchase more qualifying loans than the percentage of the total market that these loans constitute. 137 CHRG-110hhrg41184--62 Mr. Bernanke," Congresswoman, first of all, I agree. It is very important to protect consumers in their dealings with credit cards. As you mentioned, we have put out Reg Z revisions for comment, and includes this 45-day period. Within the Reg Z authority, we could not take that second step that you mentioned, but as I mentioned in my testimony, we are currently looking under a different authority, which is the FTC, Unfair Deceptive Acts and Practices Authority, at a range of practices including billing practices. And we will hope to come up with some rules for comment within the next few months. So we are looking at all those issues and we will be providing some proposed rules. " CHRG-111hhrg51698--325 Mr. Morelle," I would point out that, as it relates to state regulation of insurance companies, that we have reserving requirements and insolvency tests. The question about collateral calls, which is often talked about, a posting of collateral; typically, the collateral posted is not nearly the amount of collateral necessary to be able to pay claims. So reserving does do it. It requires an analysis of losses, projected losses based on histories, and we have not had those insurers who have defaulted in regulated states. We have not had defaults. In fact, they remain robust and strong. I point out AIG, for instance, the subsidiary companies are robust; and we do that through reserving and making certain that when people take on risk or underwrite risk they have adequate resources to be able to cover the claims. " CHRG-110shrg38109--59 Chairman Bernanke," I would say that qualitatively it is fairly similar to the recovery that followed the 1991 recession, with many of the same features. There was weakness for some time after the recession ended, including a period of so-called ``jobless growth.'' Senator Bunning. But we did not have a housing market that---- " CHRG-110hhrg41184--195 Mr. Bernanke," Well, there is a certain tendency to fight the last war in all areas of effort. But, as this episode has found areas of weakness and problems, we need to do our best to address them, and do our best to be alert to new problems that might crop up in other unforeseen areas. " CHRG-111hhrg74090--215 Mr. Dingell," You represent consumers. Why shouldn't we just leave FTC as it is and let these other folk go about their nefarious business under the kind of weak-minded regulation that the Treasury has traditionally given to these institutions? Ms. Hillebrand. We are absolutely in favor of---- " CHRG-111hhrg55814--405 Mr. Bachus," Thank you, Mr. Chairman. Mr. Chairman, I would like to ask each of the panelists--and maybe just a yes or no, or a very brief response, have you had time since the discussion draft was issued to thoroughly analyze the bill, as far as strengths and weaknesses? " CHRG-111shrg57320--7 Mr. Rymer," Good morning, Mr. Chairman, Ranking Member Coburn, and Senator Kaufman. Thank you for the opportunity to appear here today and present the results of the Federal Deposit Insurance Corporation Office of Inspector General work relating to Washington Mutual Bank.--------------------------------------------------------------------------- \1\ The prepared statement of Mr. Rymer appears in the Appendix on page 119.--------------------------------------------------------------------------- WaMu represents the largest bank failure to date. At the time of its failure, WaMu operated over 2,300 branches in 15 States and had assets of $307 billion. Because of WaMu's size, the circumstances leading up to the failure, and the non-Deposit Insurance Fund losses, such as shareholder value, we initiated a review of WaMu to evaluate the actions of the Office of Thrift Supervision and the FDIC. We very much appreciate the cooperation we received from the OTS and the FDIC in conducting our work, and we appreciate the contributions by my colleagues at the Department of Treasury OIG. As Mr. Thorson did, I would like to recognize key members of my staff who participated in this review. They are Peggy Wolf, Ann Lewis, Diana Chatfield, and Andriana Rojas, and they were led by Marshall Gentry. This is a very important project for our staff. Our resulting report is unique. It provides a comprehensive look at a failed institution from both the primary and back-up regulatory perspectives and has resulted in significant insights regarding the effectiveness of each and the interplay between the two. We released the report yesterday afternoon on our public Website. As you just heard Mr. Thorson say, Treasury OIG focused on the causes of WaMu's failure and the OTS supervision of the institution. My office focused on the FDIC's role as insurer and back-up supervisor. My statement discusses an over-reliance on an institution's safety and soundness, or CAMELS, rating and capital levels for the purpose of assessing the risk that the institution may pose to the Insurance Fund. My statement will also highlight the FDIC's regulatory tools to mitigate risk, noting significant limitations in the interagency agreement related to information sharing and back-up examination authority. The FDIC was the deposit insurer for WaMu and was responsible for monitoring and assessing WaMu's risk to the fund. Prior to its failure, WaMu was the eighth-largest institution insured by the FDIC. The FDIC conducted its required monitoring of WaMu for the period covered for our review, and that is 2003 to 2008, and it identified risks with WaMu that ultimately caused its failure, namely a high-risk lending strategy, liberal underwriting, and inadequate internal controls. FDIC monitoring indicated more risk at WaMu than was reflected in the OTS CAMELS ratings. FDIC also identified the significance of those risks earlier than OTS. However, the risks noted in the FDIC monitoring reports were not reflected in WaMu's deposit insurance premium payments. This discrepancy occurred because the deposit insurance regulations rely on the CAMELS ratings and regulatory capital levels to gauge risk and assess related deposit insurance premiums. Because OTS examinations results rated WaMu as fundamentally sound from 2003 to 2007, increases in deposit insurance premiums were not triggered. Additionally, because of statutory limitations and congressionally-mandated credits, WaMu paid $51 million, or only about a quarter of the $216 million in deposit premiums it was assessed during the period of 2003 to 2008. The FDIC estimates that WaMu's failure could have caused, as you said earlier, Mr. Chairman, a $41.5 billion loss to the Deposit Insurance Fund. The FDIC has three primary tools at its disposal to address the risk that it identified at WaMu. One is back-up examination authority. Two is challenging the OTS CAMELS ratings. And three is regulatory enforcement actions. The FDIC made use of some, but not all, of these tools. Back-up examination authority allows the FDIC to conduct its own examination of non-FDIC supervised institutions when the FDIC believes it is necessary to determine the condition of the institution for insurance purposes. The FDIC, OTS, Office of the Comptroller of the Currency, and the Federal Reserve entered into an interagency agreement in 2002 that provided guidance on invoking back-up examination authority, including the sharing of institution information. According to the terms of the interagency agreement, the FDIC needed to request permission from OTS to begin back-up examination authority. This would have allowed FDIC examiners to review information on-site at WaMu so they could better assess WaMu's risk to the fund. The interagency agreement required FDIC to prove to OTS that WaMu exhibited one of the following: A heightened level of risk, meaning WaMu was rated a 3, 4, or 5, and was undercapitalized, or material deteriorating conditions, or other adverse developments that could result in WaMu's becoming troubled in the near term. The logic of this interagency agreement is circular. The FDIC must show a specific level of risk at an institution to receive access, but the FDIC needs access to the information to determine the risk to the fund. OTS resisted providing FDIC examiners greater on-site access to WaMu information because they didn't feel that the FDIC met the requisite need for information, according to the terms of the interagency agreement, and believed that the FDIC could rely on the work performed by the OTS examiners. OTS did grant FDIC greater access at WaMu, but limited FDIC's review of WaMu's residential loan files. The FDIC wanted to review these files to assess underwriting and WaMu's compliance with the Non-Traditional Mortgage Guidance. In May 2008, FDIC began for the first time using its second regulatory tool, challenging the CAMELS rating, to challenge the OTS safety soundness ratings at WaMu. However, OTS was reluctant to lower its rating of WaMu from a 3 to a 4, in line with FDIC's view. OTS and FDIC resolved the ratings disagreement 6 days prior to WaMu's failure, when OTS lowered its rating to agree with FDIC's rating. By that time, the rating downgrade had no impact on WaMu's insurance premium assessment or payments. Finally, the FDIC chose not to invoke its third tool, its enforcement powers. FDIC has statutory authority to impose its own enforcement actions on an institution to protect the fund, provided statutory and regulatory procedures are followed. According to the FDIC, it did not use those powers for WaMu because it believed the steps to use those powers were too cumbersome. Key conclusions, our report highlighted two major concerns related to the deposit insurance regulations and the interagency agreement governing back-up authority. We made two recommendations to address these concerns. The FDIC has concurred with both recommendations and is working to implement these recommendations by year end. Mr. Chairman, this concludes my statement and I would be happy to answer any questions you may have. Thank you. Senator Levin. Thank you both, and thank you for your reports, which, of course, will be made part of the record. They are invaluable and very objective assessments which are important for Congress as we consider regulatory financial reform, so those reports of yours are going to be very helpful to us. In Exhibit 14,\1\ Mr. Franklin, one of WaMu's former examiners, said that stated income loans were ``a flawed product that can't be fixed and never should have been allowed in the first place.'' OTS management told them that was not OTS' policy. Now, those stated income loans are where income is stated on an application, but there is no verification for it. If you look at Exhibit 14, that letter from Mr. Franklin, not only does he say these loans are a terrible mistake, but he also says, ``I concur totally on the W-2 borrowers. The worst cases I saw were instances where the W-2 was in the file and the information was redacted out.'' How is that for unbelievability? You have got a W-2 in the file and the income is redacted. That is what was going on here.--------------------------------------------------------------------------- \1\ See Exhibit No. 14, which appears in the Appendix on page 261.--------------------------------------------------------------------------- Then you look at Exhibit 79.\1\ Another OTS official voiced his concern over another kind of loan where there is no income and no asset figures that are shown--this was May 2007--saying that these are unsafe and unsound. We had Mr. Vanasek on Tuesday, WaMu's former Chief Risk Officer, testifying that loan application forms without verification led to fraud. And in fact, on some loan application forms, he also testified that WaMu loan officers were coaching the people who were filing the forms.--------------------------------------------------------------------------- \1\ See Exhibit No. 79, which appears in the Appendix on page 478.--------------------------------------------------------------------------- Do any banking regulators now ban the practice of no stated loans and these NINA loans, in other words, where income is not stated, the so-called stated income loans but there is no proof, and where NINA loans are allowed? Do you know of any current regulator that disallows those kind of loans? " CHRG-110hhrg44901--67 Mr. Bernanke," Again, I think I would not put much weight on this technical terminology. I mean, I think it is clear that growth has been slow, and that the labor market is weak. And so conditions are tough on families. I have no doubt whether it is technically a recession or not, and I don't see how that makes a great deal of difference. As far as the projection is concerned, we see continued growth, positive growth but weak for the rest of the year. Looking at the housing market, it is beginning to stabilize, at some point around the end of the year, early next year. And with the hope that we can continue to strengthen the financial system, we would hope to see recovery back to more normal levels of growth in 2009. But like all economic forecasting, there are uncertainties in both directions. But with respect to the current situation, again, whether it is a recession or not doesn't really play in our policy decisions. " CHRG-110hhrg34673--213 Mr. Ellison," Do you have any views on things like universal default? This is a credit card practice I am sure you are familiar with. If you default, if you are late on one credit card, a credit card company you are not late on can jack up your rate. Do you have any views on that practice and how Congress might approach that kind of phenomena? " fcic_final_report_full--144 Multisector CDOs went through a tough patch when some of the asset-backed se- curities in which they invested started to perform poorly in —particularly those backed by mobile home loans (after borrowers defaulted in large numbers), aircraft leases (after /), and mutual fund fees (after the dot-com bust).  The accepted wis- dom among many investment banks, investors, and rating agencies was that the wide range of assets had actually contributed to the problem; according to this view, the asset managers who selected the portfolios could not be experts in sectors as diverse as aircraft leases and mutual funds. So the CDO industry turned to nonprime mortgage–backed securities, which CDO managers believed they understood, which seemed to have a record of good performance, and which paid relatively high returns for what was considered a safe investment. “Everyone looked at the sector and said, the CDO construct works, but we just need to find more stable collateral,” said Wing Chau, who ran two firms, Maxim Group and Harding Advisory, that managed CDOs mostly underwritten by Merrill Lynch. “And the industry looked at residential mortgage–backed securities, Alt-A, subprime, and non-agency mortgages, and saw the relative stability.”  CDOs quickly became ubiquitous in the mortgage business.  Investors liked the combination of apparent safety and strong returns, and investment bankers liked having a new source of demand for the lower tranches of mortgage-backed securities and other asset-backed securities that they created. “We told you these [BBB-rated securities] were a great deal, and priced at great spreads, but nobody stepped up,” the Credit Suisse banker Joe Donovan told a Phoenix conference of securitization bankers in February . “So we created the investor.”  By , creators of CDOs were the dominant buyers of the BBB-rated tranches of mortgage-backed securities, and their bids significantly influenced prices in the market for these securities. By , they were buying “virtually all” of the BBB tranches.  Just as mortgage-backed securities provided the cash to originate mort- gages, now CDOs would provide the cash to fund mortgage-backed securities. Also by , mortgage-backed securities accounted for more than half of the collateral in CDOs, up from  in .  Sales of these CDOs more than doubled every year, jumping from  billion in  to  billion in .  Filling this pipeline would require hundreds of billions of dollars of subprime and Alt-A mortgages. “It was a lot of effort” Five key types of players were involved in the construction of CDOs: securities firms, CDO managers, rating agencies, investors, and financial guarantors. Each took vary- ing degrees of risk and, for a time, profited handsomely. Securities firms underwrote the CDOs: that is, they approved the selection of col- lateral, structured the notes into tranches, and were responsible for selling them to investors. Three firms—Merrill Lynch, Goldman Sachs, and the securities arm of Citigroup—accounted for more than  of CDOs structured from  to . Deutsche Bank and UBS were also major participants.  “We had sales representa- tives in all those [global] locations, and their jobs were to sell structured products,” Nestor Dominguez, the co-head of Citigroup’s CDO desk, told the FCIC. “We spent a lot of effort to have people in place to educate, to pitch structured products. So, it was a lot of effort, about  people. And I presume our competitors did the same.”  The underwriters’ focus was on generating fees and structuring deals that they could sell. Underwriting did entail risks, however. The securities firm had to hold the assets, such as the BBB-rated tranches of mortgage-backed securities, during the ramp-up period—six to nine months when the firm was accumulating the mortgage- backed securities for the CDOs. Typically, during that period, the securities firm took the risk that the assets might lose value. “Our business was to make new issue fees, [and to] make sure that if the market did have a downturn, we were somehow hedged,” Michael Lamont, the former co-head for CDOs at Deutsche Bank, told the FCIC.  Chris Ricciardi, formerly head of the CDO desk at Merrill Lynch, likewise told the FCIC that he did not track the performance of CDOs after underwriting them.  Moreover, Lamont said it was not his job to decide whether the rating agen- cies’ models had the correct underlying assumptions. That “was not what we brought to the table,” he said.  In many cases, though, underwriters helped CDO managers select collateral, leading to potential conflicts (more on that later). CHRG-111shrg57322--1058 Mr. Blankfein," I don't know specifically about Long Beach. I know we have, in all our businesses, due diligence processes that are appropriate for the business. So I would say as a matter of process, I would assume appropriate due diligence was done on it, based on our standards and our protocols. Senator McCaskill. Well, in May 2006, you were the co-lead underwriter with WaMu to securitize about 532 in subprime second lien fixed rate mortgages originated by Long Beach. Now, keep in mind that this is the same Long Beach that had to buy back hundreds of millions of dollars of mortgages because of problems. At one point in time a few years earlier, they had been shut down because of problems. And I guess I would like to request, on behalf of the Subcommittee, that we see the analysis, first of all, that we figure out what mortgages these were that were analyzed, where you found fraud and you found 5 percent fraud, 7 percent material occupancy misrepresentation, 20 percent material compliance issues. I think it would be important for us to see those documents on the instruments you created for folks to take a side on. " Mr. Blankfein," OK. I am not sure whether an instrument was created out of this, but I get the point and will look for it. Senator McCaskill. Yes. I mean, I think the point is that it is hard for us to believe that if you all were doing the due diligence that you have stated a couple of times in your testimony, now we know that these things were full of this kind of stuff. We know that. And you obviously knew it on one instance because we have a document from somebody in your employ that 38 percent of the loans are out of tolerance. I recommend putting back 26 percent of the pool, if possible. It doesn't make me comfortable that you all, after doing the due diligence, actually disclosed as much as you maybe should have disclosed about some of the problematic paper that you were packaging up for investors, and so I would like to follow that trail and get the same kind of documents on the instruments that you did put out in the market, both in 2006, 2007---- " FinancialCrisisInquiry--215 HOLTZ-EAKIN: But—but in the recent years, we haven’t seen dramatic changes in that aspect of policy, but we did see a big jump in the homeownership rate. ROSEN: Right. HOLTZ-EAKIN: I mean, those facts are right? 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. ROSEN: FOMC20070918meeting--173 171,MR. ALVAREZ., That’s the current practice. That’s right. FOMC20070918meeting--174 172,CHAIRMAN BERNANKE., That’s the same practice we use for a dissent on the action. CHRG-111shrg57321--192 Mr. McDaniel," As far as barbelling by taking strong and weak FICO scores---- Senator Kaufman. Right. Mr. McDaniel [continuing]. And averaging those out, we do not look at FICO scores on an average basis, so that barbelling, I don't---- Senator Kaufman. And you never have? " CHRG-111hhrg56847--123 Mr. Bernanke," There are three areas where private final demand is relatively strong. The consumer has been pretty strong, which is a very important component. It is a big component, obviously. Equipment and software investment by firms, not construction but equipment, and exports have been strong. Those are the main components. The others are relatively weak. " CHRG-110hhrg46594--328 Mr. Wagoner," Ours aren't down quite as much. We had a strong prior September, so we had a little weaker October. We are not down quite that much. But we think the industry is still going to be running in the 11-ish range. Maybe a little less, maybe a little more. So very weak by any standard. " CHRG-110shrg46629--88 Chairman Bernanke," It is a consideration. As you pointed out initially, I am not taking a position on this. Senator Schumer. I understand. I am just asking your economic views of these things and I appreciate it. Next, I would like to go to subprimes. Basically, you mentioned today that direct Federal legislation would help speed up the Fed's efforts to fix the problems in the subprime industry. As you know, Senators Brown, Casey, and I have introduced proposed legislation that would specifically regulate the mortgage broker industry. Our bill would establish a fiduciary duty and good faith stands for mortgage brokers and other nonbank originators and require originators to underwrite loans at the fully indexed rate, prohibit steering, among other things. First, could you give us your thoughts--I am not asking you to endorse the specific bill--but on those concepts and whether it makes sense? And are these types of proposals some that would help the Fed's efforts to regulate the subprime mortgage broker industry? " CHRG-111hhrg67816--2 Mr. Rush," The Subcommittee on Commerce, Trade and Consumer Protection will come to order. Today's hearing is a hearing that we are anxiously awaiting to conduct. It is a hearing on Consumer Credit and Debt, the Role of the Federal Trade Commission in Protecting the Public. The chair would yield himself 5 minutes for the purposes of a opening statement. Three weeks ago, the Subcommittee on Commerce, Trade, and Consumer Protection held a hearing on abusive credit practices in the used-car industry. Today, I want to expand our inquiry into the world of consumer credit and debt in general. For the past decade, if not longer, American consumers, particularly low-income Americans, have been swimming in shark-infested waters. Whether it is sub-prime mortgages, auto loans, or pay-day loans, too many companies have had a free reign to saddle Americans with debts they simply cannot afford. They sold their snake oil by taking advantage of the people's circumstances, or with outright deception. Unfortunately, there wasn't a strong enforcement or regulatory authority at the federal level protecting consumers from these abusive practices. The result has been a wrecked economy, and, I might add, wrecked lives. The purpose of today's hearing is twofold. First, I want us to examine the actions taken by the Federal Trade Commission in cracking down on abusive credit practices. The FTC has broad authority under the FTC Act to enforce against ``unfair or deceptive acts of practices.'' How was this broad authority exercised is one question that we may ask. If the Commission took insufficient action in the past, then why was that the case is another looming question. Was it political will or was it because the Commission lacks sufficient statutory authority and resources is the third question that we should explore. Second, in this hearing, I want members of the subcommittee to deliberate on reforms that Congress can initiate to make the FTC as effective as possible in protecting consumers from abusive credit and debt practices in the marketplace. I am working on legislation that will better equip the Commission to aggressively address abusive lending practices. How can we utilize the Commission's historical authority to prohibit and enforce against unfair or deceptive acts or practices to our advantage? The FTC is America's foremost consumer protection agency, and we need to take advantage of its historical authority by enhancing the Commission's underlying regulatory and enforcement powers. I believe the basic cornerstones of the Consumer Credit Protection Agency are already in place but some reforms are more than likely necessary. Does the Commission need more resources? Should the Commission be given regulatory or rulemaking authority under the Administrative Procedures Act to replace its current, burdensome rulemaking process under Magnusson-Moss? Should the Commission be given additional civil penalty authority? If the FTC has one hand tied behind its back, I believe that we should untie that one hand, but if we do so, we must be assured that the Commission will aggressively utilize these tools to protect consumers to the fullest extent. Today, I want to explore how the FTC can be equipped to adequately deal with not only today's abusive practices, such as sub-prime mortgages and pay-day loans, but also tomorrow's unforeseen snake oil that will be sold to consumers in the future. I want to congratulate and welcome the new chairman of the FTC, Mr. Jon Leibowitz. I have had the opportunity to meet with him, and I find him an outstanding and fine gentleman and a dedicated public servant. And this is his first appearance on Capitol Hill as chairman of the FTC. And I hope that this hearing today will be first in a series of constructive hearings. As chairman of this subcommittee, I want to have a constructive relationship with Chairman Leibowitz and with our friends at the Commission to ensure that both Congress and the FTC are doing everything we can to protect the American consumers, particularly poor American consumers, from the unfair, deceptive, and abusive practices that are far too prevalent in the American economy. With that, I yield back the balance of my time. [The prepared statement of Mr. Rush follows:] [GRAPHIC] [TIFF OMITTED] T7816A.001 CHRG-111shrg57319--116 Mr. Vanasek," Senator, I would have answered the question somewhat differently. I realized by 2004 that the industry was in some degree of difficulty. Obviously, I didn't know then and I didn't foresee the magnitude of the difficulty. I didn't see the broad-based failure in financial institutions to the degree that they subsequently unfolded. But it was clear to me that the practices were fundamentally unsound, and it couldn't go on forever. We had housing prices increasing much more rapidly than incomes and you knew that ultimately there was a limit to this. It just practically could not go on. So that was part of my 2004, in effect, urgent message to management that we needed to drop these practices and become more conservative at that point in time. Senator Coburn. And unfortunately, they did not heed that advice. " CHRG-111hhrg56766--311 Mr. Bernanke," On the first point, I am not advocating and I do not think anyone is advocating trying to balance the budget this year or next year. Obviously, there has been a big drop in revenues, a lot of extra expenses. The issue is trying to have an exit strategy, try to find some years down the road a sustainable fiscal path that will give confidence that we can in fact exit from this extraordinary situation. I have talked, as you know, a good bit about getting lending going again and talking about supervisory efforts that we are doing. I think it is worth noting that there was a poll this morning the NFIB put out and asked small firms what their most important problem is. We got an answer which we have seen before which is only 8 percent said credit was their most important problem. The majority of them think weak demand, the weak economy, is the most important problem. This is not a complete answer to your question, but I do think as we get the economy moving again and strengthening, that is going to make banks more willing to lend and it is going to bring good borrowers to the banks to get credit. I think just strengthening the economy is going to be a big help. It is important for us as supervisors, and I have mentioned, for example, the various new efforts we are making to get feedback, to get data, to do analyses, to try to make sure our examiners are taking a balanced perspective and are not blocking loans to good creditworthy borrowers. We do not want to make loans to borrowers who cannot pay back, but we do want to make loans to those who are creditworthy. That is an important objective we can continue to work on. " fcic_final_report_full--178 As mortgage fraud grew, state agencies took action. In Florida, Ellen Wilcox, a special agent with the state Department of Law Enforcement, teamed with the Tampa police department and Hillsborough County Consumer Protection Agency to bring down a criminal ring scamming homeowners in the Tampa area. Its key member was Orson Benn, a New York–based vice president of Argent Mortgage Company, a unit of Ameriquest. Beginning in ,  investigators and two prosecutors worked for years to unravel a network of alliances between real estate brokers, appraisers, home repair contractors, title companies, notaries, and a convicted felon in a case that in- volved some  loans.  According to charging documents in the case, the perpetrators would walk through neighborhoods, looking for elderly homeowners they thought were likely to have substantial equity in their homes. They would suggest repairs or improvements to the homes. The homeowners would fill out paperwork, and insiders would use the information to apply for loans in their names. Members of the ring would prepare fraudulent loan documents, including false W- forms, filled with information about invented employment and falsified salaries, and take out home equity loans in the homeowners’ names. Each person involved in the transaction would receive a fee for his or her role; Benn, at Argent, received a , kickback for each loan he helped secure. When the loan was funded, the checks were frequently made out to the bogus home construction company that had proposed the work, which would then disap- pear with the proceeds. Some of the homeowners never received a penny from the refinancing on their homes. Hillsborough County officials learned of the scam when homeowners approached them to say that scheduled repairs had never been made to their homes, and then sometimes learned that they had lost years’ worth of equity as well. Sixteen of  defendants, including Benn, have been convicted or have pled guilty.  Wilcox told the Commission that the “cost and length of these investigations make them less attractive to most investigative agencies and prosecutors trying to justify their budgets based on investigative statistics.”  She said it has been hard to follow up on other cases because so many of the subprime lenders have gone out of business, making it difficult to track down perpetrators and witnesses. Ameriquest, for example, collapsed in , although Argent, and the company’s loan-servicing arm, were bought by Citigroup that same year. CHRG-111shrg57320--70 Mr. Thorson," Sixty percent? Senator Kaufman. Would you be surprised if I told you that approximately 90 percent of all WaMu's home equity loans were stated income loans. Now, folks, when you are writing a report--and, again, I have spent a lot of time on this, plus I have the advantage of hearing the witnesses the other day and the rest of it, so I have a different view. And you are doing your report, and you are doing a good job, and I am not being critical. But if you have a company where 90 percent of their home equity loans are stated loans, a practice which you both define as just exactly--I mean, you did it much more articulately, but just you should not be doing that in a bank. You have got to think maybe that was one of the causes that things went the way they did. Let me ask you, the Option ARMs, these are high-risk loans, Option ARMs, right? I will not do the same thing. Seventy-three percent of all Option ARMs were stated income loans. " CHRG-111hhrg53240--112 Mr. Carr," I would agree with that. I would add, however, that the first step in enforcement is actually knowing there is a problem. And one of the great opportunities of this new agency is to have a staff steeped in the ability and understanding of consumer issues such that they can examine the trends and practices, and patterns and practices, to bring forth really powerful studies with a Federal imprimatur. " CHRG-111shrg56376--90 Mr. Tarullo," I would just say, Senator, that you alluded to circumstances in which interstate operations became a problem, and I think that can be the case. But that is where it is important to focus upon the business model of the entity in question. It ought not to be allowed to engage in unsafe and unsound practices, whether they involve excessive branching that is unsupported by a sound business plan or other practices. " CHRG-111hhrg58044--21 Chairman Gutierrez," We have two panels this morning. The first panel will focus on the use of credit information for insurance underwriting and ratings, and the second panel will focus on the use of credit information in other areas such as employment. The first panel consists of three witnesses. First, the honorable Michael T. McRaith, director of the Illinois Department of Insurance, on behalf of the National Association of Insurance Commissioners. I welcome Mr. McRaith here from Illinois. He is doing a great job out in the State of Illinois. I am happy to have him here. Then, we have Mr. David Snyder, the vice president and associate general counsel of the American Insurance Association. Our third witness is going to be introduced by Mr. Price of Georgia. " CHRG-111hhrg58044--175 Chairman Gutierrez," The time of the gentleman has expired. The gentlelady from New York is recognized for 5 minutes. Mrs. McCarthy of New York. Thank you, Mr. Chairman. I thank you for having this hearing. I thank the panelists for their information. We know that some individuals do not have traditional credit reports. Some have alternative reports that are created by items such as rental payments and utilities, to create a credit history. Those kinds of reports typically are different than a traditional credit report in underwriting. For all of you, the current economic downturn has resulted in financial struggles for many of our constituents. As a result, they have seen their credit reports negatively impacted, even though they have had a good history from the past. How could this affect an individual's ability to renew their insurance? I will throw that out to all of you. " CHRG-111shrg56262--93 PREPARED STATEMENT OF GEORGE P. MILLER Executive Director, American Securitization Forum October 7, 2009 On behalf of the American Securitization Forum, I appreciate the opportunity to testify before this Subcommittee as it explores problems and solutions associated with the securitization process. The American Securitization Forum (ASF) is a broad-based professional forum through which participants in the U.S. securitization market advocate their common interests on important legal, regulatory and market practice issues. ASF members include over 350 firms, including investors, mortgage and consumer credit lenders and securitization issuers, financial intermediaries, legal and accounting firms, and other professional organizations involved in the securitization markets. The ASF also provides information, education, and training on a range of securitization market issues and topics through industry conferences, seminars and similar initiatives. ASF is an affiliate of the Securities Industry and Financial Markets Association. \1\--------------------------------------------------------------------------- \1\ For more information on ASF, please visit our Web site: http://www.americansecuritization.com. For more information on the Securities Industry and Financial Markets Association, please see: http://www.sifma.org.--------------------------------------------------------------------------- My testimony today will address the following topics: 1. The role and importance of securitization to the financial system and U.S. economy; 2. Current conditions in the securitization market; 3. Limitations and deficiencies in securitization revealed by the recent financial market crisis; and 4. Views on certain securitization policy and market reform initiatives now underway or under consideration.I. The Role and Importance of Securitization to the Financial System and U.S. Economy Securitization--generally speaking, the process of pooling and financing consumer and business assets in the capital markets by issuing securities, the payment on which depends primarily on the performance of those underlying assets--plays an essential role in the financial system and the broader U.S. economy. Over the past 25 years, securitization has grown from a relatively small and unknown segment of the financial markets to a mainstream source of credit and financing for individuals and businesses alike. In recent years, the role that securitization has assumed in providing both consumers and businesses with credit is striking: currently, there is over $12 trillion of outstanding securitized assets, \2\ including mortgage-backed securities (MBS), asset-backed securities (ABS), and asset-backed commercial paper. This represents a market nearly double the size of all outstanding marketable U.S. Treasury securities--bonds, bills, notes, and TIPS combined. \3\ Between 1990 and 2006, issuance of mortgage-backed securities grew at an annually compounded rate of 13 percent, from $259 billion to $2 trillion a year. \4\ In the same time period, issuance of asset-backed securities secured by auto loans, credit cards, home equity loans, equipment loans, student loans and other assets, grew from $43 billion to $753 billion. \5\ In 2006, just before the downturn, nearly $2.9 trillion in mortgage- and asset-backed securities were issued. As these data demonstrate, securitization is clearly an important sector of today's financial markets.--------------------------------------------------------------------------- \2\ SIFMA, ``Asset-Backed Securities Outstanding'', http://www.sifma.org/uploadedFiles/Research/Statistics/SIFMA_USABSOutstanding.pdf . \3\ U.S. Department of the Treasury, ``Monthly Statement of the Public Debt of the United States: August 31, 2009'', (August 2009). http://www.treasurydirect.gov/govt/reports/pd/mspd/2009/opds082009.pdf. \4\ National Economic Research Associates, Inc. (NERA), ``Study of the Impact of Securitization on Consumers, Investors, Financial Institutions and the Capital Markets'', p. 16 (June 2009). http://www.americansecuritization.com/uploadedFiles/ASF_NERA_Report.pdf . \5\ SIFMA, ``U.S. ABS Issuance'', http://www.sifma.org/uploadedFiles/Research/Statistics/SIFMA_USABSIssuance.pdf.--------------------------------------------------------------------------- The importance of securitization becomes more evident by observing the significant proportion of consumer credit it has financed in the U.S. It is estimated that securitization has funded between 30 and 75 percent of lending in various markets, including an estimated 59 percent of outstanding home mortgages. \6\ Securitization plays a critical role in nonmortgage consumer credit as well. Historically, most banks have securitized 50-60 percent of their credit card assets. \7\ Meanwhile, in the auto industry, a substantial portion of automobile sales are financed through auto ABS. \8\ Overall, recent data collected by the Federal Reserve Board show that securitization has provided over 25 percent of outstanding U.S. consumer credit. \9\ In the first half of 2009 alone, securitization financed over $9.5 billion in student loans. \10\ Securitization also provides an important source of commercial mortgage loan financing throughout the U.S., through the issuance of commercial mortgage-backed securities.--------------------------------------------------------------------------- \6\ Citigroup, ``Does the World Need Securitization?'' pp. 10-11 (Dec. 2008).http://www.americansecuritization.com/uploadedFiles/Citi121208_restart_securitization.pdf. \7\ Ibid., p. 10. \8\ Ibid., p. 10. \9\ Federal Reserve Board of Governors, ``G19: Consumer Credit'', (September 2009). http://www.federalreserve.gov/releases/g19/current/g19.htm. \10\ SIFMA, ``U.S. ABS Issuance'', http://www.sifma.org/uploadedFiles/Research/Statistics/SIFMA_USABSIssuance.pdf.--------------------------------------------------------------------------- Over the years, securitization has grown in large measure because of the benefits and value it delivers to transaction participants and to the financial system. Among these benefits and value are the following: 1. Efficiency and Cost of Financing. By linking financing terms to the performance of a discrete asset or pool of assets, rather than to the future profitability or claims-paying potential of an operating company, securitization often provides a cheaper and more efficient form of financing than other types of equity or debt financing. 2. Incremental Credit Creation. By enabling capital to be recycled via securitization, lenders can obtain additional funding from the capital markets that can be used to support incremental credit creation. In contrast, loans that are made and held in a financial institution's portfolio occupy that capital until the loans are repaid. 3. Credit Cost Reduction. The economic efficiencies and increased liquidity available from securitization can serve to lower the cost of credit to consumers. Several academic studies have demonstrated this result. A recent study by National Economic Research Associates, Inc., concluded that securitization lowers the cost of consumer credit, reducing yield spreads across a range of products including residential mortgages, credit card receivables and automobile loans. \11\ \11\ National Economic Research Associates, Inc. (NERA), ``Study of the Impact of Securitization on Consumers, Investors, Financial Institutions and the Capital Markets'', (June 2009), p. 16. http://www.americansecuritization.com/uploadedFiles/ASF_NERA_Report.pdf.--------------------------------------------------------------------------- 4. Liquidity Creation. Securitization often offers issuers an alternative and cheaper form of financing than is available from traditional bank lending, or debt or equity financing. As a result, securitization serves as an alternative and complementary form of liquidity creation within the capital markets and primary lending markets. 5. Risk Transfer. Securitization allows entities that originate credit risk to transfer that risk to other parties throughout the financial markets, thereby allocating that risk to parties willing to assume it. 6. Customized Financing and Investment Products. Securitization technology allows for precise and customized creation of financing and investment products tailored to the specific needs of issuers and investors. For example, issuers can tailor securitization structures to meet their capital needs and preferences and diversify their sources of financing and liquidity. Investors can tailor securitized products to meet their specific credit, duration, diversification and other investment objectives. \12\--------------------------------------------------------------------------- \12\ The vast majority of investors in the securitization market are institutional investors, including banks, insurance companies, mutual funds, money market funds, pension funds, hedge funds and other large pools of capital. Although these direct market participants are institutions, many of them--pension funds, mutual funds and insurance companies, in particular--invest on behalf of individuals, in addition to other account holders. Recognizing these and other benefits, policymakers globally have taken steps to help encourage and facilitate the recovery of securitization activity. The G-7 finance ministers, representing the world's largest economies, declared that ``the current situation calls for urgent and exceptional action . . . to restart the secondary markets for mortgages and other securitized assets.'' \13\ The Department of the Treasury stated in March that ``while the intricacies of secondary markets and securitization . . . may be complex, these loans account for almost half of the credit going to Main Street,'' \14\ underscoring the critical nature of securitization in today's economy. The Chairman of the Federal Reserve Board recently noted that securitization ``provides originators much wider sources of funding than they could obtain through conventional sources, such as retail deposits'' and also that ``it substantially reduces the originator's exposure to interest rate, credit, prepayment, and other risks.'' \15\ Echoing that statement, Federal Reserve Board Governor Elizabeth Duke recently stated that the ``financial system has become dependent upon securitization as an important intermediation tool,'' \16\ and last week the International Monetary Fund (IMF) noted in its Global Financial Stability Report that ``restarting private-label securitization markets, especially in the United States, is critical to limiting the fallout from the credit crisis and to the withdrawal of central bank and Government interventions.'' \17\ There is clear recognition in the official sector of the importance of the securitization process and the access to financing that it provides lenders, and of its importance to the availability of credit that ultimately flows to consumers, businesses and the real economy.--------------------------------------------------------------------------- \13\ G-7 Finance Ministers and Central Bank Governors Plan of Action (Oct. 10, 2008). http://www.treas.gov/press/releases/hp1195.htm. \14\ U.S. Department of the Treasury, ``Road to Stability: Consumer & Business Lending Initiative'', (March 2009). http://www.financialstability.gov/roadtostability/lendinginitiative.html. \15\ Bernanke, Ben S., ``Speech at the UC Berkeley/UCLA Symposium: The Mortgage Meltdown, the Economy, and Public Policy, Berkeley, California'', Board of Governors of the Federal Reserve System (Oct. 2008). http://www.federalreserve.gov/newsevents/speech/bernanke20081031a.htm. \16\ Duke, Elizabeth A., ``Speech at the AICPA National Conference on Banks and Savings Institutions, Washington, DC'', Board of Governors of the Federal Reserve System (Sept. 2009). http://www.federalreserve.gov/newsevents/speech/duke20090914a.htm. \17\ International Monetary Fund, ``Restarting Securitization Markets: Policy Proposals and Pitfalls'', Global Financial Stability Report: Navigating the Financial Challenges Ahead (Oct. 2009), p. 33. http://www.imf.org/external/pubs/ft/gfsr/2009/02/pdf/text.pdf.--------------------------------------------------------------------------- Restoration of function and confidence to the securitization markets is a particularly urgent need, in light of capital and liquidity constraints currently confronting financial institutions and markets globally. As mentioned above, at present nearly $12 trillion in U.S. assets are funded via securitization. With the process of bank de-leveraging and balance sheet reduction still underway, and with increased bank capital requirements on the horizon, the funding capacity provided by securitization cannot be replaced with deposit-based financing alone in the current or foreseeable economic environment. Just last week, the IMF estimated that a financing ``gap'' of $440 billion will exist between total U.S. credit capacity available for the nonfinancial sector and U.S. total credit demand from that sector for the year 2009. \18\ Moreover, nonbank finance companies, who have played an important role in providing financing to consumers and small businesses, are particularly reliant on securitization to fund their lending activities, since they do not have access to deposit-based funding. Small businesses, who employ approximately 50 percent of the Nation's workforce, depend on securitization to supply credit that is used to pay employees, finance inventory and investment, and other business purposes. Furthermore, many jobs are made possible by securitization. For example, a lack of financing for mortgages hampers the housing industry; likewise, constriction of trade receivable financing can adversely affect employment opportunities in the manufacturing sector. To jump start the engine of growth and jobs, securitization is needed to help restore credit availability.--------------------------------------------------------------------------- \18\ International Monetary Fund, ``The Road to Recovery'', Global Financial Stability Report: Navigating the Financial Challenges Ahead (Oct. 2009), p. 29. http://www.imf.org/external/pubs/ft/gfsr/2009/02/pdf/text.pdf.--------------------------------------------------------------------------- Simply put, the absence of a properly functioning securitization market, and the funding and liquidity this market has historically provided, adversely impacts consumers, businesses, financial markets, and the broader economy. The recovery and restoration of confidence in securitization is therefore a necessary ingredient for economic growth to resume, and for that growth to continue on a sustained basis into the future.II. Current Conditions in the Securitization Market The U.S. securitization markets experienced substantial dislocation during the recent financial market turmoil, with a virtual collapse of both supply and demand in the new-issue market, very substantial reductions in liquidity, widespread declines in securities prices and valuations, and increases in risk premiums throughout the secondary market. While there have been signs of recovery in certain parts of the securitization market throughout the first three calendar quarters of 2009, some market segments--most notably, private-label residential mortgage backed securities--remain dormant, with other securitization asset classes and market sectors remaining significantly challenged. In the asset-backed securities market, total issuance volume remains at a relatively low level, with 2009 issuance projected to reach $130 billion, roughly in line with the $140 billion issued in 2008 but sharply down from the $750 billion issued in 2006. \19\ Although issuance rates in nearly all major asset classes, including credit cards, auto and equipment loans, and student loans, picked up in the second quarter of 2009, a recent ASF survey showed that market participants expect securitization issuance rates to return to only half of their predownturn levels over the next 2 to 3 years. For residential mortgage-backed securities, 2009 to date has seen over $1.2 trillion in issuance, compared with a yearlong total of $1.3 trillion in 2008 and $2.1 trillion in 2006. However, in 2009, less than 1 percent of this has been issued without a Government or GSE guarantee (i.e., private-label MBS); this is compared with private-label MBS comprising over 23 percent of all issuance during the time period from 1996 to 2006. \20\ Furthermore, private-label MBS transactions that have occurred in 2009 involved pools of seasoned, conforming loans--no major private-label residential mortgage-backed securities deal of which we are aware has directly financed new mortgage loan origination this year.--------------------------------------------------------------------------- \19\ SIFMA, ``U.S. ABS Issuance'', http://www.sifma.org/uploadedFiles/Research/Statistics/SIFMA_USABSIssuance.pdf. \20\ SIFMA, ``U.S. Mortgage-Related Issuance'', http://www.sifma.org/uploadedFiles/Research/Statistics/SIFMA_USMortgageRelatedIssuance.pdf.--------------------------------------------------------------------------- Part of the reason for this involves a broad retreat from risk by many investors. The events of 2007 and 2008, especially in the RMBS markets, resulted in significant losses for many investors. While it seems unlikely that some types of investors, such as those who purchased securitized instruments issued by structured investment vehicles (SIVs) or certain types of collateralized debt obligations (CDOs), will play a significant role in the future MBS and ABS markets, the number of traditional securitization investors has also diminished, and along with it, the liquidity they have provided to both senior and subordinate parts of the market. Replacing at least a portion of this investor base is a significant challenge faced by participants in today's market. Certain programs sponsored by the Federal Government--in particular, the TALF program--have been successful in stimulating parts of the new-issue securitization market. President Obama described TALF as the Government's ``largest effort ever to help provide auto loans, college loans, and small business loans to the consumers and entrepreneurs who keep this economy running,'' \21\ and in many ways, TALF is among the most successful of the Government's efforts to bolster the consumer economy. As of September 2009, TALF has directly financed $46 billion \22\ of ABS issuances out of the approximately $80 billion of ABS eligible for TALF that has been issued since March. \23\ Due in significant measure to TALF, credit costs on consumer ABS have, across the board, returned to levels more in line with their historical trends than the extremely high levels that were seen in late 2008 and early 2009. For example, 3-year AAA credit card spreads to benchmark rates had ballooned to more than 500 basis points, or 5 percent, above LIBOR by January 2009, but have retracted to a level less than 1 percent above LIBOR. \24\ While this is not quite back to the spread levels seen over the years leading up to the crisis, it represents a more stable and economical level for issuers that translates into more affordable rates for borrowers. In recent months a number of issuers have been able to sell, at economical levels, transactions without the support of TALF. \25\ Clearly there are other factors at play in this recovery, including a generally more benign credit market, but one cannot dismiss the considerable and positive impact of TALF.--------------------------------------------------------------------------- \21\ Obama, Barack, ``Remarks of President Barack Obama--Address to Joint Session of Congress'', (Feb. 24, 2009). http://www.whitehouse.gov/the_press_office/remarks-of-President-Barack-Obama-address-to-joint-session-of-congress. \22\ SIFMA, ``TALF'', http://www.sifma.org/research/research.aspx?ID=10256#TALF. \23\ Allison, Herbert M., ``Written Testimony: Senate Committee on Banking, Housing and Urban Affairs'', (Sept. 2009). http://www.ustreas.gov/press/releases/tg298.htm. \24\ JPMorgan Securitized Products Weekly, September 18, 2009, pp. 22-23. \25\ See, for example: ``AmeriCredit's $725 Million Auto ABS transaction'', (July 2009) http://www.reuters.com/article/pressRelease/idUS140529+31-Aug-2009+BW20090831; JPMorgan's $2.53 billion credit card ABS deal, (Sept. 2009) http://online.wsj.com/article/SB125311472402316179.html.--------------------------------------------------------------------------- TALF has helped somewhat to bring investors back to the parts of consumer ABS markets that are not directly eligible for the program, although the markets for debt rated lower than AAA are still struggling. For example, 5-year single-A rated credit card ABS, which are not TALF eligible, saw an even more severe spread widening than that of AAA during the height of the disruption in late 2008. By January 2009 spreads had ballooned to more than 15 percent above LIBOR, but have since come back in to lower levels. \26\ The subordinate ABS markets are still relatively dormant, and unless banks are able to finance a greater portion of the capital structure, credit origination via securitization cannot be fully restored.--------------------------------------------------------------------------- \26\ ``JPMorgan Securitized Products Weekly'', September 18, 2009, pp. 22-23.--------------------------------------------------------------------------- Notwithstanding the success of the TALF program and the restoration of a modest degree of securitization financing and liquidity in some market segments, significant challenges remain, including establishing a stable, sustainable, and broad-based platform for future securitization market issuance and investment activity that is less reliant on direct Government support.III. Limitations and Deficiencies in Securitization Revealed by the Recent Financial Market Crisis The recent financial market crisis revealed several limitations and weaknesses in securitization market activity. Among the multiple (and, in many cases, interrelated) deficiencies revealed were the following: 1. Risk management failures, including the excessive or imprudent use of leverage and mismanagement of liquidity risk. Many market participants--including financial intermediaries, investors, and others--established large, leveraged risk positions in securitized instruments. A significant number of these market positions were, in effect, highly levered triggers which, when tripped by an adverse rating action or downward price movement, caused widespread deleveraging and further price reductions. At the same time, large parts of the securitization market became reliant on cheap, short term liquidity to finance long-term assets. When this liquidity disappeared and financing was either repriced or withdrawn completely, a more systematic deleveraging and unwinding process ensued. 2. Credit ratings methodologies and assessments that proved to be overly optimistic, and excessive reliance on credit ratings. Especially in parts of the residential mortgage market, a favorable economic environment and persistent increase in housing prices masked gaps in credit rating agency models and methodologies that did not sufficiently factor in the risk of nationwide housing price declines and a high correlation in the performance of the assets underlying certain mortgage and asset-backed securities. At the same time, market participants became overly reliant on credit ratings, and many failed to perform or to act upon their own assessment of the risks created by certain securitized transaction structures. 3. Deteriorating underwriting standards and loan quality. Underwriting standards declined precipitously throughout various segments of the credit markets, including but not limited to subprime mortgages, with housing prices rising steeply and credit and liquidity in plentiful supply. As loan demand and competition among lending institutions intensified, asset quality declined, leaving securitized instruments vulnerable to credit-related performance impairments. 4. Gaps in data integrity, reliability and standardization. Especially in parts of the residential mortgage market, a combination of explosive lending growth, operational weaknesses, the absence of standardized and comparable loan- level data, an increasing prevalence of fraud and other factors caused investors broadly to question the accuracy and integrity of performance data relating to the assets underlying securitizations. This led to a massive loss of confidence and widespread aversion to securitized risk, including asset classes and transaction structures that were far removed from the direct source of these concerns. 5. A breakdown in checks and balances and lack of shared responsibility for the system as a whole. While many within the securitization industry were aware of the general deterioration in credit underwriting standards and the other factors outlined above, no single party or group of market participants enforced sufficient discipline across all parts of the interdependent securitization value chain. Weaknesses and deficiencies in one part of the chain thus impaired the function of the chain in its entirety. It is important to note that the weaknesses outlined above are not inherent in securitization per se. Instead, they relate to the manner in which securitization was used in some settings by some market participants. In general, the amount of risk inherent in a securitization is equal to the risk that is embedded in the securitized assets themselves. However, in retrospect it is clear that securitization technology can be used in ways that can reduce and distribute risk (i.e., can be beneficial to the financial system), or that increase and concentrate that risk (i.e., can be detrimental to the financial system). Ancillary practices and strategies employed in some securitization transactions by some market participants--for example, the use of additional leverage; reliance on short-term funding for long-term liabilities; or the absence of effective risk management controls--can amplify and concentrate those risks. This is especially true when such practices and strategies relate to large dollar volumes of transactions and risk positions held by multiple participants throughout the financial system. It is also important to recognize that many of the deficiencies outlined above were prevalent, or at least more heavily concentrated, in certain securitization market products and sectors, rather than characterizing conditions or practices in the securitization market as a whole. In fact, the most consequential deficiencies were concentrated in portions of the residential mortgage market--and the subprime mortgage market, in particular--and in certain types of CDOs, SIVs and similar securities arbitrage structures. These transactions--many of which relied on high degrees of leverage--generated significant incremental demand for underlying securitization products. However, much of that demand was ``artificial,'' in the sense that production of underlying securitization products (e.g., subordinated risk tranches of subprime RMBS) was driven by demand from CDOs and SIVs, rather than by the financing needs of lenders or borrowing needs of consumers. In other parts of the securitization market, including prime RMBS, credit card, auto and student loan ABS, and asset-backed commercial paper conduits, among others, securitization activity largely remained focused on its historical role of financing the credit extension activities of lenders, and the credit needs of their consumer and business customers.IV. Views on Securitization Policy and Market Reform Initiatives Numerous policy and market reforms aimed at the securitization market have been advanced in response to the broader financial market crisis. Global policymaking bodies have proposed a series of securitization reforms as part of their broader response to financial market turmoil, and in the United States, both legislative and regulatory responses are under active consideration. At the same time, industry participants and their representative organizations are moving forward with important reforms to securitization market practices and to retool key parts of the market's operational infrastructure. Overall, we believe that a targeted combination of thoughtful policy reforms, coupled with industry initiatives to improve the securitization market infrastructure, will help to establish a more stable and lasting platform for future securitization market activity. In general, we believe that these policy and industry reform measures should facilitate the ability to originate and fund of a wide range of consumer and business credit via securitization. However, this activity must be supported by improved data and transparency that enables securitized risk to be evaluated and priced efficiently by market participants, and by enhanced operational controls (including but not limited to asset origination practices, due diligence and quality review practices, standardized and more effective representations and warranties, standardization of key documentation provisions and rating agency methodologies, among others) that provide necessary assurances to investors and other market participants regarding the accuracy, integrity and reliability of securitization data and transaction structures. At the same time, we believe that it is important, as a recent IMF report noted, to consider the individual and combined effects of various reform measures under consideration, to ensure that they do not inadvertently stifle otherwise sound and desirable securitization activity. \27\--------------------------------------------------------------------------- \27\ The exact language used by the IMF in its Global Financial Stability Report states: ``While most of the current proposals are unambiguously positive for securitization markets and financial stability, some proposals--such as those designed to improve the alignment of securitizer and investor interests and accounting changes that will result in more securitized assets remaining on balance sheets--may be combined in ways that could halt, not restart, securitization, by inadvertently making it too costly for securitizers.'' See, ``The Road to Recovery'', (Oct. 2009), p. 29. http://www.imf.org/external/pubs/ft/gfsr/2009/02/pdf/text.pdf.--------------------------------------------------------------------------- In the United States, a primary policy focus is on legislative proposals advanced by the Obama Administration, which in turn reflect many of the reform themes and initiatives under consideration globally. Together with other reforms being pursued by Federal regulatory agencies and accounting standards setters, these securitization reform initiatives may be broadly categorized as follows: 1. Increased Data Transparency, Disclosure, and Standardization; and Improvements to the Securitization Infrastructure. Initiatives designed to increase the type and amount of information and data (including loan-level data) that is captured and disclosed with respect to securitized instruments, and to improve and standardize that information and data as well as key documentation provisions, market practices and procedures employed in securitization transactions. 2. Required Risk Retention and Other Incentive Alignment Mechanisms. Mandated requirements for asset originators and/or securitizers to retain an economic interest in securitization transactions, and other mechanisms designed to produce a closer alignment of economic risks and incentives of originators, securitizers, and end investors. 3. Increased Regulatory Capital Requirements and Limitations on Off- Balance Sheet Accounting. Increases in regulatory capital required to be held against securitized exposures by regulated financial institutions, as a means of creating an additional safety and soundness buffer against potential losses associated with those exposures, and revisions to generally accepted accounting standards that restrict off-balance sheet accounting for securitized transactions and produce more widespread accounting consolidation of the assets and liabilities of securitization special purpose entities. 4. Credit Rating Agency Reforms. Various reforms intended to eliminate or minimize conflicts of interest, and to promote the accuracy, integrity and transparency of methodologies and processes that credit rating agencies apply to securitization transactions. A summary of ASF's views on each of these reform directions and initiatives are set forth below.A. Increased Transparency, Disclosure, Standardization; and Improvements to the Securitization Market Infrastructure ASF supports increased transparency and standardization in the securitization markets, and related improvements to the securitization market infrastructure. We believe that such efforts should be focused on those areas and products where preexisting practices have been determined to be deficient, and where improvements can help to restore confidence and function to the related market segment(s). Our principal focus in this area is ASF's Project on Residential Securitization Transparency and Reporting (Project RESTART), which is initially directed at addressing transparency and standardization deficiencies in the residential mortgage-backed securities (RMBS) market. Prior studies and market surveys conducted by ASF have clearly identified the RMBS market as most in need of these types of reform. Overall, Project RESTART seeks to address transparency and standardization needs in the RMBS market via the substantial injection of new disclosures and reporting by issuers and servicers on new transactions as well as on the trillions of dollars of outstanding private-label RMBS. Project RESTART would create a uniform set of data standards for such disclosure and reporting, including at the loan level. This will create a more level playing field where issuers provide the same information at the initiation of a securitization transaction and on an ongoing basis throughout the life of that transaction. With these standards in place, information provided by different issuers will be more comparable and capable of meaningful evaluation by investors and other market participants. In addition to supporting investment analysis, these data and standardization improvements will also support more robust and reliable rating agency, due diligence, quality review and valuation processes, and other downstream applications that will benefit from more robust, reliable and comparable underlying data. Project RESTART for RMBS transactions consists of the following phases: (i) the Disclosure Package, which will provide substantially more loan-level data than is currently available to investors, rating agencies and other parties, and standardize the presentation of transaction-level and loan-level data to allow for a more ready comparison of transactions and loans across issuers; (ii) the Reporting Package, which will provide for monthly updating of critical loan-level information that will enable improvements in the ability of investors, rating agencies and other market participants to analyze the performance of outstanding securities; (iii) Model RMBS Representations and Warranties, which will provide assurances to investors in RMBS transactions regarding the allocation and assumption of risk associated with loan origination and underwriting practices; (iv) Model Repurchase Procedures, which will be used to enforce the Model Representations and Warranties and to clearly delineate the roles and responsibilities of transaction parties in the repurchase process; (v) Model Pre-Securitization Due Diligence Standards, which will buttress due diligence and quality review practices relating to mortgage underwriting and origination practices and the data supplied to market participants through the Disclosure Package; and (vi) Model Servicing Provisions for Pooling and Servicing Agreements, which will create more standardized documentation provisions and work rules in key areas, such as loss mitigation procedures that servicers may employ in dealing with delinquent or defaulting loans. Final versions of the Disclosure and Reporting Packages were released by ASF in July 2009, with industry implementation beginning in 2010. Work continues on the other Project RESTART workstreams identified above, with an immediate focus on the development of Model RMBS Representations and Warranties, which are used to act as a ``return policy'' to guard against the risk of defective mortgage loans being sold into a securitization trust. Much like a defective product is returned to the store from which it was sold, a defective mortgage loan will be ``returned'' to the issuer through its removal from a securitization trust for cash. A mortgage loan is ``defective'' if it materially breaches one of the representations and warranties. Examples of defects range from a general fraud in a loan's origination to a failure to properly verify a borrower's income or employ an independent appraiser. The ASF supports 100 percent risk retention for defective loans that result from an originator's failure to meet specified underwriting criteria. Although Project RESTART has initially been focused on the RMBS market, members of the ASF have begun development of the ASF Credit Card ABS Disclosure Package, which seeks to provide increased transparency and standardization to the Credit Card ABS market. Finally, ASF believes that every mortgage loan should be assigned a unique identification number at origination, which would facilitate the identification and tracking of individual loans as they are sold or financed in the secondary market, including via RMBS securitization. ASF recently selected a vendor who will work with us to provide this unique Loan ID, which is called the ASF LINCTM. Implementation of the ASF LINC will enable market participants to access Project RESTART's valuable loan-level information without violating privacy laws by removing personal nonpublic information and other protected information from the process.B. Required Risk Retention ASF supports initiatives to align the economic interests of asset originators and securitization sponsors with investors. As suggested above, we believe that the principal goal of these efforts should be to establish and reinforce commercial incentives for originators and sponsors to create and fund assets that conform to stated underwriting standards and securitization eligibility criteria, thereby making those parties economically responsible for the stated attributes and underwriting quality of securitized loans. The creation and maintenance of effective mechanisms of this type will facilitate responsible lending, as well as a more disciplined and efficient funding of consumer assets via securitization (i.e., where the varying credit and performance risks presented by different types of securitized assets can be properly evaluated and priced in the capital markets). Securitization risk retention proposals currently under consideration, including legislation advanced by the Obama Administration, call for securitization sponsors and/or asset originators to retain an economic interest in a material portion of the credit risk that the sponsor and/or asset originator conveys to a third party via a securitization transaction. As noted above, we support the concept of requiring retention of a meaningful economic interest in securitized loans as a means of creating a better alignment of incentives among transaction participants. Many securitizations already embed this concept through various structuring mechanisms, including via the retention of subordinated or equity risk in the securitization, holding portfolio assets bearing credit exposure that is similar or identical to that of securitized assets, and representations and warranties that require originators or sponsors to repurchase assets that fail to meet stated securitization eligibility requirements, among others. However, we do not believe that mandated retention of specific portions of credit risk--one such form of economic interest--necessarily constitutes the sole or most effective means of achieving this alignment in all cases. There are numerous valid and competing policy goals that stand in opposition to requiring the retention of credit risk in securitized assets and exposures. Among others, these include the proper isolation of transferred assets (i.e., meeting legal criteria necessary to effect a ``true sale''); reduction and management of risk on financial institutions' balance sheets; balance sheet management; and the redeployment of capital to enable financial institutions to originate more credit than their limited capital resources would otherwise allow. Balancing these competing and worthwhile policy goals suggests that retention and incentive alignment mechanisms other than universal credit risk retention requirements should be considered. This viewpoint was echoed by the IMF last week in its Global Financial Stability Report, which expressed strong concerns about the potential unintended negative consequences of implementing suggested credit risk retention requirements and instead indicated that regulatory authorities ``should consider other mechanisms that incentivize due diligence and may be able to produce results comparable to a retention requirement, including, perhaps, representations and warranties.'' \28\--------------------------------------------------------------------------- \28\ International Monetary Fund, ``Restarting Securitization Markets: Policy Proposals and Pitfalls.'' Global Financial Stability Report: Navigating the Financial Challenges Ahead (Oct. 2009), p. 31. http://www.imf.org/external/pubs/ft/gfsr/2009/02/pdf/text.pdf.--------------------------------------------------------------------------- We believe that the risk or ``skin in the game'' traditionally retained by originators of RMBS is embodied in the representations and warranties that issuers provide with respect to the mortgage loans sold into the securitization trust. These representations and warranties are designed to ensure that the loans are free from undisclosed origination risks, leaving the investor primarily with normal risks of loan ownership, such as the deterioration of the borrower's credit due to loss of employment, disability or other ``life events.'' However, many market participants have indicated that the traditional representations and warranties and their related remedy provisions have not sufficiently provided a means to return defective loans to the originator. Because of this, the ASF has sought to enhance and standardize these items through the previously discussed Project RESTART Model RMBS Representations and Warranties and Model Repurchase Provisions. We therefore believe that to the extent legislation is adopted to require risk retention, regulators should have flexibility to develop and apply alternative retention mechanisms. This flexibility should include the ability for regulators to specify permissible forms and amounts of retention, how retention requirements may be calculated and measured, the duration of retention requirements, whether and to what extent hedging or risk management of retained positions is permissible, and other implementation details. Finally, we believe that it is imperative to achieve global harmonization and consistency of policy approaches to securitization risk retention. Different approaches are being considered and/or have been adopted in different jurisdictions. \29\ Given the global nature of securitization activity and the mobility of global capital among jurisdictions, significant competitive disparities and inefficiencies may be produced by introducing substantively different retention standards throughout the world's financial markets. We believe that is essential for policymakers to coordinate their approaches in this area.--------------------------------------------------------------------------- \29\ One such approach was adopted by the European Parliament in May 2009. Article 122a to the Capital Requirements Directive prohibits EU banks from investing in securitizations unless the originator retains on an ongoing basis at least 5 percent of the material net economic interest of the securities securitized. The article proposes four ways the 5 percent retention requirement may be applied. The article's requirement is scheduled to go into effect on December 31, 2010, for new issues, and December 31, 2014, for existing securitizations where new underlying exposures are added or subtracted after that date. For more information, see: http://www.europarl.europa.eu/sides/getDoc.do?type=TA&reference=P6-TA-2009-0367&language=EN&ring=A6-2009-0139#BKMD-35.---------------------------------------------------------------------------C. Increased Regulatory Capital and Limitations on Off-Balance Sheet Financing The Obama Administration has advocated that risk-based regulatory capital requirements should appropriately reflect the risk of structured credit products, including the concentrated risk of senior tranches and resecuritizations and the risk of exposures held in highly leveraged off-balance sheet vehicles. Global policymakers have also advocated for minimizing opportunities for financial institutions to use securitization to reduce their regulatory capital requirements without a commensurate reduction in risk. Consistent with the above views, the Basel Committee on Banking Supervision has amended the Basel II risk-based capital framework to require additional regulatory capital to be held against certain resecuritizations (such as CDOs), on the basis that previous rules underestimated the risks inherent in such structures. In the U.S., the combined bank regulatory agencies recently issued proposals that would continue to link risk-based capital requirements to whether an accounting sale has occurred under U.S. GAAP. Given that recent accounting changes (which will generally take effect in January 2010) will make it very difficult to achieve GAAP sales in many securitizations, including both term asset-backed securities and asset-backed commercial paper vehicles, these proposed rules will likely materially increase the capital that financial institutions will be required to hold in against securitizations, since many securitized assets will remain on or return to those institutions' balance sheets. ASF supports efforts to addresses weaknesses in the risk-based capital framework that have been revealed in certain securitization products by the recent financial market dislocation, and agrees that regulatory capital levels should adequately reflect the risks of different types of securitization transactions. Furthermore, ASF supports efforts to reduce or eliminate opportunities for regulatory capital arbitrage that are unrelated to differences in the risk profiles of securitization instruments. We therefore believe that increases in regulatory capital requirements for certain securitizations may be appropriate, based on the conclusion that they present more risk than had been previously understood (for example, because of their use of leverage or where underlying risk positions are more highly correlated than they were assumed to be, as in the case of certain CDOs and SIVs). However, a broader increase in capital requirements for securitization across the board, that is not tied to the differing risk profiles of different transactions, may produce very negative consequences for the economic viability of securitization. In turn, this outcome could unduly constrain the ability of financial institutions to originate and fund consumer and business credit demand, particularly as the broader economy begins to recover. ASF is particularly concerned that linking risk-based capital requirements to accounting outcomes--particularly when those outcomes are produced by the application of accounting standards that are not themselves risk-based--is an inappropriate policy response. We believe that the resulting increase in regulatory capital required to be held against securitized assets held on financial institutions' balance sheets will grossly misrepresent the actual, incremental risk inherent in those assets. We believe that a more targeted approach to revising the securitization risk-based capital framework is warranted. Last week ASF asked the U.S. bank regulatory agencies for a 6-month moratorium relating to any changes in bank regulatory capital requirements resulting from the implementation of FASB's Statements 166 and 167. We believe that this action is necessary to avoid a potentially severe capital and credit shock to the financial system as of January 1st, when the new accounting rules generally take effect. We will be providing detailed input and recommendations to bank regulatory agencies and other policymakers on this important topic by the October 15th deadline.D. Rating Agency Reforms ASF supports credit rating reform in the securitization markets, focusing on steps designed to increase the quality, accuracy and integrity of credit ratings and the transparency of the ratings process. Credit ratings have occupied a central role in the securitization markets, providing investors and other market participants with expert views on the credit performance and risks associated with a wide range of securitization products. As an outgrowth of the financial market crisis, confidence in rating agencies and the ratings process for securitization have been significantly impaired. We believe that a restoration of such confidence is a necessary step in restoring broader confidence and function to the securitization markets. Various credit rating reform measures targeting the securitization markets have been advanced by policymakers, and a number of proposals have been adopted or remain under consideration by the Securities Exchange Commission. Our views on some of the more significant proposals affecting the securitization market are summarized below: \30\--------------------------------------------------------------------------- \30\ For more detail on ASF's views on these and other credit rating agency reform proposals, see the series of letters submitted to the SEC by ASF between May and September of 2008. These letters may be found at: http://www.americansecuritization.com/uploadedFiles/ASFpercent20CRA percent20-percent20ratings percent20scale.pdf (May 2008); http://www.americansecuritization.com/uploadedFiles/Release_34-57967_ASF_Comment_Letter_.pdf (July 2008); and http://www.americansecuritization.com/uploadedFiles/ASF_Final_SEC_CRA--Letter_9_5_08.pdf (Sept. 2008). 1. Conflicts of Interest. We support measures aimed at developing and enhancing strong conflict of interest policies and rules governing the operations of credit rating agencies. We believe that effective management and disclosure of actual and potential conflicts is a necessary component for ensuring --------------------------------------------------------------------------- transparency and integrity in the rating process. 2. Differentiation of Structured Finance Ratings. ASF supports full and transparent disclosure of the basis for structured finance ratings, so that the risk of securitizations can be understood and differentiated from risks presented by other types of credit instruments. However, we strongly oppose proposals advocating that a special ratings designation or modifier be required for structured finance ratings. We believe that such a designation or modifier would not convey any meaningful information about the rating, and would require significant revisions to private investment guidelines that incorporate ratings requirements. 3. Ratings Performance Disclosure. We support the publication in a format reasonably accessible to investors of a record of all ratings actions for securitization instruments for which ratings are published. We believe that publication of these data will enable investors and other market participants to evaluate and compare the performance, stability, and quality of ratings judgments over time. 4. Disclosure of Ratings Methods and Processes. ASF strongly supports enhanced disclosure of securitization ratings methods and processes, including information relating to the use of ratings models and key assumptions utilized by those models. 5. Reliance on Ratings. We believe that investors and other market participants, including regulators, should not place an undue reliance on credit ratings, and should employ other mechanisms for performing an independent credit analysis. However, ASF believes that credit ratings are an important part of existing regulatory regimes, and that steps aimed at reducing or eliminating the use of ratings in regulation should be considered carefully, to avoid undue disruption to market function and efficiency.Conclusion The securitization market is an essential mechanism for supporting credit creation and capital formation throughout the consumer and business economy. Its role is even more important today, when other sources of credit and financing are limited, due to balance sheet, capital, and liquidity constraints facing financial institutions. Securitization activity was significantly impaired as a consequence of the financial market crisis. While portions of the securitization market have recovered to some extent throughout 2009, other market segments remain significantly challenged. The financial market crisis revealed weaknesses in several key areas of securitization market activity. Targeted reforms are needed, and a number are being pursued through both public- and private-sector responses. In pursuing market reforms and redressing these weaknesses, care should be taken to avoid imposing undue impediments to the restoration of securitization activity that could adversely impact credit availability and retard economic recovery and growth. Thank you for the opportunity to share these views, and I look forward to answering any questions that Members of the Subcommittee may have. ______ CHRG-111shrg56415--5 Mr. Tarullo," Thank you, Mr. Chairman, Senator Crapo, members of the Subcommittee. Let me begin by echoing a few points that my colleagues made in either their written or oral statements. First, compared to the situation of 8 to 12 months ago, the financial system has been significantly stabilized. The largest banking institutions, each of whose financial conditions was evaluated in our stress tests and then announced to markets and the public, have raised $60 billion in capital since last spring. We continue to see a narrowing of spreads in some parts of the market, such as corporate bonds, and in short-term funding markets. Second, however, important segments of our credit system are still not functioning effectively. Many securitization markets have had trouble restarting without Government involvement. Lending by commercial banks has declined through much of 2009. This decline reflects both weaker demand and tighter supply conditions, with particularly severe consequences for small and medium-sized businesses, which are much more dependent on banks than on the public capital markets that can be accessed by larger corporations. Banks will continue to suffer significant losses in coming quarters as residential mortgage markets continue to adjust. Losses on CRE loans, which represent a disproportionate share of the assets of some small and medium-sized banks, are likely to climb. The strains on these banks, when added to the more cautious underwriting typical of recessions, compound the problems of small businesses that rely on community banks for their borrowing. Third, it is important that bank supervisors take an even-handed approach in examining banks during these stressful times. We certainly do not want examiners to exacerbate the problems of declining CRE prices and restricted availability of credit by reflexively criticizing loans solely because, for example, the underlying collateral has declined in value. At the same time, we do not want supervisory forbearance that will put off inevitable losses, which may well increase over time, with attendant implications for the Federal Deposit Insurance Fund. So it is relatively easy to summarize the situation and state the problem. The question on everyone's mind is when and how it can be ameliorated. There are no easy answers, but let me offer a few observations. We as banking regulators should certainly redouble our efforts to ensure that the even-handed guidance we are issuing in Washington will be implemented faithfully by our examiners throughout the country. But we should not fool ourselves that even the best implementation of this policy will come close to solving the problems caused by significantly reduced demand for commercial properties that were in many cases highly leveraged on the assumption of rising asset prices. The problems lie deeper. In a weak economy that has, in turn, weakened many of our banks, supervisory guidance is neither appropriate for, nor effective as, an economic stimulus measure. At the most basic level, the strengthening of CRE markets and a return to a fully healthy banking system depend on growth in the economy as a whole, and particularly on a reduction in unemployment. I believe that the most important Federal Reserve action to promote CRE recovery is through our monetary policy. Our actions to date have helped return the Nation to growth sooner than many have expected. Nonetheless, because economic performance remains relatively weak, the Federal Open Market Committee indicated after our last meeting that conditions are likely to warrant exceptionally low levels of the Federal funds rate for an extended period. The Federal Reserve has also taken a series of steps to increase liquidity for financing capital of interest to consumers and small businesses, including the TALF program, which we recently extended through March, with a longer extension for commercial mortgage-backed securities. I suspect, though, that more direct efforts may be needed to make credit available to some creditworthy small businesses. Congress and the Administration may wish to consider temporary targeted programs while conditions in the banking industry normalize. Thank you very much, Mr. Chairman. Senator Johnson. Thank you. Ms. Matz. STATEMENT OF DEBORAH MATZ, CHAIRMAN, NATIONAL CREDIT UNION CHRG-111shrg52619--120 Chairman Dodd," You cannot just look at losses. Is the practice acceptable? " CHRG-111hhrg67816--135 Mr. Pitts," The FTC prohibits both unfair and deceptive practices. " fcic_final_report_full--174 MORTGAGE FRAUD: “CRIME FACILITATIVE ENVIRONMENTS” New Century—where  of the mortgages were loans with little or no documenta- tion  —was not the only company that ignored concerns about poor loan quality. Across the mortgage industry, with the bubble at its peak, standards had declined, documentation was no longer verified, and warnings from internal audit depart- ments and concerned employees were ignored. These conditions created an environ- ment ripe for fraud. William Black, a former banking regulator who analyzed criminal patterns during the savings and loan crisis, told the Commission that by one estimate, in the mid-s, at least . million loans annually contained “some sort of fraud,” in part because of the large percentage of no-doc loans originated then.  Fraud for housing can entail a borrower’s lying or intentionally omitting informa- tion on a loan application. Fraud for profit typically involves a deception to gain fi- nancially from the sale of a house. Illinois Attorney General Lisa Madigan defines fraud more broadly to include lenders’ “sale of unaffordable or structurally unfair mortgage products to borrowers.”  In  of cases, according to the FBI, fraud involves industry insiders.  For ex- ample, property flipping can involve buyers, real estate agents, appraisers, and com- plicit closing agents. In a “silent second,” the buyer, with the collusion of a loan officer and without the knowledge of the first mortgage lender, disguises the existence of a second mortgage to hide the fact that no down payment has been made. “Straw buy- ers” allow their names and credit scores to be used, for a fee, by buyers who want to conceal their ownership.  In one instance, two women in South Florida were indicted in  for placing ads between  and  in Haitian community newspapers offering assistance with immigration problems; they were accused of then stealing the identities of hun- dreds of people who came for help and using the information to buy properties, take title in their names, and resell at a profit. U.S. Attorney Wilfredo A. Ferrer told the Commission it was “one of the cruelest schemes” he had seen.  Estimates vary on the extent of fraud, as it is seldom investigated unless proper- ties go into foreclosure. Ann Fulmer, vice president of business relations at Inter- thinx, a fraud detection service, told the FCIC that her firm analyzed a large sample of all loans from  to  and found  contained lies or omissions significant enough to rescind the loan or demand a buyback if it had been securi- tized. The firm’s analysis indicated that about  trillion of the loans made during the period were fraudulent. Fulmer further estimated  billion worth of fraudu- lent loans from  to  resulted in foreclosures, leading to losses of  bil- lion for the holders. According to Fulmer, experts in the field—lenders’ quality assurance officers, attorneys who specialize in loan loss mitigation, and white- collar criminologists—say the percentage of transactions involving less significant forms of fraud, such as relatively minor misrepresentations of fact, could reach  of originations.  Such loans could stay comfortably under the radar, because many borrowers made payments on time. CHRG-111hhrg67816--96 Mr. Leibowitz," Well, that is a great question, and we do think that these--and, by the way, I should mention that we are also members of the Sacramento Task Force and many task forces in your districts around the country. Well, I do think that the cases against Hope Now and New Hope, which are two entities that are claiming to be affiliated with the Hope Now alliance, are ones that will be helpful as a deterrent but we also think that rulemaking authority and fining authority will make our ability to deter more effective. And again we want to do rules because they are needed in the mortgage servicing area, in the mortgage modification, and rescue area, and going after rescue scams. So we would like to be able to use the whole arsenal. We have been given some authority in the Omnibus Appropriations Act that will be helpful. We are looking for more authority from this committee and we want to move forward with that if the committee believes it is appropriate. Ms. Matsui. OK. Some examples of fraudulent schemes are, as we mentioned, advance fee scams where, you know, consumers are charged for services that are never rendered, and in exchange for this fee, it is up from $1,500 to $9,000, homeowners are promised guarantees to save their homes. In some cases, consumers usually pay these fees with a credit card, which should make it easier to track the payment and help the consumer recoup their money. What is the government doing to help recoup these advance fees to make consumers whole again, and is there a mechanism in place to help consumers recoup their advance fees? " CHRG-111hhrg58044--196 Mr. McRaith," No, that is generally the practice across the country, not in every State, but it is generally the practice. In terms of geography and credit scores, I believe different studies have shown that different parts of your district, for example, will generally have higher credit scores. Again, we have heard today higher credit scores result in lower insurance premiums. " CHRG-111shrg52619--152 Chairman Dodd," I have said over and over again I am sort of agnostic on all of this. I want to do what works. But if you ask me where I was inclining, it is on that point. I think you have got to watch practices. Just because something is called important does not mean it is. And there may be practices that may not seem important but are terribly important. And it seems to me we ought to be focusing on that, not at the exclusion of the other. Let me ask the other panelists quickly to comment if they have--any comments on this from anyone else on this discussion? Sheila, do you have---- " CHRG-111shrg57320--387 Mr. Corston," Well, policy is not my area of expertise, but I will say this: As an examiner in an institution, a tool such as a regulation is fairly easy to support. Guidance becomes--you can support it, but it is not as strong. Because it goes more to best practices, again, it becomes more something you need to influence. So it is something that, certainly from a rules standpoint, obviously needs to be looked at. From an examiner's standpoint, it is a challenge. Senator Levin. You had an acceptable structure at WaMu, as you said. " fcic_final_report_full--190 Since the late s, Lehman had also built a large mortgage origination arm, a formidable securities issuance business, and a powerful underwriting division as well. Then, in its March  “Global Strategy Offsite,” CEO Richard Fuld and other executives explained to their colleagues a new move toward an aggressive growth strategy, including greater risk and more leverage. They described the change as a shift from a “moving” or securitization business to a “storage” business, in which Lehman would make and hold longer-term investments.  By summer , the housing market faced ballooning inventories, sharply re- duced sales volumes, and wavering prices. Senior management regularly disregarded the firm’s risk policies and limits—and warnings from risk managers—and pursued its “countercyclical growth strategy.” It had worked well during prior market disloca- tions, and Lehman’s management assumed that it would work again.  Lehman’s Au- rora unit continued to originate Alt-A loans after the housing market had begun to show signs of weakening.  Lehman also continued to securitize mortgage assets for sale but was now holding more of them as investments. Across both the commercial and residential real estate sectors, the mortgage-related assets on Lehman’s books in- creased from  billion in  to  billion in . This increase would be part of Lehman’s undoing a year later. Lehman’s regulators did not restrain its rapid growth. The SEC, Lehman’s main regulator, knew of the firm’s disregard of risk management. The SEC knew that Lehman continued to increase its holding of mortgage securities, and that it had in- creased and exceeded risk limits—facts noted almost monthly in official SEC reports obtained by the FCIC.  Nonetheless, Erik Sirri, who led the SEC’s supervision pro- gram, told the FCIC that it would not have mattered if the agency had fully recog- nized the risks associated with commercial real estate. To avoid serious losses, Sirri maintained, Lehman would have had to start selling real estate assets in .  In- stead, it kept buying, well into the first quarter of . In addition, according to the bankruptcy examiner, Lehman understated its lever- age through “Repo ” transactions—an accounting maneuver to temporarily re- move assets from the balance sheet before each reporting period. Martin Kelly, Lehman’s global financial controller, stated that the transactions had “no sub- stance”—their “only purpose or motive . . . was reduction in the balance sheet.” Other Lehman executives described Repo  transactions as an “accounting gimmick” and a “lazy way of managing the balance sheet as opposed to legitimately meeting balance sheet targets at quarter-end.” Bart McDade, who became Lehman’s president and chief operating officer in June , in an email called Repo  transactions “an- other drug we R on.”  Ernst & Young (E&Y), Lehman’s auditor, was aware of the Repo  practice but did not question Lehman’s failure to publicly disclose it, despite being informed in May  by Lehman Senior Vice President Matthew Lee that the practice was im- proper. The Lehman bankruptcy examiner concluded that E&Y took “virtually no action to investigate the Repo  allegations, . . . took no steps to question or chal- lenge the non-disclosure by Lehman,” and that “colorable claims exist that E&Y did not meet professional standards, both in investigating Lee’s allegations and in con- nection with its audit and review of Lehman’s financial statements.”  New York At- torney General Andrew Cuomo sued E&Y in December , accusing the firm of facilitating a “massive accounting fraud” by helping Lehman to deceive the public about its financial condition.  CHRG-111shrg57320--57 Mr. Rymer," Senator Kaufman, let 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, even though problems were there in underwriting, the product mix, the distribution process, the origination process, all in my view extraordinarily risky, not things perhaps that should not be done, but certainly if they are done, they need to be done in some moderation, certainly with some control environment. And I did not see in this bank's case an adequate control of its environment. Senator Kaufman. Mr. Rymer, if you were running OTS, and your largest customer was having reports like this from your examiners, and they were making money. Let us say we are a year from now. What would you do? Would you say, well, they are making money, it is going to be very difficult politically to move forward on this? " FinancialCrisisInquiry--53 How—in retrospect, looking back over the last decade, how effective do you think your performance standards have been and the compensation that they have generated to achieving goals of the—of your institution and the broader economy? MOYNIHAN: I’d say that, like my colleagues, we could do a better job of aligning, really, in some areas the timeframe of which a risk can be taken on by a decision today that could come true or not down the road. We’ve also do that through the holdbacks of equity and claw backs that we’d have in other areas, like credit card, where you make underwriting decisions today and they turn out to be true later. But that is one of the changes that we’ve made in the incentive plans, as we—for ‘09 and ‘10, and it will continue to hold, because I think we learned a lesson in—over the last several years that the—the nature of the underwriting—it takes time to figure out whether a decision made today comes true, and that’s the claw backs and stuff we put in, so we’re trying to address that, sir. CHAIRMAN ANGELIDES: Senator Graham, one—one minute. GRAHAM: Yes. Well, one last question to Mr. Blankfein. Your firm about 10 years ago changed from being a partnership to a publicly held corporation and now you changed again to a bank-holding company. How have your approaches to performance evaluation changed, or have they, as you have changed the structure of Goldman Sachs? BLANKFEIN: I think we’ve—owing to becoming a public company; I—I think we stayed and tried very hard to stay—keep the partnership ethic. So, for example, there are elements of our compensation scheme that might be a little different. It suits our culture, and it suits our history, might not suit everyone’s. So, for example, no one at Goldman Sachs gets paid solely out of his or her own performance, not traders, not salespeople. Everyone gets paid partly on the base of the firm as a whole, their business unit, and, of course, we take account of their own performance, but the object for us is to keep going with that spirit of partnership and cooperation and teamwork, and also, by the way, an incentive for everyone to surveil everyone else around him or her, because we make everybody co- responsible for each other. FOMC20070509meeting--51 49,MR. MOSKOW.," Thank you, Mr. Chairman. Conditions in the Seventh District have improved modestly since my last report. The overall pace of business activity is still rather restrained, but we have seen some pickup in our manufacturing sector. The key issues regarding the national outlook are the same as the ones the last time we met. How will the residential investment puzzle settle out, and can we explain this puzzling weakness in business fixed investment? Based on the data that we’ve received since March and my contact calls this round, I’ve become somewhat more optimistic about investment and somewhat more pessimistic about housing. At the same time, higher gasoline prices have the potential to weigh on consumer spending. So on balance our growth projection for ’07 and ’08 is a bit lower than it was in March. We now think that growth will average moderately short of potential over the remainder of ’07 and then run close to potential in 2008. However, our GDP numbers are a bit higher than the Greenbook’s, reflecting both a smaller shortfall from potential this year and a somewhat higher assumption about the rate of potential output growth. Indeed, there has been some good news regarding the near-term outlook. First, the international outlook continues to improve. Many of our contacts noted exceptionally strong demand from abroad, particularly for capital goods. Second, although we’ve been actively looking for spillovers from the problems with subprime mortgages, we have not yet seen major effects on pricing or the supply of credit in other markets. That is not to say that we have not heard of any effects. One of our directors, the CFO of a major national homebuilder, noted that tighter underwriting standards are reducing housing demand somewhat outside the subprime sector. Consumers still appear to have ample access to financing. For example, the head of GM noted that banks were making more auto loans with six- or seven-year maturities in order to lower monthly payments for liquidity-strapped consumers. Finally, as I noted earlier, we feel a bit more confident in our assumption that the weakness in BFI will turn out to be relatively transitory. I don’t want to make too much out of one month’s noisy data, but the latest readings on capital good orders and the PMI (purchasing managers’ index) were encouraging, and most of the comments from my business contacts have been positive in this regard. The impression I have from these discussions is that the pause in investment spending is showing early signs of ending; but this is very early, and we clearly need to keep monitoring developments carefully. Beyond the near-term cyclical developments, the changes in structural productivity in the Greenbook highlight an important source of risk to the longer-run outlook for sustainable non- inflationary growth, as Janet just discussed. There is a lot of uncertainty about the components of structural productivity. In our view, we haven’t seen enough evidence yet to mark down structural productivity as much as the Greenbook has. Consequently, our estimate of potential output growth is a bit higher than that of the Greenbook. With regard to inflation, the incoming information has caused the forecasts from our indicator models to come down a bit. They now project that core PCE prices will rise 2¼ percent this year and 2.1 percent in ’08. But we do not see any progress beyond that. If we carry our models out to ’09, they have inflation staying at 2.1 percent, higher than my preferred range. Furthermore, I see some upside risks to this forecast. Neither our GDP projection nor the Greenbook’s generates any meaningful resource slack over the projection period, and then there are the higher costs for energy and other commodities and increases in import prices. So we will be relying heavily on stable expectations to keep inflation in check. I believe we are currently achieving some implicit tightening of policy by keeping rates on hold during this period of sluggish activity, but this restraint will wane if the real economy returns to potential by early next year as we expect. So I continue to think that the risks to price stability dominate the risks to sustainable growth." CHRG-111hhrg51698--315 Mr. Morelle," Well, thank you for the question, Mr. Chairman. First of all, I am appearing on behalf of National Conference of Insurance Legislators. I think we agree that a group of states together in either compact or with model legislation would come up with a national standard that could be used. And, obviously, as you point out, New York has a special position relative to this kind of regulation. In many ways, this mirrors the work that we do with bond insurers, where we require reserving, as we would do with any underwriter of risk, as well as insuring those insurable interests. The speculative activity simply put, in our view, is gaming, and that is what I believe the Superintendent has said at various times. We are working together, but we would work with the various states, and we would have reserving requirements, as we do for what we call monoline insurers, those insurers who write bond insurance. " CHRG-110hhrg34673--51 Mr. Watt," Thank you, Mr. Chairman. Welcome, Chairman Bernanke. I am over here. I happen to like your predecessor. The problem is I didn't understand a thing he ever said. So you are a breath of fresh air in the sense that, whether I agree with you or not, at least you are speaking in English, and I can understand what you are saying. And I especially want to thank you for your response to Ms. Waters' question. Let me follow up quickly on Mrs. Maloney's question, because I am not clear, and I hope you can answer this question just with a yes or a no answer. Does the guidance that the underwriting--the guidance that you are issuing regarding 2/28 and 3/27 mortgages require that those mortgages be underwritten to the fully indexed rate just like you do with traditional mortgages, or does it not? " FinancialCrisisInquiry--734 ROSEN: I—I think the dot com bubble—the—the main problem there was again, I think related to the underwriting of unprofitable companies. It used to be you had to have, you know, a year of profit under your belt before you could go public. That was the Wall Street standard. They enforced it. Then that all changed. So it’s really the same thing. The lowering of standards, because you could get it done, and there were investors to buy it. This housing problem is much more serious though, because it is such a large sector as Mark said -- $11 trillion. It’s—every financial institution has this. It is larger than the public debt that we have, you know? And that’s why it’s so important, and so why the bubble is so much bigger. I would say the dot com bubble set up this bubble though. Because to clean up the last bubble, the Fed kept at rates too low too long. Their idea of not trying to do something about the bubble is either regulatory or through policy I think is—really is the core of the problem. Monetary policy is poorly—was poorly done under the last chairman. FinancialCrisisReport--175 WaMu, which it conducted concurrently with ongoing OTS examination efforts. 630 Other financial institutions were also failing, compounding the concern of those who worried whether the Deposit Insurance Fund had sufficient funds. In July 2008, IndyMac Bank, another thrift with high risk loans, failed and was taken over by the FDIC. 631 In response, Washington Mutual depositors began to withdraw more funds from the bank, eventually removing over $10 billion. 632 The Federal Home Loan Bank of San Francisco also began to limit WaMu’s borrowing, further straining its liquidity. 633 The parent holding company supplied an additional $2 billion in capital to the bank. In the final three months before WaMu’s collapse, tensions increased further between OTS and the FDIC as they disagreed on the course of action. On July 3, 2008, the head of OTS sent an email to the CEO of WaMu informing him that the agency had decided to require the bank to issue a nonpublic Memorandum of Understanding (MOU). 634 On July 15, OTS and the FDIC met with the WaMu Board of Directors to discuss the latest examination findings and formally advise the Board of the OTS decision to require the MOU. On July 21, 2008, the FDIC sent a letter to OTS urging it to take tough supervisory action in the MOU, including by requiring WaMu to increase its loan loss reserves, begin providing regular financial updates, and raise an additional $5 billion in capital. 635 OTS rejected the FDIC’s advice. 636 On July 31, 2008, both OTS and FDIC officials met with WaMu’s Board. An FDIC official suggested at the Board meeting that WaMu look for a strategic partner to buy or invest in the bank; OTS expressed anger that the FDIC had raised the issue without first clearing it with OTS. 637 On August 1, 2008, the FDIC informed OTS that it thought WaMu should be downgraded to a 4 CAMELS rating, signaling it was a troubled bank exhibiting unsafe and unsound practices. 638 OTS strongly disagreed. 639 Also on August 1, OTS provided WaMu with the proposed MOU. The proposed MOU would require the bank to correct lending and risk management deficiencies identified in a June 30 examination report, develop a capital contingency plan (rather than, as the FDIC originally urged, raise additional capital), submit a 3- year business plan, and engage a consultant to review its underwriting, risk management, 630 See 7/21/2008 letter from FDIC to OTS, FDIC_WAMU_000001730, Hearing Exhibit 4/16-59. 631 For more information on IndyMac Bank, see section E(2), below. 632 See undated charts prepared by FDIC on “Daily Retail Deposit Change,” FDIC-PSI-01-000009. 633 See, e.g., 12/1/2008 “WaMu Bank Supervisory Timeline,” prepared by OTS Examiner-in-Charge Benjamin Franklin, at Franklin_Benjamin-00035756_001, at 032 (7/22/2008 entry: “Although they have $60 billion in borrowing capacity, the FHLB is not in a position to fund more than about $4 to $5 billion a week”). See also FDIC LIDI Report for the Second Quarter of 2008, at FDIC_WAMU_000014991 [Sealed Exhibit]. 634 7/3/2008 email from John Reich to Kerry Killinger, “MOU vs. Board Resolution,” Hearing Exhibit 4/16-44. 635 7/21/2008 letter from FDIC to OTS, FDIC_WAMU_000001730, Hearing Exhibit 4/16-59. 636 7/22/2008 letter from OTS to FDIC, OTSWMS08-015 0001312, Hearing Exhibit 4/16-60. 637 See 8/1/2008 email exchange among FDIC colleagues, FDIC-EM_00246958, Hearing Exhibit 4/16-64. 638 8/1/2008 email exchange among OTS officials, Hearing Exhibit 4/16-62. The FDIC had performed a capital analysis earlier in the summer and had been pushing for a downgrade for weeks. See 7/21/2008 letter from FDIC to OTS, FDIC_WAMU_000001730, Hearing Exhibit 4/16-59. 639 8/1/2008 email from OTS Director John Reich to FDIC Chairman Sheila Bair, Hearing Exhibit 416-63. management, and board oversight. On August 4, WaMu asked OTS to drop the requirement that the consultant review the Board’s oversight efforts, and OTS agreed. CHRG-110hhrg34673--57 Mr. Watt," Okay. The increase in foreclosures is a serious problem, and one of the concerns we have is that the Fed has never adopted a final rule under its authority under the truth and lending act to prohibit practices or acts that it found to be unfair or deceptive or designed to evade the purposes of HOPA over the entire class of mortgage loans. There has never been a real rule on these things, and I think that is one of the things that is putting pressure on us to be more aggressive in having a Federal predatory lending standard, or at least a Federal predatory lending floor. I am wondering whether you view that as a problem, and maybe I could just get you to discuss with me why the Fed has never used that more aggressive, unfair, deceptive trade practices language to be more aggressive in this area in light--and especially in light of the increasing number of foreclosure that we are experiencing. " FOMC20080625meeting--64 62,MR. STOCKTON.," That's correct--and the timing. So there are two aspects. One is that we have interpreted some of the surprise as a persistent strengthening in aggregate demand that we had not anticipated. The other is that the economy is not as weak now, and therefore the bounceback in activity next year won't be as strong. As Larry said, there are a lot of moving parts, but both of those considerations are built into this forecast. " CHRG-110hhrg46594--66 Mr. Wagoner," The analysis that we have done is based on an assumption that the U.S. market continues at about the current rate, which is a weak level. We don't assume a lot of recovery. We hope it won't get worse. On that basis, we would--with the amount of funding that proportionately would presumably be allocated to us, we think we have a good shot to make it through next year. And our effort is to do that. " CHRG-111shrg57319--509 Mr. Rotella," Senator, Chairman Levin repeated a couple of colorful comments I made in some emails about my views of the business. As I said in my opening statement, this business was on an explosive growth path when I joined. It was on an explosive growth path with a very weak infrastructure. Senator Kaufman. Exactly. " CHRG-110shrg50414--271 RESPONSE TO WRITTEN QUESTIONS OF SENATOR REED FROM JAMES B. LOCKHART IIIQ.1. Director Lockhart, I was pleased to see your recent statement affirming your support for the multifamily lending programs of Fannie Mae and Freddie Mac, and your intention not to sell the low income housing tax credit interests at either institution. As you know, Fannie and Freddie are the single most important sources of financing for affordable multifamily rental housing, vital to hundreds of thousands of low income families across the country. The GSEs provide valuable stability to multi-family rental housing by being active in this market all the time. Do you agree that this part of the enterprises' business is fulfilling their liquidity and stability missions, and that you will continue to support their financing of this housing, which overwhelmingly serves people below 100 percent of area median income, and is a significant contributor to Fannie Mae and Freddie Mac's regulatory housing goals?A.1. Yes. Fannie Mae and Freddie Mac historically have provided valuable stability to the multifamily market by maintaining a regular presence in the financing of such housing, and they should continue to do so. Such a presence, however, requires an innovative and market-oriented approach that reflects the current financial condition of the Enterprises themselves and the actual needs of the multifamily market.Q.2. Given the serious dislocation of the Low Income Tax Credit market in the absence of Fannie and Freddie investments, are you planning to permit the companies to reopen that business line as soon as practicable?A.2. While we recognize that LIHTC investments have provided significant assistance to affordable housing markets in the past, new investments in LIHTC are not economically attractive for the Enterprises when they are reporting losses. In their most recent quarterly financial statements, both Enterprises established valuation allowances for their deferred tax assets, which are indicative of their potential inability to realize future tax benefits associated with LIHTC investments. Part of what needs to be done to assist the LIHTC market is to broaden participation. Accordingly, FHFA has been working very hard with the Enterprises to determine how they can play a key role in achieving that goal. That involves the Enterprises looking at creative transaction structures, in consultation with FHFA, as well as conducting outreach to stakeholders, including housing advocates, lenders, and state and local housing finance agencies, with the goal of expanding the universe of these credits. FHFA's meetings with such groups have been regular, extensive, and productive, and are ongoing.Q.3. Last year HUD declared the regulatory housing goals ``infeasible'' for both enterprises because of market conditions. Since then, Congress has adopted a new approach to the calculation and measurement of the companies' housing goals, as well as added new ``duties to serve'' specific populations and markets. I'm sure you agree that given the current market and the companies' situation it is vitally important to reaffirm and clarify their housing goals requirements. What is your plan to quickly issue new regulations to execute these new provisions and ensure that both companies have clear direction in meeting these important requirements, and to publish clear guidance on what FHFA considers to be the important additional ``duties to serve'' under the statute?A.3. Given current market conditions, it is vitally important to reaffirm and clarify the Enterprises' requirements with respect to housing goals. FHFA has begun the process of reviewing housing goals for 2009 and will issue proposed goals for public comment in the first quarter of 2009. In addition, FHFA has begun the process of implementing regulations to establish new housing goals, as well as new ``duty to serve'' requirements, for 2010. We expect to issue a proposed regulation for public comment by the second quarter of 2009 and to issue a final regulation by the fourth quarter.Q.4. Over the years the GSEs have provided important services to populations that are especially hard to serve, such as Native Americans living on trust lands, and people with special needs. Fannie Mae also has provided lines of credit and equity and equity-like investment to community loan funds and community development lenders. These investments provide community-oriented lenders with more capital to support revitalization projects in come of America's hardest hit communities. They also have developed products such as Community Express and Modernization Express that help public agencies finance important public investments in housing. Do you agree that these specialized lending products are important extensions of their mission to serve low and moderate income people and underserved communities, and what role do you anticipate these specialized and targeted products will play in their future business?A.4. Specialized and targeting lending products have made a significant contribution to the Enterprises' achievement of their affordable housing mission. FHFA expects that Fannie Mae and Freddie Mac will continue to develop and market such products to fulfill that mission in the future, consistent with safe and sound management of credit risk and maintenance of adequate capital.Q.5. Much has been said about the GSEs' affordable housing mission. Specifically, their mission includes providing ``ongoing assistance to the secondary market for residential mortgages (including activities relating to mortgages on housing for low- and moderate-income families involving a reasonable economic return that may be less than the return earned on other activities) by increasing the liquidity of mortgage investments and improving the distribution of investment capital available for residential mortgage financing.'' (12 Sec. U.S.C. 1716 and 12 U.S.C. Sec. 1451) The statute specifically recognizes the need to provide affordable housing for low- and moderate-income families. It seems to me that the Affordable Housing Fund and the Capital Magnet Fund will help ensure that the enterprises fulfill this mission. Do you agree? Why or why not?A.5. Section 1337 of the Federal Housing Enterprises Financial Safety and Soundness Act of 1992, as amended, requires each Enterprise to set aside an amount equal to 4.2 basis points for each dollar of the unpaid principal balance of its total new business purchases as funding for the Housing Trust Fund and Capital Magnet Fund. Each Enterprise's contributions to those funds will further its mission of supporting affordable housing. Section 1337 also authorizes FHFA to suspend the contributions on a temporary basis. After reviewing the Enterprises' 3Q 2008 financial results, FHFA exercised that authority on November 13, 2008, by directing each Enterprise, until further notice, not to set aside or allocate funds for the contributions.Q.6. Director Lockhart, an article in the September 8, 2008 Wall Street Journal stated as follows: ``At both Fannie and Freddie, so-called Alt-A loans, a category between prime and subprime, amounted for roughly 50% of credit losses in the second quarter, even though such loans accounted for only about 10% of the companies' business. Alt-A mortgages include loans made with less than full documentation of borrowers' income or assets.'' Is it true that a disproportionate share of Fannie and Freddie's credit losses are related to mortgage loans that were made without anyone checking the borrower's income? If so, do you think it would be prudent, especially now that the American taxpayer is responsible for insuring loans held by Fannie and Freddie, for the FHFA to require that Fannie and Freddie purchase only those mortgage loans for which income verification has been performed?A.6. A disproportionate share of each Enterprise's credit losses have been on Alternative-A (Alt A) single-family mortgages, which are loans made to borrowers who generally have limited verification of income or assets or no employer. Fannie Mae and Freddie have greatly curtailed their purchases of Alt-A and other low documentation loans in 2008. Beginning in 2009, neither Enterprise will purchase any such mortgages on a flow basis (where loans are delivered pursuant to pre-negotiated contracts and pricing). Acquisitions of pools of such loans on a negotiated basis will occur only after adequate due diligence and with appropriate pricing.Q.7. As I understand it, part of the strategy of the entire mortgage lending crisis is that it would have been so simple to verify consumers' incomes. In her April 6, 2008, New York Times column, Gretchen Morgenson wrote about the IRS 4506-T form, which is a request for tax transcripts, and how lenders could have used that form to avoid a considerable part of the subprime mortgage mess. According to Morgenson's sources, approximately 90 percent of borrowers signed the form, but lenders used the form to obtain tax transcripts only 3 to 5 percent of the time--and usually after the loan had closed. Tax transcripts are prepared by the IRS with data contained in tax returns, and are therefore unlikely to contain exaggerated amounts of income. Given that the 4506-T process is cheap and efficient, do you think IRS tax transcripts should be utilized to protect the GSEs and therefore the American taxpayer from bearing the losses for inappropriate mortgages? Another reason for requiring tax transcripts is that they provide an easy means for identifying fraud. Section 1379 E of the Housing and Economic Recovery Act of 2008 contains the following report requirement:The Director shall require a regulated entity to submit to the Director a timely report upon discovery by the regulated entity that it has purchased or sold a fraudulent loan or financial instrument, or suspects a possible fraud relating to the purchase or sale of any loan or financial instrument. The Director shall require each regulated entity to establish and maintain procedures designed to discover any such transactions.A.7. The income verification processes at Fannie Mae and Freddie Mac have been subject to increased scrutiny by FHFA and these processes have tightened considerably. Working with FHFA, the Enterprises have explored the use of a variety of tools, including IRS forms 4506 and 4506-T, to better verify and document borrower income. Considering the pros and cons of those various approaches, the Enterprises have decided to reduce significantly their purchases of Alt-A mortgages and other lower documentation loans in 2009 and beyond. Given the volume of loans Fannie Mae and Freddie Mac guarantee, it is not operationally feasible for them to individually review every loan; instead, they rely on lenders to verify borrower income and assets and other necessary information. The lenders represent and warrant that mortgages are eligible for Enterprise purchase; if an Enterprise identifies a misrepresentation, it requires the lender to repurchase the questionable loan. Both Fannie Mae and Freddie Mac now require lenders to verify borrower income, have increased their quality control reviews, and are issuing repurchase requests in cases where nonconforming loans are identified. Such repurchases discourage poor underwriting practices, including the use of unverified income to establish borrower eligibility.Q.8. The FDIC's summer 2007 issue of Supervisory Insights cites an April 2006 Mortgage Asset Research Institute report for the fact that ``90 percent of stated incomes [on mortgage loan application] were exaggerated by 5 percent or more, and 60 percent of stated incomes were inflated by more than 50 percent.'' Given these statistics, do you plan to institute, as part of your anti-fraud program, a rule requiring Fannie and Freddie to purchase, re-sell, or otherwise back only loans for which income verification has been executed and what method will you recommend for verification?A.8. Fannie Mae and Freddie Mac are subject to a mortgage fraud reporting regulation promulgated by the Office of Federal Housing Enterprise Oversight (OFHEO), one of the predecessor agencies to FHFA, as set forth in Title 12, Chapter 17, Part 1731 of the Code of Federal Regulations (CFR). That regulation requires each Enterprise to establish adequate and efficient internal controls and procedures and an operational training program to assure an effective system to detect and report mortgage fraud or possible mortgage fraud. The regulation defines mortgage fraud broadly in order to give the Enterprises the flexibility to adapt their internal controls and procedures to fraudulent practices that may emerge over time within the industry. FHFA's ongoing examinations include evaluations of the extent to which the internal policies, procedures, and training programs of the Enterprises minimize risks from mortgage fraud and mortgage fraud or possible mortgage fraud is consistently reported to FHFA. Fannie Mae and Freddie Mac have also increased quality control reviews to identify cases of exaggerated income. The Enterprises are actively requiring lenders to repurchase such loans. As mentioned in the previous answer, working with FHFA the Enterprises have decided to significantly reduce the use of stated income going forward. Any change to that standard will also require a safety-and-soundness review by FHFA.Q.9. The 4506-T process for IRS tax transcripts has a proven track recorded and is currently being utilized by the FDIC in their efforts to modify loans as the conservator for IndyMac. In Housing and Economic Recovery Act of 2008, Congress enacted a requirement pursuant to the HOPE for Homeowners Program that mortgagors' income be checked via tax transcripts or tax returns. In the Bankruptcy Reform Act of 2005, Congress provided debtors the option of producing a transcript of their tax returns via a 4506-T form in lieu of providing their actual tax returns to the court. This was to provide consumers additional privacy protections as well as speed of service. And, as Housing and Urban Development Secretary Preston well knows because he used to be the Administration of the Small Business Administration, the SBA requires a 4506-T form for its loan applications. Given that this process has been adopted and recognized so pervasively, do you see any reason that Fannie and Freddie should not require its use for the loans they purchase, re-sell, or otherwise deal with?A.9. As indicated above, Fannie Mae and Freddie Mac have decided to reduce significantly the use of stated income loans going forward. The Enterprises give lenders several options for verifying income, including using tax records for self-employed individuals. Enterprise lenders use forms 4506 and 4506-T to obtain borrower permission to request tax transcripts from the IRS." CHRG-111hhrg48674--190 Mr. Posey," What practices were in the statutes that I saw that were exempt from audit so they could not be audited? " CHRG-111hhrg56766--271 Mr. Bernanke," Our standards are based on a finding of unfair and deceptive practices. " FOMC20050322meeting--185 183,MR. POOLE., I think that’s the only practical alternative at this point. CHRG-111hhrg53238--209 The Chairman," Well, given the next job the gentleman looks for, that is probably a good practice. " CHRG-110hhrg46595--391 The Chairman," I understand that. But, as a practical matter, what would the effect be if they got out? Would their lawsuit still go forward? " CHRG-111shrg57319--596 Mr. Killinger," Yes. Well, clearly, the money was flooding into Wall Street both from international sources and domestic sources with a very strong appetite for buying various mortgage-related securities, and I think that very strong pressure to buy certainly had an influence on the products that they were willing to buy and ultimately the kind of conditions around those loans. Where we saw a particular change, I will say, is in the Option ARM, which for many years was a portfolio product and there was not a secondary market. What we saw in the mid-2000s is the emergence of a secondary market with Wall Street and Fannie Mae and Freddie Mac, and that led to a huge surge in brokers originating Option ARMs, and I think that certainly changed the competitive landscape for us. It caused us to lose significant market share and, I think, had an impact on the different competitive features of that product. So certainly the development of the secondary markets had a huge impact on that product. Similarly, it was the primary outlet for the origination of subprime loans, so that demand from Wall Street had, I think, a big impact on the criteria that were used to underwrite subprime loans. Senator Levin. And would you say that the criteria were looser as a result of that demand? " CHRG-111hhrg46820--111 Mr. Roth," Thank you, Madam Chairwoman. With regard to our suggestion of one-time grants for broadband buildout, particularly to unserved areas, there is a positive side to having lots of old infrastructure and old telephone lines out there. And that is that our companies already have the rights-of-way, they already have the conduits, they already have the basic building blocks in place. So they could put a lot of people to work quickly, digging trenches, laying new lines, upgrading existing equipment and employing salespeople to serve new customers. So in that respect, in terms of new service to unserved areas, we think there actually is great potential there for broadband grant programs. There is also an RUS, or Rural Utilities Service, telecom loan program that I spoke about in my testimony. Our understanding is that in the last go-around, in the fiscal year 2008 go-around, that program was oversubscribed by $250 million, showing that there is a great deal of interest among smaller companies that are eligible for those loans seeking assistance that RUS was not able to provide. A relatively small amount of money, about a half million dollars in appropriations, could underwrite about another $250 million in loan authority and fulfill all of those pending requests, which could come forth very, very quickly. " CHRG-109hhrg28024--180 Mr. Bernanke," Congressman, you are correct that the incidence of these so-called non-traditional mortgage products has been increasing. There are some customers for whom these products are appropriate, but there are also some customers for whom they are probably not appropriate. The Federal Reserve and the other banking agencies have issued guidance for comment to the banks, asking them first to re-think their underwriting standards, to make sure that when they make a loan of this type, the recipient is able to finance not only their first payment but also the payments that may come later if interest rates adjust, for example. Secondly, the guidance asks banks to be sure their disclosure to consumers is adequate so the consumers fully understand these complex financial instruments and understand what they are getting into. Third, that the banks themselves are adequately managing the risks inherent in making these kinds of loans. We are addressing these issues. These loans are quite popular in terms of new credit extensions. They remain a fairly modest portion of the outstanding mortgages. This goes back to a question that was asked earlier. I think the one area where they may pose some risks if the housing market slows down might be in the sub-prime area where they have been popular and it's more likely in those cases that they are inappropriate for the borrower. " CHRG-111shrg51303--84 Mr. Polakoff," Well, I think our respective staffs certainly at the annual conferences that we held communicated the various risks within this complex company. There is a difference between, as you know, underwriting credit default swaps and actually investing in residential mortgage-backed securities. Nonetheless, Senator, as you described, the theme should have been consistent in both parties. And certainly, in listening to the testimony today, I think it is worthy for us to go back and chat with our staffs as to what was communicated. Clearly, we know in the supervisors' college in 2007 we discussed the risks of the credit default swaps in FP, and I suspect that the various State insurance commissioners had ample opportunities to discuss in the supervisory colleges the risks that they were identifying. Senator Reed. Thank you very much. Mr. Chairman, thank you. " FOMC20080109confcall--58 56,MR. LACKER.," Yes. At the outset, in your discussion you said you were doing this in part to seek our views before you made a speech and testified and wanted our views before you engaged in overt signaling to the market. Someone else mentioned this, but I wanted to support this as a practice. I don't expect you to consult us before every public utterance you make but I would just compliment you on this innovation in Federal Open Market Committee practice. So thank you very much. " FinancialCrisisReport--4 In April 2010, the Subcommittee held four hearings examining four root causes of the financial crisis. Using case studies detailed in thousands of pages of documents released at the hearings, the Subcommittee presented and examined evidence showing how high risk lending by U.S. financial institutions; regulatory failures; inflated credit ratings; and high risk, poor quality financial products designed and sold by some investment banks, contributed to the financial crisis. This Report expands on those hearings and the case studies they featured. The case studies are Washington Mutual Bank, the largest bank failure in U.S. history; the federal Office of Thrift Supervision which oversaw Washington Mutual’s demise; Moody’s and Standard & Poor’s, the country’s two largest credit rating agencies; and Goldman Sachs and Deutsche Bank, two leaders in the design, marketing, and sale of mortgage related securities. This Report devotes a chapter to how each of the four causative factors, as illustrated by the case studies, fueled the 2008 financial crisis, providing findings of fact, analysis of the issues, and recommendations for next steps. B. Overview (1) High Risk Lending: Case Study of Washington Mutual Bank The first chapter focuses on how high risk mortgage lending contributed to the financial crisis, using as a case study Washington Mutual Bank (WaMu). At the time of its failure, WaMu was the nation’s largest thrift and sixth largest bank, with $300 billion in assets, $188 billion in deposits, 2,300 branches in 15 states, and over 43,000 employees. Beginning in 2004, it embarked upon a lending strategy to pursue higher profits by emphasizing high risk loans. By 2006, WaMu’s high risk loans began incurring high rates of delinquency and default, and in 2007, its mortgage backed securities began incurring ratings downgrades and losses. Also in 2007, the bank itself began incurring losses due to a portfolio that contained poor quality and fraudulent loans and securities. Its stock price dropped as shareholders lost confidence, and depositors began withdrawing funds, eventually causing a liquidity crisis at the bank. On September 25, 2008, WaMu was seized by its regulator, the Office of Thrift Supervision, placed in receivership with the Federal Deposit Insurance Corporation (FDIC), and sold to JPMorgan Chase for $1.9 billion. Had the sale not gone through, WaMu’s failure might have exhausted the entire $45 billion Deposit Insurance Fund. This case study focuses on how one bank’s search for increased growth and profit led to the origination and securitization of hundreds of billions of dollars in high risk, poor quality mortgages that ultimately plummeted in value, hurting investors, the bank, and the U.S. financial system. WaMu had held itself out as a prudent lender, but in reality, the bank turned increasingly to higher risk loans. Over a four-year period, those higher risk loans grew from 19% of WaMu’s loan originations in 2003, to 55% in 2006, while its lower risk, fixed rate loans fell from 64% to 25% of its originations. At the same time, WaMu increased its securitization of subprime loans sixfold, primarily through its subprime lender, Long Beach Mortgage Corporation, increasing such loans from nearly $4.5 billion in 2003, to $29 billion in 2006. From 2000 to 2007, WaMu and Long Beach together securitized at least $77 billion in subprime loans. FOMC20081216meeting--5 3,MR. DUDLEY.," Yes. There are two potential explanations, and it's really hard to sort out what's driving it. One is just that trading volumes have come down, and as trading volumes have come down, fails have come down. So that's part of it. It's just tied to trading volume. The second explanation is that the Treasury Market Practices Group published a best practices report basically arguing that a penalty rate should be put on fails, and it is going to design a road map to show how that might be implemented in practice. It may be that, given that publication, people who before might have been more cavalier about shorting Treasury securities at very low interest rates are now somewhat less inclined to do so just because of the moral suasion of that report that it is not a good thing to do. So it is some combination of those two, I think. " CHRG-111hhrg56766--90 Mr. Bernanke," Well, there are two separate issues there. It's true that because the economy is weak that some borrowers are not in the market for credit and that's one of the reasons why bank lending is down. The other issue, though, which I think you began with is that in situations where there is a creditworthy borrower who would like credit, we want to make sure that they get credit and we have been very focused on that issue. " CHRG-110shrg50414--242 Mr. Bernanke," I don't know how they make those decisions. I don't know. But I do know that a weak economy means lower tax revenues. So if it goes either way, there is going to be a fiscal hit. Senator Tester. OK. I understand. So what you are saying is the increase in potential debt would not have an impact on U.S. Treasuries. " CHRG-111shrg50814--59 Mr. Bernanke," Well, the projections we gave are for the labor market still to be weak through 2010. We have seen in the last few recessions that the labor market has been slow to recover after the real economy, in terms of total output, has begun to recover. Senator Schumer. Thank you, Mr. Chairman. " CHRG-111shrg55117--67 Mr. Bernanke," Let me use this opportunity to make a clear statement to Federal Reserve examiners everywhere and I hope to examiners of other Federal agencies. It is good for the bank, it is good for safety and soundness for banks to make safe loans to creditworthy borrowers, to maintain those relationships, and to extend credit to profitable and economic purposes. We recognize that there is a kind of a built-in bias among examiners in a period like this where the economy is weak and there is a lot of risk to be overconservative and push banks to be overconservative in their lending decisions. On the one hand, we certainly do not want banks to be making bad loans. That is how we got into trouble in the first place. Senator Martinez. Right. " CHRG-111shrg53085--213 PREPARED STATEMENT OF GAIL HILLEBRAND Financial Services Campaign Manager, Consumers Union of United States, Inc., March 24, 2009 Chairman Dodd, Ranking Member Shelby, and Members of the Committee, I appreciate the opportunity to testify on behalf of Consumers Union, the nonprofit publisher of Consumer Reports, \1\ on the important topic of reforming and modernizing the regulation and oversight of financial institutions and financial markets in the United States.--------------------------------------------------------------------------- \1\ Consumers Union of United States, Inc., publisher of Consumer Reports and Consumer Reports Online, is a nonprofit membership organization chartered in 1936 to provide consumers with information, education, and counsel about goods, services, health and personal finance. Consumers Union's print and online publications have a combined paid circulation of approximately 8.5 million. These publications regularly carry articles on Consumers Union's own product testing; on health, product safety, financial products and services, and marketplace economics; and on legislative, judicial, and regulatory actions that affect consumer welfare. Consumers Union's income is solely derived from the sale of Consumer Reports, its other publications and services, and noncommercial contributions, grants, and fees. Consumers Union's publications and services carry no outside advertising and receive no commercial support. Consumers Union's mission is ``to work for a fair, just, and safe marketplace for all consumers and to empower consumers to protect themselves.'' Our Financial Services Campaign engages with consumers and policymakers to seek strong consumer protection, vigorous law enforcement, and an end to practices that impede capital formation for low and moderate income households.---------------------------------------------------------------------------Introduction and Summary The job of modernizing the U.S. system of financial markets oversight and financial products regulation will involve much more than the addition of a layer of systemic risk oversight. The regulatory system must provide for effective household risk regulation as well as systemic risk regulation. Regulators must exercise their existing and any new powers more vigorously, so that routine, day to day supervision becomes much more effective. Gaps that allow unregulated financial products and sectors must be closed. This includes an end to unregulated status for the ``shadow'' financial sector. Regulators must place a much higher value on the prevention of harm to consumers. This new infrastructure, and the public servants who staff it, must protect individuals as consumers, workers, small business owners, investors, and taxpayers. A reformed financial regulatory structure must include: Strong consumer protections to reduce household risk; A changed regulatory culture; A federal agency independent of the banking industry that focuses on the safety of consumer financial products; An active role for state consumer protection; Credit reform leading to suitable and sustainable credit; An approach to systemic risk that includes systemic oversight addressing more than large financial institutions, stronger prudential regulation for risk, and closing regulatory gaps; and Increased accountability by all who offer financial products.1. Strong, effective, preventative consumer protection can reduce systemic risk Proactive, affirmative consumer protection is essential to modernizing financial system oversight and to reducing risk. The current crisis illustrates the high costs of a failure to provide effective consumer protection. The complex financial instruments that sparked the financial crisis were based on home loans that were poorly underwritten; unsuitable to the borrower; arranged by persons not bound to act in the best interest of the borrower; or contained terms so complex that many individual homeowners had little opportunity to fully understand the nature or magnitude of the risks of these loans. The crisis was magnified by highly leveraged, largely unregulated financial instruments and inadequate risk management. The resulting crisis of confidence led to reduced credibility for the U.S. financial system, gridlocked credit markets, loss of equity for homeowners who accepted nonprime mortgages and for their neighbors who did not, empty houses, declining neighborhoods and reduced property tax revenue. All of this started with a failure to protect consumers. Effective consumer protection is a key part of a safe and sound financial system. As FDIC Chairman Bair testified before this Committee, ``There can no longer be any doubt about the link between protecting consumers from abusive products and practices and the safety and soundness of the financial system. Products and practices that strip individual and family wealth undermine the foundation of the economy.'' \2\--------------------------------------------------------------------------- \2\ Bair, Sheila C., Chairman, Federal Deposit Insurance Corporation, Testimony before the Senate Committee on Banking, Housing and Urban Affairs on Modernizing Bank Supervision and Regulation, March 19, 2009, http://www.fdic.gov/news/news/speeches/chairman/spmar0319.html.--------------------------------------------------------------------------- Effective consumer protection will require: Changing the regulatory culture so that every existing federal financial regulatory agency places a high priority on consumer protection and the prevention of consumer harm; Creating an agency charged with requiring safety in financial products across all types of financial services providers (holding concurrent jurisdiction with the existing banking agencies); and Restoring to the states the full ability to develop and enforce consumer protection standards in financial services.2. A change in federal regulatory culture is essential Consumer advocates have long noted that federal banking agencies give insufficient attention to achieving effective consumer protection. \3\ Perhaps this stems partly from undue confidence in the regulated industry or an assumption that problems for consumers are created by just a few ``bad apples.'' One federal bank regulator has even attempted to weaken efforts by another federal agency to protect consumers from increases in credit card interest rates on funds already borrowed. \4\ Consumers Union believes that federal banking regulators have placed too much confidence in the private choices of bank management and too much unquestioning faith in the benefits of financial innovation. Too often, the perceived value of financial innovation has not been weighed against the value of preventing harm to individuals. The Option ARM, as sold to a broad swath of ordinary homeowners, has shown that the harm from some types and uses of financial services innovation can far outweigh the benefits.--------------------------------------------------------------------------- \3\ Improving Federal Consumer Protections in Financial Services, Testimony of Travis Plunkett, before the Committee on Financial Services of the U.S. House of Representatives, July 25, 2007, available at http://www.consumerfed.org/pdfs/Financial_Services_Regulation_House_Testimony_072507.pdf. \4\ The OCC unsuccessfully asked the Federal Reserve Board to add significant exemptions to the Fed's proposed rule to limit the raising of interest rates on existing credit card balances. See the OCC's comment letter: http://www.occ.treas.gov/foia/OCC%20Reg%20AA%20Comment%20Letter%20to%20FRB_8%2018%2008.pdf.--------------------------------------------------------------------------- We need a fundamental change in regulatory culture at most of the federal banking regulatory agencies. Financial regulators must place a much higher value on preventing harm to individuals and to the public. Comptroller Dugan's testimony to this Committee on March 19, 2009, may have unintentionally illustrated the regulatory culture problem when he described the ``sole mission'' of the OCC as ``bank supervision.'' \5\--------------------------------------------------------------------------- \5\ The Comptroller stated: ``Most important, moving all supervision to the Board would lose the very real benefit of having an agency whose sole mission is bank supervision. That is, of course, the sole mission of the OCC . . . '' Dugan, John C., Comptroller of the Currency, Testimony before the Senate Committee on Banking, Housing and Urban Affairs on Modernizing Bank Supervision and Regulation, March 19, 2009, p.11, available at: http://banking.senate.gov/public/index.cfm?FuseAction=Hearings.Testimony&Hearing_ID=494666d8-9660-439f82fa-b4e012fe9c0f&Witness_D=845ef046-9190-4996-8214-949f47a096bd. Other parts of the testimony indicate that the Comptroller was including compliance with existing consumer laws within ``supervision.''--------------------------------------------------------------------------- The purpose of this hearing is to build for a better future, not to assign blame for the current crisis. However, the missed opportunities to slow or stop the products and practices that led to the current crisis should inform the decisions about the types of changes needed in future regulatory oversight. Consumer groups warned federal banking agencies about the harms of predatory practices in subprime lending long before it exploded in volume. For example, Consumers Union asked the Federal Reserve Board in 2000 to reinterpret the triggers for the application of the Home Ownership and Equity Protection Act (HOEPA) in a variety of ways that would have expanded its coverage. \6\ Other consumer groups, such as the National Consumer Law Center, had been seeking similar reforms for some time. In the year 2000, the New York Times reported on how securitization was fueling the growth in subprime loans with abusive features. \7\ While the current mortgage meltdown involves practices in loan types beyond subprime and high cost mortgages, we will never know if stamping out some of the abusive practices that consumer advocates sought to end in 2000 would have prevented more of those practices from spreading.--------------------------------------------------------------------------- \6\ Garcia, Norma Paz, Senior Attorney, Consumers Union, Testimony before the Federal Reserve Board of Governors regarding Predatory Lending Practices, Docket No. R-1075, San Francisco, CA, September 7, 2000, available at: www.defendyourdollars.org/2000/09/cus_history_of_against_predato.html. In that testimony, Consumers Union asked the Federal Reserve Board to adjust the HOEPA triggers to include additional costs within the points and fees calculation, which would have brought more loans under the basic HOEPA prohibition on a pattern or practice of extending credit based on the collateral--that is, that the consumer is not expected to be able to repay from income. We also asked the Board to issue a maximum debt to income guideline to further shape industry practice in complying with the affordability standard. \7\ Henriques, D., and Bergman, L., Mortgaged Lives: A Special Report.; Profiting from Fine Print with Wall Street's Help, New York Times, March 20, 2000, available at: http://www.nytimes.com/2000/03/15/business/mortgagedlives-special-report-profiting-fine-print-with-wall-street-s-help.html.--------------------------------------------------------------------------- Some have claimed that poor quality loans and abusive lender practices were primarily an issue only for state-chartered, solely state-overseen lenders, but the GAO found that a significant volume of nonprime loans were originated by banks and by subsidiaries of nationally chartered banks, thrifts or holding companies. The GAO analyzed nonprime originations for 2006. That report covers the top 25 originators of nonprime loans, who had 90 percent of the volume. The GAO report shows that the combined nonprime home mortgage volume of all banks and of subsidiaries of federally chartered banks, thrifts, and bank holding companies actually exceeded the nonprime origination volume of independent lenders subject only to state oversight. The GAO reported these volumes for nonprime originations: $102 billion for all banks, $203 billion for subsidiaries of nationally chartered entities, and $239 billion for independent lenders. Banks had a significant presence, and subsidiaries of federally chartered entities had a volume of nonprime originations nearly as high as the volume for state-only-supervised lenders. \8\--------------------------------------------------------------------------- \8\ Financial Regulation: A Framework for Crafting and Assessing Proposals to Modernize the Outdated U.S. Financial Regulatory System, GAO 09-216, January 2009, at 24, available at: http://www.gao.gov/new.items/d09216.pdf.--------------------------------------------------------------------------- It is too easy for a bank regulator to see its job as complete if the bank is solvent and no laws are being violated. The current crisis doesn't seem to have brought about a fundamental change in this regulatory perspective. Comptroller Dugan told this Committee just last week: ``Finally, I do not agree that the banking agencies have failed to give adequate attention to the consumer protection laws that they have been charged with implementing.'' \9\ Clearly, the public thinks that bank regulation has failed. Homeowners in distress, as well as their neighbors who are suffering a loss in home values, think that bank regulation has failed. Taxpayers who are footing the bill for the purchase of bank capital think that bank regulation has failed.--------------------------------------------------------------------------- \9\ Dugan, John C., Comptroller of the Currency, Testimony before the Senate Committee on Banking, Housing, and Urban Affairs. U.S. Senate, March 19, 2009. p 11, available at: http://banking.senate.gov/public/index.cfm?FuseAction=Hearings.Testimony&Hearing_ID=494666d8-9660-439f82fa-b4e012fe9c0f&Witness_ID=845ef046-9190-4996-8214-949f47a096bd.---------------------------------------------------------------------------3. Consumers need a Financial Product Safety Commission (FPSC) The bank supervision model lends itself to the view that the regulator's job is finished if existing laws are followed. Unfortunately, a compliance-focused mentality leaves no one with the primary job of thinking about how evolving, perhaps currently legal, business practices and product features may pose undue harm to consumers. A strong Financial Product Safety Commission can fill the gap left by compliance-focused bank regulators. The Financial Product Safety Commission would set a federal floor for consumer protection without displacing stronger state laws. It would essentially be an ``unfair practices regulator'' for consumer credit, deposit and payment products. \10\ Investor protection would remain elsewhere. \11\--------------------------------------------------------------------------- \10\ Payment products include prepaid cards, which increasingly are marketed as account substitutes, including to the unbanked. For a discussion of the holes in current consumer law with respect to these cards, see: G. Hillebrand, Before the Grand Rethinking, 83 Chicago-Kent L. Rev. No. 2, 769 (2008), available at: http://www.consumersunion.org/pdf/WhereisMyMoney08.pdf. Consumers Union and other consumer and community groups asked the Federal Reserve Board to expand Regulation E to more clearly cover these cards, including cards on which unemployment benefits are delivered, in 2004. Consumer Comment letter to Federal Reserve Board in Docket R-1210, October 24, 2004, available at: http://www.consumersunion.org/pdf/payroll1004.pdf. That protection is still lacking. In February 2009, the Associated Press reported on consumer difficulties with the use of prepaid cards to deliver unemployment benefits. Leonard, C., Jobless Hit with Bank Fees on Benefits, Associated Press, Feb. 19, 2009. \11\ Investor protection has long been important to Consumers Union. In May 1939, Consumer Reports said: ``I know it is quite impossible for the average investor to examine and judge the real security that stands behind mere promises of security, and that unless one has expert knowledge and disinterested judgment available, he must shun all such plans, no matter how attractive they seem. We cannot wait for the next depression to tell us that these financial plans--appealing and reasonable in print--failed and created such widespread havoc, not because of the depression, but because they were not safeguarded to weather a depression.''--------------------------------------------------------------------------- The Financial Product Safety Commission would not remove the obligation on existing regulators to ensure compliance with current laws and regulations. Instead, the Commission would promulgate rules that would apply regardless of the chartering status of the product provider. This would insulate consumers from some of the harmful effects of ``charter choice,'' because chartering would be irrelevant to the application of rules designed to minimize unreasonable risks to consumers. Only across the board standards can eliminate a ``race to the bottom'' in consumer protection. Without endorsing the FPSC, FDIC Chairman Bair has emphasized the need for standards that apply across types of providers of financial products, stating: Whether or not Congress creates a new commission, it is essential that there be uniform standards for financial products whether they are offered by banks or nonbanks. These standards must apply across all jurisdictions and issuers, otherwise gaps create competitive pressures to reduce standards, as we saw with mortgage lending standards. Clear standards also permit consistent enforcement that protects consumers and the broader financial system. \12\--------------------------------------------------------------------------- \12\ Bair, Sheila C., Chairman, Federal Deposit Insurance Corporation, Testimony before the Committee on Banking, Housing, and Urban Affairs on Modernizing Bank Supervision and Regulation, March 19, 2009. The Financial Product Safety Commission is part of a larger shift we must make in consumer protection to move away from failed ``disclosure-only'' approaches. Financial products which are too complex for the intended consumer carry special risks that no amount of additional disclosure or information will fix. Many of the homeowners who accepted predatory mortgages did not understand the nature of their loan terms. The over 60,000 individuals who filed comments in the Federal Reserve Board's Regulation AA docket on unfair or deceptive credit card practices described many instances in which they experienced unfair surprise because the fine print details of the credit arrangement did not match their understanding of the product that they were currently using. The Financial Product Safety Commission can pay special attention to practices that make financial products difficult for consumers to use safely.4. State power to protect financial services consumers, regardless of the chartering of the financial services provider, must be fully restored The Financial Product Safety Commission would set a federal floor, not a federal cap, on consumer protection in financial services products. No agency can foresee all of the potentially harmful consequences of new practices and products. A strong concurrent role for state law and state agencies is essential to provide more and earlier enforcement of existing standards and to provide places to develop new standards for addressing emerging practices. Harmful financial practices often start in one region or are first targeted to one subgroup of consumers. When those practices go unchallenged, others feel a competitive pressure to adopt similar practices. State legislatures should be in a unique position to spot and stop bad practices before they spread. However, federal preemption has seriously compromised the ability of states to play this role. Some might ask why states can't just regulate state-chartered entities, while federal regulators address the conduct of federally chartered entities. There are several reasons. First, federal bank regulators aren't well-suited to address conduct issues of operating subsidiaries of national banks in local and state markets. Second, assertions of federal preemption for nationally chartered entities and their subsidiaries interfere with the ability of states to restrict the conduct of state-chartered entities. The reason for this is simple: if national financial institutions or their operating subsidiaries have a sizable percentage of any market, this creates a barrier to state reforms applicable only to state-only entities. The state-chartered entities argue strongly against the reforms on the grounds that their direct competitors would be exempt. As FDIC Chairman Bair told the Committee on March 19, 2009: Finally, in the ongoing process to improve consumer protections, it is time to examine curtailing federal preemption of state consumer protection laws. Federal preemption of state laws was seen as a way to improve efficiencies for financial firms who argued that it lowered costs for consumers. While that may have been true in the short run, it has now become clear that abrogating sound state laws, particularly regarding consumer protection, created an opportunity for regulatory arbitrage that frankly resulted in a ``race-to-the-bottom'' mentality. Creating a ``floor'' for consumer protection, based on either appropriate state or federal law, rather than the current system that establishes a ceiling on protections would significantly improve consumer protection. \13\--------------------------------------------------------------------------- \13\ Bair, Sheila C., Chairman, Federal Deposit Insurance Corporation. Testimony before the Senate Committee on Banking, Housing, and Urban Affairs on Modernizing Bank Supervision and Regulation, March 19, 2009. The Home Owners' Loan Act stymies application of state consumer protection laws to federally chartered thrifts due to its field preemption, which should be changed by statute. State standards for lender conduct and state enforcement against national banks and their operating subsidiaries have been severely compromised by the OCC's preemption rules and operating subsidiary rule. \14\ The OCC has even taken the position that state law enforcement cannot investigate violations of non-preempted state laws against a national bank or its operating subsidiaries. \15\ That latter issue is now pending in the U.S. Supreme Court.--------------------------------------------------------------------------- \14\ In 2004, the Office of the Comptroller of the Currency promulgated regulations to preempt state laws, state oversight, and consumer enforcement in the broad areas of deposits, real-estate loans, non-real estate loans, and the oversight of operating subsidiaries of national banks. 12 CFR 7.4000, 7.4007, 7.4008, 7.4009, and 34.4. These regulations interpret portions of the National Bank Act that consumer advocates believe were designed to prevent states from imposing harsher conditions on national banks than on state banks, not to give national banks an exemption from state laws governing financial products and services. The OCC has repeatedly sided in court with banks seeking to invalidate state consumer protection laws. One example is the case of Linda A. Watters, Commissioner, Michigan Office of Insurance and Financial Services v. Wachovia Bank, N.A., 550 U.S. 1 (2007). The OCC filed an amicus brief in support of Wachovia in the United States Supreme Court to prevent Michigan from regulating the practices of a Wachovia mortgage subsidiary. The OCC argued that its regulations and the National Bank Act preempt state oversight and enforcement and prevented state mortgage lending protections from applying to a national bank's operating subsidiary. The Supreme Court then held that Michigan's licensing, reporting, and investigative powers were preempted. Wachovia is no longer in business, and many observers attribute that to its mortgage business. \15\ In Office of the Comptroller of the Currency v. Spitzer, 396 F. Supp. 2d 383 (S.D.N.Y., 2005), aff'd in part, vacated in part on other grounds and remanded in part on other grounds sub nom. The Clearing House Ass'n v. Cuomo, 510 F.3d 105 (2d Cir., 2007), cert. granted, Case No. 08-453, New York's Attorney General sought to investigate whether the residential mortgage lending practices of several national banks doing business in New York were racially discriminatory because the banks were issuing high-interest home mortgage loans in significantly higher percentages to African-American and Latino borrowers than to White borrowers. The OCC and a consortium of national banks sued to prevent the Attorney General from investigating and enforcing the anti-discrimination and fair lending laws against national banks. The OCC claimed that only it could enforce these state laws against a national bank. The district court granted declaratory and injunctive relief, and the Second Circuit affirmed. (See http://www.ca2.uscourts.gov:8080/isysnative/RDpcT3BpbnNcT1BOXDA1LTU5OTYtY3Zfb3BuLnBkZg==/055996-cv_opn.pdf.) The case is now being briefed in the U.S. Supreme Court.--------------------------------------------------------------------------- The OCC is an agency under the U.S. Treasury Department. The Administration should take immediate steps to repeal the OCC's package of preemption and visitorial powers rules. \16\ This would remove the agency's thumb from the scale as courts determine the meaning of the National Bank Act. Further, because the OCC's broad view of preemption has influenced the Courts' views on the scope of preemption under the National Bank Act, Congress should amend the National Bank Act to make it crystal clear that state laws requiring stronger consumer protections for financial services consumers are not preempted; state law enforcement is not ``visitation'' of a national bank; and any visitorial limitation has no application to operating subsidiaries of national banks.--------------------------------------------------------------------------- \16\ Those rules are 12 CFR 7.4000, 7.4007, 7.4008, 7.4009, and 34.4.--------------------------------------------------------------------------- Once the preemption barrier is removed, state legislation can provide an early remedy for problems that are serious for one subgroup of consumers or region of the country. State legislation can also develop solutions that may later be adopted at the federal level. Prior to the overbroad preemption rules, as well as in the regulation of credit reporting agencies which falls outside of OCC preemption, states have pioneered such consumer protections as mandatory limits on check hold times, the free credit report, the right to see the credit score, and the security freeze for use by consumers to stop the opening of new accounts by identity thieves. \17\ Congress later adopted three of these four developments into statute for the benefit of consumers nationwide.--------------------------------------------------------------------------- \17\ The first two of these developments were described by Consumers Union in its comment letter to the OCC opposing its broad preemption rule before adoption. Consumers Union letter of Oct. 1, 2003, in OCC Docket 03-16, available at: http://www.consumersunion.org/pub/core_financial_services/000770.html. The free credit report and the right to a free credit score if the score is used in a home-secured loan application process were both made part of the FACT Act. For information on the security freeze, which is available in 46 states by statute and the remaining states through an industry program, see: http://www.consumersunion.org/campaigns//learn_more/003484indiv.html.---------------------------------------------------------------------------5. Credit reform can provide access to suitable and sustainable credit Attempts to protect consumers in financial services are often met with assertions that protections will cause a reduction in access to credit. Consumers Union disputes the accuracy of those assertions in many contexts. However, we also note that not every type of credit is of net positive value to consumers. For example, the homeowner with a zero interest Habitat for Humanity loan who was refinanced into a high cost subprime mortgage would have been much better off without that subprime loan. \18\ The same is true for countless other homeowners with fixed rate, fully amortizing home loans who were persuaded to refinance into loans that contained rate resets, balloon payments, Option ARMs, and other adverse features of variable rate subprime loans.--------------------------------------------------------------------------- \18\ Center for Responsible Lending founder Martin Eakes described this homeowner as the reason he become involved in anti-predatory lending work in a speech to the CFA Consumer Assembly.--------------------------------------------------------------------------- Creating access to sustainable credit will require substantial credit reform. This will have to include steps such as: outlawing pricing structures that mislead; requiring underwriting to the highest rate the loan payment may reach; requiring that the ``shelter rule'' which ends purchaser responsibility for problems with the loan be waived by the purchaser of any federally related mortgage loan; requiring borrower income to be verified; ending complex pricing structures that obscure the true cost of the loan; requiring suitability and fiduciary duties; and ending steering payments and negative amortization abuses.6. Systemic risk regulation, prudential risk regulation, and closing regulatory gapsA. Scope of systemic risk regulation There has been discussion about whether the systemic risk regulator should focus on institutions which are ``too big to fail.'' Federal Reserve Board Chairman Bernanke has noted that the incentives, capital requirements, and other risk management requirements must be tight for any institution so large that its failure would pose a systemic risk. \19\--------------------------------------------------------------------------- \19\ Bernanke, Ben S., Chairman, Federal Reserve Board. Speech to the Council on Foreign Relations. Washington, DC, March 10, 2009, available at: http://www.federalreserve.gov/newsevents/speech/bernanke20090310a.htm#f4.--------------------------------------------------------------------------- FDIC Chairman Bair's recent testimony posed the larger question about whether any value to the economy of extremely large and complex financial institutions outweighs the risk to the system should such institutions fail, or the cost to the taxpayer if policymakers decide that these institutions cannot be permitted to fail. Consumers Union suggests that one goal of systemic risk regulation should be to internalize to large and complex financial market participants the costs to the system that the risks created by their size and complexity impose on the financial system. ``Too big to fail'' institutions either have to become ``smaller and less complex'' or they have to become ``too strong to fail'' despite their size and complexity--without future expectations of public assistance. There are many ideas in development with respect to what a systemic risk oversight function would entail, who should perform it, and what powers it should have. Systemic risk oversight should focus on protecting the markets, not specific financial institutions. Systemic risk oversight probably cannot be limited to the largest firms. It will have to also focus on practices used by bank and nonbank entities that create or magnify risk through interdependencies with both insured depository institutions and with other entities which hold important funds such as retirement savings and the money to fund future pensions. The mortgage crisis has shown that a nonfinancial institution, such as a rating agency or a bond insurer, can adopt a practice that has consequences throughout the entire financial system. Toxic mortgage securitizations which initially received solid gold ratings are an example of the widespread consequences of practices of nonfinancial institutions.B. Who should undertake the job of systemic risk regulation? There are many technical questions about the exact structure for a systemic risk regulator and its powers. Like other groups, Consumers Union looks forward to learning from the debate. Accordingly we do not offer a recommendation as between giving the job to the Federal Reserve Board, the Treasury, the FDIC, the new agency, or to a panel, committee, or college of regulators. However, we offer the following comments on some of the proposal. We agree with the proposition put forth by the AFL-CIO that the systemic risk regulator should not be governed by, or do its work through, any body that is industry-dominated or uses a self-regulatory model. We question whether the same agency should be responsible for both ongoing prudential oversight of bank holding companies and systemic risk oversight involving those same companies. If part of the idea of the systemic risk regulator is a second pair of eyes, that can't be accomplished if one regulator has both duties for a key segment of the risk-producers. The panel or committee approach has other problems. A panel made up of multiple regulators would be composed of persons who have a shared allegiance to the systemic risk regulator and to another agency. It could become a forum for time-wasting turf battles. In addition, systemic risk oversight should not be a part-time job. We also are concerned with the proposal made by some industry groups that the systemic risk regulator be limited in most cases to acting through or with the primary regulator. This could recreate the type of cumbersome and slow interagency process that the GAO discussed in the context of mortgage regulation. \20\--------------------------------------------------------------------------- \20\ Government Accountability Office. Financial Regulation: A Framework for Crafting and Assessing Proposals to Modernize the Outdated U.S. Financial Regulatory System, January 2009, GAO 09-216, p. 43, available at: http://www.gao.gov/new.items/d09314t.pdf.--------------------------------------------------------------------------- Consumers Union supports a clear, predictable, rules-based process for overseeing the orderly resolution of nondepository institutions. However, it is not clear that the systemic risk regulator should oversee the unwinding. That job could be given to the FDIC, which has deep experience in resolving banks. Assigning the resolution job to the FDIC might leave the systemic risk regulator more energy to focus on risk, rather than the many important details in a well-run resolution.C. Relationship of systemic risk regulation to stronger across the board prudential regulation and to closing regulatory gaps Federal financial regulators must have new powers and new obligations. How much of the job is assigned to the systemic risk regulator may depend in part on how effectively Congress and the regulators close existing loopholes and by how much the regulators improve the quality and sophistication of day to day prudential regulation. For example, if the primary regulator sees and considers all liabilities, including those now treated as off-balance sheet, that will change what remains to the done by the systemic oversight body. Thus, each of the powers described in the next subsection for a systemic risk regulator should also be held, and used, by primary prudential regulators. The more effectively they do so, the more the systemic risk regulator will be able to focus on new and emerging practices and risks. Closing the gaps that have allowed some entities to offer financial products, impose counterparty risk on insured institutions, engage in bank-like activities, or otherwise impinge on the health of the financial system without regulation is at least as important, if not more important, than the creation and powers of a systemic risk regulator. Gaps in regulation must be closed and kept closed. Gaps can permit small corners of the law to become safe harbors from the types of oversight applicable to similar practices and products. The theory that some investors don't require protection, due to their level of sophistication, has been proved tragically wrong for those investors, with adverse consequences for millions of ordinary people. The conduct of sophisticated investors and the shadow market sector contributed to the crisis of confidence and thus to the credit crunch. The costs of that crunch are being paid, in part, by individuals facing tighter credit limits and loss of jobs as their employers are unable to get needed business credit.D. Powers of a systemic risk regulator Consumers Union suggests these powers for a systemic risk regulator. Other powers may also be needed. As already discussed, we also believe that the primary regulator should be exercising all or most of these powers in its routine prudential supervision. Power to set capital, liquidity, and other regulatory requirements directly related to risk and risk management: It is essential to ensuring that all the players whose interconnections create risk for others in the financial system are well capitalized and well-managed for risk. Power to act by rule, corrective action, information, examination, and enforcement: The systemic risk regulator must have the power to act with respect to entities or practices that pose systemic risk, including emerging practices that could fall in this category if they remain unchecked. This should include the power to require information, take corrective action, examine, order a halt to specific practices by a single entity, define specific practices as inappropriate using a generally applicable rule, and engage in enforcement. Power to publicize: The recent bailout will be paid for by U.S. taxpayers. Even if some types of risks might have to be handled quietly at some stages of the process, the systemic risk regulator must have the power and the obligation to make public the nature of too-risky practices, and the identities of those who use those practices. Power and obligation to evaluate emerging practices, predict risks, and recommend changes in law: Even the best-designed set of regulations can develop unintended loopholes as financial products, practices and industry structure change. Part of the failure of the existing regulatory structure has been that financial products and practices regularly outpace existing legal requirements, so that new products fit into regulatory gaps. For this reason, every financial services regulator, including the systemic risk regulator, should be required to make an annual, public evaluation of emerging practices, the risks that those emerging practices may pose, and any recommendations for legislation or regulation to address those practices and risks. Power to impose receivership, conservatorship, or liquidation on an entity which is systemically important, for orderly resolution: Consumers Union agrees with many others who have endorsed developing a method for predictable, orderly resolution of certain types of nonbank entities. There will have to be a required insurance premium, paid in advance, for the costs of resolution. Such an insurance program is unlikely to work if it is voluntary, since those engaged in the riskiest practices might also be those least likely to choose to opt in to a voluntary insurance system. Undermining of confidence from a power to modify or suspend accounting requirements: Some have recommended that the systemic risk regulator be given the power to suspend, or modify the implementation of, accounting standards. Consumers Union believes that this could lead to a serious undermining of confidence. As the past year has shown, confidence is an essential element in sustaining financial markets.7. Promoting increased accountability Consumers Union strongly agrees with President Obama's statement that market players must be held accountable for their actions, starting at the top. \21\ There are many elements to accountability. Here is a nonexclusive list.--------------------------------------------------------------------------- \21\ Overhaul, post to the White House blog on Feb. 25, 2009, available at http://www.whitehouse.gov/blog/09/02/25/Overhaul/.--------------------------------------------------------------------------- Consumers Union believes that accountability must include making every entity receiving a fee in connection with a financial instrument responsible for future problems with that instrument. This would help to end the ``keep the fee, pass the risk'' phenomenon which helped to fuel poor underwriting of nonprime mortgages. Moreover, everyone who sells a financial product to an individual should have an enforceable legal obligation to ensure that the product is suitable. Likewise, everyone who advises individuals about financial products should have an enforceable fiduciary duty to those individuals. Executive compensation structures should be changed to avoid overemphasis on short term returns rather than the long term health and stability of the financial institution. We also agree with the recommendation which has been made by regulators that they should engage in a thorough review of regulatory rules to identify any rules which may permit or encourage overreliance on ratings or risk modeling. Consumers Union also supports more accountability for financial institutions who receive public support. Companies that choose to accept taxpayer funds or the benefit of taxpayer-backed programs or guarantees should be required to abandon anti-consumer practices and be held to a high standard of conduct. \22\--------------------------------------------------------------------------- \22\ For example, in connection with the Consumer and Business Lending Initiative, which is to be managed through the Term Asset Backed Securities Facility (TALF), Consumers Union and 26 other groups asked Secretary Geithner on Jan. 29, 2009, to impose eligibility restrictions on program participants to ensure that the TALF would not support the taxpayer financed purchase of credit card debt with unfair terms. That request was made before the program's size was increased from $200 billion to $1 trillion. http://www.consumersunion.org/pdf/TALF.pdf.--------------------------------------------------------------------------- A stronger role for state law and state law enforcement also will enhance accountability. Regulatory oversight and strict enforcement at all levels of government can stop harmful products and practices before they spread. ``All hands on deck,'' including state legislatures, state Attorneys General and state banking supervisors, will help to enforce existing standards, identify problems, and develop new solutions.Conclusion Even the best possible regulatory structure will be inadequate unless we also achieve a change in regulatory culture, better day to day regulation, an end to gaps in regulation, real credit reform, accountability, and effective consumer protection. Creating a systemic risk regulator without reducing household risk through effective consumer protection would be like replacing the plumbing of our financial system with all new pipes and then still allowing poisoned water into those new pipes. The challenges in regulatory reform and modernization are formidable and the stakes are high. We look forward to working with you toward reforming the oversight of financial markets and financial products.LIST OF APPENDICES 1. General Accountability Office figure showing 2006 nonprime mortgage volume of banks ($102 billion), subsidiaries of nationally chartered financial institutions ($203 billion) and independent lenders ($239 billion). 2. Consumers Union's Principles for Regulatory Reform in Consumer Financial Services. 3. Consumers Union's Platform on Mortgage Reform. Appendix 1 Page 24 from GAO Report, GAO 09-0216, A Framework for Crafting and Assessing Proposals to Modernize the Outdated U.S. Financial Regulatory System. Also found at: http://www.gao.gov/new.items/d09216.pdf. Appendix 2Consumers Union Principles for Regulatory Reform in Consumer Financial Services 1. Every financial regulatory agency must make consumer protection as important as safety and soundness. The crisis shows how closely linked they are. 2. Consumers must have the additional protection of a Financial Product Safety agency whose sole job is their protection, and whose rules create baseline federal standards that apply regardless of the nature of the provider. This agency would have dual jurisdiction along with the functional regulator. States would remain free to set higher standards. 3. State innovation in financial services consumer protection and state enforcement of both federal and state laws must be honored and encouraged. This will require repeal of the OCC's preemption regulations and its rule exempting operating subsidiaries of national banks from state supervision. The OCC should also immediately cease to intervene in cases, or to file amicus briefs, against the enforceability of state consumer protection laws. 4. Every financial services regulator must have: a proactive attitude to find and stop risky, harmful, or unfair practices; prompt, robust, effective complaint handling for individuals; and an active and public enforcement program. 5. Financial restructuring will be incomplete without real credit reform, including: outlawing pricing structures that mislead; requiring underwriting for the ability to repay the loan at the highest interest rate and highest payment that the loan may reach; a requirement that the ``shelter rule'' that ends most purchaser responsibility for problems with a loan be waived by the purchaser of any federally related mortgage loan; a requirement that borrower income be verified; an end to complex pricing structures that obscure the true cost of credit; suitability and fiduciary duties on credit sellers and credit advisors; and an end to steering payments and negative amortization abuses. Appendix 3Consumers Union Mortgage Reform Platform We need strong new laws to make all loans fair. This should include these requirements for every home mortgage: Require underwriting: Every lender should be required to decide if the borrower will be able to repay the loan and all related housing costs at the highest interest rate and the highest payment allowed under the loan. Lenders should be required to verify all income on the loan application. End complex pricing structures that obscure the true cost of the loan. Brokers and lenders should be required to offer only those types of loans that are suitable to the borrower. Brokers and lenders should have a fiduciary obligation to act in the best interest of the borrower. Stop payments to brokers to place consumers in higher cost loans. End the use of negative amortization to hide the real cost of a loan. Require translation of loan documents into the language in which the loan was negotiated. Hold investors accountable through assignee liability for the loans they purchase. Require that everyone who gets a fee for making or arranging a loan is responsible later if something goes wrong with that loan. Adopt extra protections for higher-cost loans. Restore state powers to develop and enforce consumer protections that apply to all consumers and all providers. For more information, see: http:// www.defendyourdollars.org/topic/mortgages. CHRG-110shrg50417--22 Mr. Zubrow," Thank you very much, Mr. Chairman. Chairman Dodd and Members of the Committee, thank you for including us in today's hearing on the Capital Purchase Program. I am pleased to represent JPMorgan Chase before this Committee. You have with you my detailed written testimony. Given the size of this panel, allow me to summarize a few key points. At JPMorgan Chase, we believe that the Government's investment in our firm comes with a responsibility to honor the goals of the Capital Purchase Program. To that end, we are using the CPP funds to expand the flow of credit into the U.S. economy and to modify the terms of hundreds of thousands of residential mortgages. At the same time, we continue to maintain prudent business practices and underwriting standards that have helped JPMorgan Chase to create and maintain a fortress balanced sheet. What does this mean in practice? Let me begin with our loan modification efforts, which we believe will help to strengthen the U.S. real estate markets and to keep people in their homes. Last week, we announced the significantly expanded loan modification program that we expect will help roughly 400,000 additional families to stay in their homes. Since early 2007, Chase has helped about 250 families avoid foreclosure, primarily by modifying their loans or their loan payments. Our new initiative is reaching out to additional customers of Chase, but also to Washington Mutual and the EMC unit of Bear Stearns, which are now part of the bank. As part of these efforts, we are opening 24 regional counseling centers to provide borrowers with face-to-face help in high delinquency areas. We are hiring over 300 new loan counselors, bringing our total to more than 2,500, so that homeowners can work with the same counselor from the start to the finish of the process. Proactively, we are reaching out to borrowers to offer pre-qualified modifications, such as interest rate reductions and principal forbearance. We seek to expand the range of financing alternatives which are available to our customers and to provide an independent review of each loan before moving it into the foreclosure process. Until all of these changes are fully implemented--we hope within the next 90 days--we have stopped any new foreclosure proceedings on our owner-occupied properties. The Capital Purchase Program's goal of providing capital to the U.S. economy is absolutely consistent with our own core business of supporting our customers through lending operations. Despite the challenges economic conditions, we continue to provide credit to our customers, whether they are consumers, small businesses, large corporations, not-for-profit organizations, or municipalities. Throughout the past year, during some of the most turbulent and difficult conditions many of us have ever witnessed, we have prided ourselves on being there for our clients, whether by making markets, committing capital to facilitate client business, investing in infrastructure and other projects, or making loans to creditworthy borrowers. In short, we have been open for business and we continue to be open for business. The CPP enhances our ability to lend to consumers and businesses large and small, and we are committed to honoring the goals of this program. The Committee has also asked us to address executive compensation practices, and I am pleased to do so. JPMorgan is in business for the long term, and our compensation philosophy reflects that. Simply stated, we believe that compensation should be based on the long-term performance of our firm and the individual's contribution to his or her business, and to provide important and appropriate safeguards for safe and sound behavior. We require our senior executives to retain at least 75 percent of all their equity awards that are granted to them so that their interests are aligned with the long-term interests of our shareholders. We offer no golden parachutes or special severance packages. Our top executives are subject to the exact same severance provisions as all of our employees. Even prior to the CPP, our firm had in place a bonus recoupment policy. We have obviously amended that to ensure full compliance with the terms of the CPP. We are not yet in a position to provide specific information about compensation for this year, given that the year is not complete. However, given the type of year we are experiencing and even though we have produced profitable results in each quarter to date, I have little doubt that employees and executives will make substantially less than they did last year. Let me also state very clearly that the CPP money will have no impact on the compensations that are taken for JPMorgan Chase employees or executives. The Government's investment in our firm came along with a special responsibility, as you have noted, Mr. Chairman, to America's taxpayers. We fully intend to honor that responsibility by promoting the goals of the CPP while also acting prudently and sensibly and in the interests of all of our shareholders to maintain a healthy and vibrant company. Many believe that irresponsible lending was one of the causes of the current distress in the financial markets. No one wants a repeat of those mistakes. Every day we seek to make capital available in a responsible, safe, and sustainable way to help get the economy back on track. John Pierpont Morgan once said that he wanted to do first-class business in a first-class way. That continues to be a guiding principle for us. It remains our goal and our commitment to our customers, to our shareholders, our employees, and to the taxpayers of this Nation. Thank you very much. " FinancialCrisisInquiry--71 And so that’s—you know, those things would have to be sorted through. The other point that he made earlier—how effective is that in terms of influencing behavior. In this—in this process, most of the problem wasn’t, in my opinion, the cynicism of companies, which held these positions, even though they knew they were toxic, and motivation. They didn’t know they were toxic. Why else would some of these balance sheets of some of these companies have many tens of billions of dollars of these securities? They were—it was a failure of risk management, I think, more than a failure of incentive. That’s just my feelings... GEORGIOU: But wouldn’t—but wouldn’t... CHAIRMAN ANGELIDES: Mr. Georgiou, you have 20 seconds. GEORGIOU: But wouldn’t the underwriter—wouldn’t the entities, the originating entities be in a better position to know whether these securities had the possibility of becoming toxic? For example, if you—I mean, as you evaluated some of the CDOs that you created, wouldn’t you be in a better position to know whether they were likely to fail? BLANKFEIN: CHRG-111hhrg55814--295 Mr. Manzullo," That is my question--the only people around here who do not seem to be getting any recognition or any respect are the people who have been doing their jobs back home in the State insurance authorities, and then all of a sudden people say, let's bring it together. The third question is open to everybody, actually to the Governor. The Feds already had the authority, it has had it for years, to set underwriting standards for mortgages. I am talking subprimes. And do ridiculous things, such as requiring written proof of a person's earnings. And yet the Fed never put those regulations into effect until October 1st of this year. So why should the Fed be given more authority under a brand new organization set up when it had that authority in the first place and simply failed to act? And the failure did not occur during Mr. Bernanke's term. By the time he got in, it was too late. " FinancialCrisisReport--483 To manage its loan repurchase campaign, Goldman expanded an operations center in St. Petersburg, Florida, 2039 and made extensive use of third party due diligence firms hired to review its securitized loan pools. 2040 Goldman instructed the firms to “re-underwrite” every loan in pools of mortgages purchased from specific lenders, including New Century, Fremont, Long Beach, and later Countrywide. 2041 By March 2007, the average EPD rate for subprime loans in Goldman’s inventory had climbed from 1% of aggregate volume to 5%, a dramatic increase. 2042 On March 7, 2007, Mr. Sparks described Goldman’s exposure as follows: “As for the big 3 originators – Accredited, New Century and Fremont, our real exposure is in the form of put-back claims. Basically, if we get nothing back we would lose around $60mm vs loans on our books (we have a reserve of $30mm) and the loans in the [CDO and RMBS] trusts could lose around $60mm (we probably suffer about 1/3 of this in ongoing exposures). ... Rumor today is that the FBI is in Accredited.” 2043 Five days later, on March 12, 2007, Mr. Sparks wrote: “The street is aggressively putting things back, like a run on the bank before there is no money left to fulfill the obligations.” 2044 One of the lenders that was an initial focus of Goldman’s loan repurchase effort was New Century, a subprime lender whose loans Goldman had used in many Goldman-originated RMBS securitizations. After completing a review of one New Century loan pool, an analyst recommended “putting back 26% of the pool ... if possible.” 2045 A putback rate of 26% meant that about one in 2039 2/27/2007 email from Christopher Gething, “Our Expansion, ” GS MBS-E-010387242 (expansion of St. Petersburg office to accommodate staff for loan repurchase effort). 2040 See, e.g. 3/2007 Goldman email chain, “RE: NC Visit ,” GS M BS-E-002048050 (mentioning four different third party “vendors ” conducting loan reviews for the loan repurchase effort and stating: “W e ’re off to other vendors at this point.”). 2041 See 3/9/2007 email from Kevin Gasvoda, “priorities,” GS M BS-E-002211055 (listing priority mortgage originators as Accredited, Fremont, New Century, and Novastar); 3/14/2007 Goldman email, “NC Visit,” GS MBS- E-002048050 (identifying New Century, Fremont and Long Beach); 6/29/2007 email from Ed Chavez, “Countrywide Investigation Review Update,” GS MBS-E-002134411. 2042 3/2/2007 email to Craig Broderick, “Audit Committee Package_Feb 21_Draft_Page.ppt,” GS MBS-E- 009986805, Hearing Exhibit 4/27-63. 2043 2044 3/7/2007 email from Daniel Sparks, “Originator exposures,” GS MBS-E-002206279, Hearing Exhibit 4/27-75. 3/12/2007 email from Daniel Sparks, “Subprime Opportunities,” GS MBS-E-004641002. See also 4/15/2007 email, “March 2007 Counterparty Surveillance,” GS MBS-E-002135667 (forwarding report to loan repurchase team, “Please find attached the March counterparty surveillance report (and boy, is it a doozy).”); 3/26/2007 “Subprime Mortgage Business, ” Goldman presentation to Board of Directors, at 5, GS MBS-E-005565527, Hearing Exhibit 4/27-22 (list of subprime related businesses bankrupted, suspended, closed, sold, or put up for sale). 2045 3/13/2007 email from Manisha Nanik, “New Century EPDs,” GS MBS-E-002146861, Hearing Exhibit 4/27-77. The review of the New Century loan pool found: “ – approx 7% of the pool has material occupancy misrepresentation where borrowers took out anywhere from 4 to 14 loans at a time and defaulted on all. ... – approx 20% of the pool has material compliance issues. These are mainly missing HUDs. ... – approx 10% of the pool is flagged as potential REO [Real Estate Owned by lender] or potential unsecured four of the loans in the New Century pool had EPDs, were fraudulent, or otherwise breached New Century’s contractual warranties. It also implied that about 25% of the expected mortgage payments might not be made to the relevant RMBS securitization. Unless the problem loans could be successfully “put back” to New Century in exchange for a refund, a fail rate of that magnitude would likely impair the performance of all of the securities dependent upon that pool of mortgages. CHRG-111shrg56262--96 PREPARED STATEMENT OF J. CHRISTOPHER HOEFFEL Executive Committee Member, Commercial Mortgage Securities Association October 7, 2009 The Commercial Mortgage Securities Association (CMSA) is grateful to Chairman Reed, Ranking Member Bunning, and the Members of the Subcommittee for giving CMSA the opportunity to share its perspective concerning the securitized credit markets for commercial real estate. In responding to the specific questions the Subcommittee has asked witnesses to address, we will focus on securitization in the commercial real estate (CRE) mortgage context and address the following issues: (1) the challenges facing the $3.5 trillion market for commercial real estate finance; (2) the unique structure of the commercial market and the need to customize regulatory reforms accordingly to support, and not undermine, our Nation's economic recovery; and, (3) efforts to restore the availability of credit by promoting and enhancing the viability of commercial mortgage-backed securities (CMBS).CMSA and the Current State of the Market CMSA represents the full range of CMBS market participants, including investment and commercial banks; rating agencies; accounting firms, servicers; other service providers; and investors such as insurance companies, pension funds, and money managers. CMSA is a leader in the development of standardized practices and in ensuring transparency in the commercial real estate capital market finance industry. Because our membership consists of all constituencies across the entire market, CMSA has been able to develop comprehensive responses to policy questions to promote increased market efficiency and investor confidence. For example, our members continue to work closely with policymakers in Congress, the Administration, and financial regulators, providing practical advice on measures designed to restore liquidity and facilitate lending in the commercial mortgage market (such as the Term Asset-Backed Securities Loan Facility (TALF) and the Public-Private Investment Program (PPIP)). CMSA also actively participates in the public policy debates that impact the commercial real estate capital markets. The CMBS market is a responsible and key contributor to the overall economy that historically has provided a tremendous source of capital and liquidity to meet the needs of commercial real estate borrowers. CMBS helps support the commercial real estate markets that fuel our country's economic growth. The loans that are financed through those markets help provide jobs and services to local communities, as well as housing for millions of Americans in multifamily dwellings. Unfortunately, the recent turmoil in the financial markets coupled with the overall downturn in the U.S. economy have brought the CMBS market to a standstill and created many pressing challenges, specifically: No liquidity or lending--While the CMBS market provided approximately $240 billion in commercial real estate financing in 2007 (nearly 50 percent of all commercial lending), CMBS issuance fell to $12 billion in 2008, despite strong credit performance and high borrower demand. There has been no new private label CMBS issuance year-to-date in 2009, as the lending markets remain frozen; Significant loan maturities through 2010--At the same time, there are significant commercial real estate loan maturities this year and next--amounting to hundreds of billions of dollars--but the capital necessary to refinance these loans remains largely unavailable and loan extensions are difficult to achieve; and The U.S. economic downturn persists--The U.S. recession continues to negatively affect both consumer and business confidence, which impacts commercial and multifamily occupancy rates and rental income, as well as business performance and property values. Significantly, it is important to note that the difficulties faced by the overall CRE market are not attributable solely to the current trouble in the CMBS market, but also stem from problems with unsecured CRE debt, such as construction loans. As described by Richard Parkus, an independent research analyst with Deutsche Bank who has testified before both the Joint Economic Committee and the TARP Oversight Panel, while the overall CRE market will experience serious strain (driven by poor consumer confidence and business performance, high unemployment and property depreciation), it is the nonsecuritized debt on the books of small and regional banks that will be most problematic, as the projected default rates for such unsecuritized commercial debt have been, and are expected to continue to be, significantly higher than CMBS loan default rates. As recently as early this year, default rates in the CMBS market, which have historically been low (less than .50 percent for several years) still hovered around a mere 1.25 percent. Unfortunately, the economic recession that began as a crisis of liquidity in some sectors transformed into a crisis in confidence that affected all sectors, and it was only a matter of time before CMBS was affected. No matter the strength of our fundamentals and loan performance, once investors lost confidence and began to shy away from mortgaged-backed securities, CMBS could not avoid the contagion. This unfortunate combination of circumstances leaves the broader CRE sector and the CMBS market with several overarching problems: (1) a liquidity gap, i.e., the difference between borrowers' demand for credit and the nearly nonexistent supply of credit; (2) an equity gap (the difference between the current market value of commercial properties and what is owed on them, which will be extremely difficult to refinance as current loans mature); and (3) the fact that potential CMBS sponsors are very reluctant to take the risk of trying to aggregate loans for securitization, since there is no assurance that private sector investors will buy the securities, all of which serves to simply perpetuate the cycle of frozen credit markets.Unique Characteristics of the CMBS Market There are a number of important distinctions between CMBS and other asset-backed securities (ABS) markets, and those distinctions should be considered in fashioning any broad securitization-related regulatory reforms. These differences relate not only to the structure of securities, but also to the underlying collateral, the type and sophistication of the borrowers, as well as to the level of transparency in CMBS deals.Commercial Borrowers Commercial borrowers are highly sophisticated businesses with cash flows based on business operations and/or tenants under leases. This characteristic stands in stark contrast to the residential market where, for example, loans were underwritten in the subprime category for borrowers who may not have been able to document their income, or who may not have understood the effects of factors like floating interest rates and balloon payments on their mortgage's affordability. Additionally, securitized commercial mortgages have different terms (generally 5-10 year ``balloon'' loans), and they are, in the vast majority of cases, nonrecourse loans. This means that if the borrower defaults, the lender can seize the collateral, although it may not pursue a claim against the borrower for any deficiency in recovery. This dramatically decreases the cost of default because the loan work-out recoveries in the CMBS context tend to be significantly more efficient than, for example, the residential loan foreclosure process.Structure of CMBS There are multiple levels of review and diligence concerning the collateral underlying CMBS, which help ensure that investors have a well informed, thorough understanding of the risks involved. Specifically, in-depth property-level disclosure and review are done by credit rating agencies as part of the process of rating CMBS bonds. Moreover, nonstatistical analysis is performed on CMBS pools. This review is possible given that there are only 100-300 commercial loans in a pool that support a bond, as opposed, for example, to tens of thousands of loans in residential mortgage-backed securities pools. This limited number of loans allows market participants (investors, rating agencies, etc.) to gather detailed information about income producing properties and the integrity of their cash flows, the credit quality of tenants, and the experience and integrity of the borrower and its sponsors, and thus conduct independent and extensive due diligence on the underlying collateral supporting their CMBS investments.First-Loss Investor (``B-Piece Buyer'') Re-Underwrites Risk CMBS bond issuances include a first-loss, noninvestment grade bond component. The third-party investors that purchase these lowest-rated securities (referred to as ``B-piece'' or ``first-loss'' investors) conduct their own extensive due diligence (usually including, for example, site visits to every property that collateralizes a loan in the loan pool) and essentially re-underwrite all of the loans in the proposed pool. Because of this, the B-piece buyers often negotiate the removal of any loans they consider to be unsatisfactory from a credit perspective, and specifically negotiate with bond sponsors or originators to purchase this noninvestment-grade risk component of the bond offering. This third-party investor due diligence and negotiation occurs on every deal before the investment-grade bonds are issued.Greater Transparency A wealth of transparency currently is provided to CMBS market participants via the CMSA Investor Reporting Package (CMSA IRP). The CMSA IRP provides access to loan, property and bond-level information at issuance and while securities are outstanding, including updated bond balances, amount of interest and principal received, and bond ratings, as well as loan-level and property-level information on an ongoing basis. The ``CMSA IRP'' has been so successful in the commercial space that it is now serving as a model for the residential mortgage-backed securities market.Current Efforts To Restore Liquidity Private investors are absolutely critical to restoring credit availability in the capital finance markets. Accordingly, Government initiatives and reforms must work to encourage private investors--who bring their own capital to the table--to come back to the capital markets. Treasury Secretary Geithner emphasized this need when he stressed during the introduction of the Administration's Financial Stability Plan that ``[b]ecause this vital source of lending has frozen up, no financial recovery plan will be successful unless it helps restart securitization markets for sound loans made to consumers and businesses--large and small.'' The importance of restoring the securitization markets is recognized globally as well, with the International Monetary Fund noting in its most recent Global Financial Stability Report that ``restarting private-label securitization markets, especially in the United States, is critical to limiting the fallout from the credit crisis and to the withdrawal of central bank and Government interventions.'' \1\--------------------------------------------------------------------------- \1\ International Monetary Fund, ``Restarting Securitization Markets: Policy Proposals and Pitfalls'', Ch. 2, Global Financial Stability Report: Navigating the Financial Challenges Ahead (October 2009), at 33 (``Conclusions and Policy Recommendations'' section) available at http://www.imf.org/external/pubs/ft/gfsr/2009/02/pdf/text.pdf. --------------------------------------------------------------------------- As a centerpiece of the Financial Stability Plan, policymakers hope to restart the CMBS and other securitization markets through innovative initiatives (such TALF and the PPIP), and CMSA welcomes efforts to utilize private investors to help fuel private lending. In this regard, the TALF program for new CMBS issuance has been particularly helpful in our space, as evidenced in triple-A CMBS cash spreads tightening almost immediately after the program was announced, as one example. To this end, CMSA continues to engage in an ongoing dialogue with many members of the relevant Congressional committees, as well as with key policymakers at the Treasury Department, Federal Reserve and other agencies, and with participants in various sectors of the commercial real estate market. The focus of our efforts has been on creative solutions to help bring liquidity back to the commercial real estate finance markets. We appreciate policymakers' recognition, as evidenced by programs like TALF and PPIP, that a major part of the solution will be to bring private investors back to the market through securitization. We also appreciate the willingness of Congress and other policymakers to listen to our recommendations on how to make these programs as effective as possible. However, there is still a long way to go toward recovery in the CRE market, despite the early success of the TALF program. The market faces the overarching problems of the liquidity and equity gaps. This is driven in part by the absence of any aggregation mechanism--securitizers are unwilling to bear all of the noncredit risks (like interest rate changes) they must currently take on between the time a loan is made and when it can be securitized (a process that takes months across a pool of loans). This is especially true now when there still is uncertainty as to whether there will be willing investors at the end of the process. CMSA also is committed to working on additional long-term solutions to ensure the market is able to meet ongoing commercial borrowing demands. For example, CMSA supports efforts to facilitate a U.S. commercial covered bond market in order to provide an additional source of liquidity through new and diverse funding sources. We will continue to work with Congress on the introduction of comprehensive legislation that would include high quality commercial mortgage loans and CMBS as eligible collateral in the emerging covered bond marketplace.Financial Regulatory Reform and Commercial Real Estate The Administration has proposed new and unprecedented financial regulatory reform proposals that will change the nature of the securitized credit markets which are at the heart of recovery efforts. The securitization reform proposals appear to be prompted by some of the practices that were typical in the subprime and residential securitization markets. At the outset, we must note that CMSA does not oppose efforts to address such issues, as we have long been an advocate within the industry for enhanced transparency and sound practices. As a general matter, however, policymakers must ensure that any regulatory reforms are tailored to address the specific needs of each securitization asset class. As discussed above, the structure of the CMBS market has incorporated safeguards that minimize the risky securitization practices that policymakers hope to address. Thus, the securitization reform initiatives should be tailored to take these differences into account. In doing so, policymakers can protect the viability of the markets that already are functioning in a way that does not pose a threat to overall economic stability, and ensure that such markets can continue to be a vital component of the economic recovery solution. CMSA and its members are concerned that certain aspects of the Administration's securitization reform proposals could undermine rather than support the Administration's many innovative efforts to restart the securitization markets, effectively stalling recovery efforts by making lenders less willing or able to extend loans and investors less willing or able to buy CMBS bonds--two critical components to the flow of credit in the commercial market. The two aspects of the securitization reform proposal that are of utmost concern to CMSA are a plan to require bond issuers or underwriters (referred to as ``securitizers'' in the Administration's draft securitization reform bill) to retain at least 5 percent of the credit risk in any securitized asset they sell, and an associated restriction on the ability of issuers to hedge the 5 percent retained risk. Again, CMSA does not oppose these measures per se, but emphasizes that they should be tailored to reflect key differences between the different asset-backed securities markets. Significantly, we are not alone in advocating a tailored approach. The IMF, which recently expressed concern that U.S. and European retained risk proposals may be too simplistic, warned that ``[p]roposals for retention requirements should not be imposed uniformly across the board, but tailored to the type of securitization and underlying assets to ensure that those forms of securitization that already benefit from skin in the game and operate well are not weakened. The effects induced by interaction with other regulations will require careful consideration.''Five Percent Risk Retention for Securitizers The retention of risk is an important component regardless of who ultimately retains it: the originator, the issuer, or the first-loss buyer. As explained above, the CMBS structure has always had a third-party in the first-loss position that specifically negotiates to purchase this risk. Most significantly, these third-party investors are able to, and do, protect their own interests in the long-term performance of the bonds rather than relying merely on the underwriting and representations of securitizers or originators. First-loss buyers conduct their own extensive credit analysis on the loans, examining detailed information concerning every property--before buying the highest risk bonds in a CMBS securitization. In many cases, the holder of the first-loss bonds is also related to the special servicer who is responsible on behalf of all bondholders as a collective group for managing and resolving defaulted loans through workouts or foreclosure. Thus, the policy rationale for imposing a risk retention requirement on issuers or underwriters as ``securitizers'' that could preclude them from transferring the first-loss position to third parties is unnecessary in this context, because, although the risk is transferred, it is transferred to a party that is acting as a ``securitizer'' and that is fully cognizant, through its own diligence, of the scope and magnitude of the risk it is taking on. In effect, when it comes to risk, the first-loss buyer is aware of everything the issuer or underwriter is aware of. Because the CMBS market is structured differently than other securitization markets, policymakers' focus in this market should be on the proper transfer of risk (e.g., sufficient collateral disclosure, adequate due diligence and/or risk assessment procedures on the part of the risk purchaser), analogous to what takes place in CMBS transactions. Therefore, CMBS securitizers should be permitted to transfer risk to B-piece buyers who--in the CMBS context at least--act as ``securitizers.'' To require otherwise would hamper the ability of CMBS lenders to originate new bond issuances, by needlessly tying up their capital and resources in the retained risk, which in turn, would squelch the flow of credit at a time when our economy desperately needs it. CMSA therefore suggests that securitization legislation include a broader definition of ``securitizer'' than is presently in the Administration's draft bill, to include third parties akin to the CMBS first-loss investors. Such an approach will provide explicit recognition of the ability to transfer retained risk to third parties under circumstances in which the third party agrees to retain the risk and is capable of adequately protecting its own interests.Prohibition on Hedging of Retained Risk In conjunction with the retained risk requirement, there also is a proposal to prohibit ``securitizers'' from hedging that risk. Rather than adopting an outright ban on hedging the retained risk, however, the measure needs to be designed to strike a balance between fulfilling the legislation's objective of ensuring that securitizers maintain an appropriate stake in the risks they underwrite. Such tailoring is necessary to avoid imposing undue constraints on ``protective'' mechanisms that are legitimately used by securitizers to maintain their financial stability. Several risks inherent in any mortgage or security exposure arise not from imprudent loan origination and underwriting practices, but from outside factors such as changes in interest rates, a sharp downturn in economic activity, or regional/geographic events such as a terrorist attack or weather-related disaster. Securitizers attempt to hedge against these market-oriented factors in keeping with current safety and soundness practices, and some examples in this category of hedges are interest rate hedges using Treasury securities, relative spread hedges (using generic interest-rate swaps), and macroeconomic hedges (that, for example, are correlated with changes in GDP or other macroeconomic factors). The hallmark of this category is that these hedges seek protection from factors the securitizer does not control, and the hedging has neither the purpose nor the effect of shielding the originators or sponsors from credit exposures on individual loans. As such, hedges relate to generally uncontrollable market forces that cannot be controlled independently. There is no way to ensure that any such hedge protects 100 percent of an investment from loss--particularly as it pertains to a CMBS transaction that, for example, is secured by a diverse pool of loans with exposure to different geographic locations, industries and property types. Therefore, loan securitizers that must satisfy a retention requirement continue to carry significant credit risk exposure that reinforces the economic tie between the securitizer and the issued CMBS even in the absence of any hedging constraints. For these reasons, securitization reform legislation should not seek to prohibit securitizers from using market-oriented hedging vehicles. Instead, if a limitation is to be placed on the ability to hedge, it should be targeted to prohibit hedging any individual credit risks within the pool of risks underlying the securitization. Because these types of vehicles effectively allow the originator or issuer to completely shift the risk of default with respect to a particular loan or security, their use could provide a disincentive to engage in prudent underwriting practices--the specific type of disincentive policymakers want to address.Retroactive Changes to Securitization Accounting Beyond the specific securitization reform proposals that have been circulated by the Administration in draft legislation, there are two other policy initiatives that greatly concern CMSA because of the adverse effect these initiatives can have on the securitization market: retroactive changes to the rules for securitization accounting, and differentiated credit rating symbols for structured finance products. Retroactive changes to securitization accounting rules known as FAS 166 and 167, which were recently adopted by the Financial Accounting Standards Board (FASB), throw into question the future of securitized credit markets. \2\ The new rules eliminate Qualified Special Purposes Entities (QSPEs), which are the primary securitization accounting vehicle for all asset-backed securities including CMBS, as well as change the criteria for the sales treatment and consolidation of financial assets. These accounting standards are important to issuers and investors, and for the liquidity of capital markets as a whole, because they free up balance sheet capacity to enable issuers to make more loans and do more securitizations, and they enable investors to invest more of their capital into the market. Under the new rules, however, issuers may not receive sales accounting treatment, while investors may be forced to consolidate an entire pool of loans on their balance sheet, despite owning only a small fraction of the loans pool.--------------------------------------------------------------------------- \2\ More specifically, these two standards provide accounting guidance on when a sale of a financial instrument has occurred and how to account for the sale, and guidance on when a securities issuer, B-piece buyer or servicer needs to consolidate the securities and liabilities on its balance sheet. The current rules facilitate securitization by allowing issuers to receive ``sales treatment'' for the assets they securitize, such that these assets are reflected on the balance sheet of the investors that purchase the bonds, rather than the issuers' balance sheet. Moreover, under present rules, investors reflect only the fraction of the securitization deal that they actually own on their balance sheet.--------------------------------------------------------------------------- The implementation date of FAS 166 and 167 is January 1, 2010, and it will be applied retroactively. The elimination of QSPEs therefore will impact trillions of dollars of outstanding asset-backed securities, including investors in these assets. These significant and retroactive changes will pose a serious threat to unlocking the frozen credit markets and another impediment to the Administration's wide-ranging efforts to restart the securitized credit markets. CMSA and a diverse coalition of 15 trade groups have raised concerns about the timing and scope of FAS 166 and 167 given the impact these rule changes could have on credit availability. These concerns have been echoed by the Federal Reserve and other banking regulators, which wrote to FASB in December 2008 to highlight the adverse impact these rule changes could have on the credit markets. More recently, Federal Reserve Board Member Elizabeth Duke capsulized the concerns shared by the industry when she cautioned that: [i]f the risk retention requirements, combined with accounting standards governing the treatment of off-balance-sheet entities, make it impossible for firms to reduce the balance sheet through securitization and if, at the same time, leverage ratios limit balance sheet growth, we could be faced with substantially less credit availability. I'm not arguing with the accounting standards or the regulatory direction. I am just saying they must be coordinated to avoid potentially limiting the free flow of credit . . . . As policymakers and others work to create a new framework for securitization, we need to be mindful of falling into the trap of letting either the accounting or regulatory capital drive us to the wrong model. This may mean we have to revisit the accounting or regulatory capital in order to achieve our objectives for a viable securitization market. \3\--------------------------------------------------------------------------- \3\ ``Regulatory Perspectives on the Changing Accounting Landscape'', Speech by Governor Elizabeth A. Duke at the AICPA National Conference on Banks and Savings Institutions, Washington, DC, September 14, 2009, available at http://www.federalreserve.gov/newsevents/speech/duke20090914a.htm. Policymakers and standard setters, including FASB and the SEC, need to proceed cautiously and deliberately in this regard, so that accounting rule changes do not hamper the recovery of the securitization markets.Credit Rating Agency Reform One aspect of the reforms currently being considered for credit rating agencies is a previously rejected proposal to require credit ratings to be differentiated for certain types of structured financial products (requiring the use of ``symbology,'' such as ``AAA.SF''). Generally speaking, ``differentiation'' is an overly simplistic and broad proposal that provides little value or information about credit ratings. Thus, CMSA's members, and specifically the investors the symbology is geared to inform, continue to have serious concerns about differentiation, although we are strong supporters of more effective means of strengthening the credit ratings system in order to provide investors with the information they need to make sound investment decisions. In fact, a broad coalition of market participants--including issuers, investors, and borrowers seeking access to credit--remain overwhelming opposed to differentiation because it will serve only to increase confusion and implementation costs, while decreasing confidence and certainty regarding ratings. Such effects would, in turn, create market volatility and undermine investor confidence and liquidity, which could exacerbate the current constraints on borrowers' access to capital, at a time when other policymakers are employing every reasonable means to get credit flowing again. In this regard, it is worth noting that the concept of differentiation has been examined extensively and rejected in recent years by the House Committee on Financial Services, as well as by the SEC and the ratings agencies themselves, \4\ for most (if not all) of the foregoing reasons. Nothing has changed in the interim.--------------------------------------------------------------------------- \4\ In early 2008, the CRAs sought feedback on various differentiation proposals, which elicited overwhelming opposition from investors. For example, see the results of Moody's Request for Comment: ``Should Moody's Consider Differentiating Structured Finance and Corporate Ratings?'' (May 2008). Moody's received more than 200 responses, including ones from investors that together held in excess of $9 trillion in fixed income securities.--------------------------------------------------------------------------- Accordingly, Congress should not include a differentiation requirement as part of any credit rating agency reform bill, but instead should include language consistent with that already passed last year by the House Committee on Financial Services in the Municipal Bond Fairness Act. That legislation would require CRAs to use ratings symbols that are consistent for all types of securities, recognizing the fact that a single and consistent ratings structure is critical to bond investors who want the ability to compare a multitude of investment options across asset classes. Ultimately, investors (who are critical to the Nation's economic recovery) expect and demand a common rating structure to provide a meaningful foundation for our markets and ratings system. Such consistency will promote certainty and confidence among investors and all market participants. In terms of credit ratings performance CMSA devoted significant resources over the last few years to affirmatively enhance transparency in credit ratings. Such enhancements will be far more effective in providing investors with the information they need to make the most informed decisions than a differentiated ratings structure. Instead of differentiated ratings, what CMBS investors have consistently sought is new, targeted transparency and disclosures about the ratings of structured products, to build on the already robust information CRAs provide in their published methodology, presale reports, and surveillance press releases. In comments filed with the SEC in July 2008, CMSA listed a number of recommendations for enhancements that would serve the investor community, such as publication of more specific information regarding NRSRO policies and procedures related to CMBS valuations; adoption of a standard presale report template with specified information regarding methodology and underwriting assumptions; and adoption of a standard surveillance press release with specified information regarding the ratings. Such information would allow investors to better understand the rating methodology and make their own investment determinations. Fundamentally, CMSA believes that one of the keys to long term viability is market transparency. As previously mentioned transparency is one of the hallmarks of our market, as exemplified by the unqualified success of our Investor Reporting Package. As we endeavor to continually update our reporting package and provide additional standardized information to market participants, one of our most important proactive initiatives is the ongoing process of creating model offering documents and providing additional disclosure fields with regard to additional subordinate debt that may exist outside the CMBS trust. To this end, CMSA is working with the Federal Reserve Board to ensure the expanded disclosure meets their information needs under TALF.Conclusion There are enormous challenges facing the commercial real estate sector. While regulatory reforms are important and warranted, these proposals should not detract from or undermine efforts to get credit flowing, which is critical to economic recovery. Moreover, any policies that make debt or equity interests in commercial real estate less liquid will have a further negative effect on property values and the cost of capital. Accordingly, we urge Congress to ensure that regulatory reform measures are tailored to account for key differences in the various securitization markets. ______ CHRG-111shrg54789--44 Mr. Barr," Thank you very much, Senator. The intent of the provision is to ensure that when the agency is thinking about the options available to it in regulating a particular product or service or sector, that it first try methods such as disclosure. So if we have a strong disclosure regime in place, could a consumer in that circumstance reasonably avoid the practice? In the context, say, of credit cards, thinking back again to the work that the Senate did in getting that bill passed, the judgment was that double-cycle billing was not a practice that a consumer could reasonably--with disclosure could reasonably understand, and so the Senate decided that that practice was a practice that should be banned. So the basic idea of this legislation is to say, let us try disclosure first. Let us see if there are ways to make disclosure work. Let us try and have robust disclosure. If disclosure can't work because the consumer can't reasonably shape his or her conduct to be responsible based on that disclosure because the information, the terms are so confusing that consumers can't get enough information to actually understand them, then it ought to think about other regulatory tools, and in doing that, it needs to consider the costs as well as the benefits. Senator Merkley. So certainly a very clear set of reasonable tests to be met, moving from disclosure forward. " CHRG-111hhrg55814--291 Mr. Manzullo," Ostensibly, but if you read the CFPA Act, it is so broad. I can see a huge fight going on over who is going to do something, and then this bill says the Fed can move unilaterally without talking to the people who have authority on it. The second question, Mr. Sullivan, I do not want you to fall asleep over there, no one has asked you any questions. Your testimony I think is very, very pointed. On page 5, you identify the blame that many in this town refuse to recognize. When you start at--on page 5, line 3, ``The insurance industry in general does not pose a systemic risk to the nation's financial markets to the extent we have seen in the bank and securities sectors. Rather, insurance companies are more often the recipients or conduits of risk. Mortgage and title insurance, for example, do not generate systemic risk. They simply facilitate underlying loan transactions.'' Is not the problem with the financial collapse that we have had in this country due to the fact that these subprime mortgages were allowed to take place with very little underwriting standard supervision? " CHRG-111hhrg54867--7 Mr. Gutierrez," Mr. Secretary, first of all, thank you for appearing. Exactly 1 year ago, we experienced the most agonizing week of the current financial crisis. And this committee began to address the root causes of the social and economic trauma that crippled our economy and caused millions of Americans--and we should remember this--to lose trillions of dollars of their hard-earned wealth. Let me repeat that: Trillions of dollars of hard-earned wealth were lost by the American people. Not so much the guys on Wall Street, they lost, but the people on Main Street lost. Predatory mortgage lending, combined with risky investment practices and poor underwriting standards, financed by some of the largest financial institutions in this country, created the financial and economic debacle that we must now address. Over a decade ago, the Federal Reserve was given the power by this committee--I was here; I got elected in 1993--to stop predatory mortgage practices through the Homeowners' Equity Protection Act. It took the Federal Reserve 12 years to implement the rules and regulations that could have prevented many, if not all, of the worst abuses by predatory lenders and originators, abuses that were a direct and immediate cause of our current crisis. Why did it take so long? While there were many theories to explain this, I believe it took the Fed this ridiculously long time, including the FDIC, which did absolutely nothing either, because it was distracted by their other regulatory obligations and by a sense in Washington, D.C., of do less, do nothing, leave it alone, it is okay. The default of these toxic mortgages and the securitized products based on them caused trillions of dollars in losses and caused the 2008 freeze in credit markets, which nearly destroyed not only our financial system but the entire international financial system. The message to those of us who want to restore the stability to the financial system could be no clearer or louder. If we do not include a strong, effective Consumer Financial Protection Agency within our regulatory reform legislation, Congress will have failed to address the current and any future economic challenges facing our country. We must also address the economic threat inherent in institutions known as ``too-big-to-fail.'' I believe we must work to a comprehensive, risk-based pricing regime which eliminates the incentives for these financial firms to grow to the point of becoming ``too-big-to-fail.'' One of the ways we can prevent an institution from becoming ``too-big-to-fail'' is through a pricing regime which discourages banks from growing so large and interconnected. We must not only increase capital requirements, but we should also require decreased leverage ratios and increased contributions to the Deposit Insurance Fund. Let me ask that this be submitted for the record, my complete statement, because it is clear to me, Mr. Chairman, we are going to have, you know, our classical debate. Our colleagues on the other side have already thrown health care into this, big government. I hear ``socialism'' coming any second. They are going to say, ``No, no, no. Global warming doesn't exist, no. We don't need to do anything about global warming. We really don't need to do anything about this.'' We do need to do something, and Mr. Geithner knows it probably better than anybody else. We can never allow a Lehman Brothers again to have a 30:1 ratio. We can't allow that kind of leverage. And government is the only one that is going to stop it from happening again. Thank you very much, Mr. Chairman. " FOMC20071211meeting--68 66,VICE CHAIRMAN GEITHNER.," May I ask one follow-up question? In the note for the Board that you circulated on Monday, Dave, you said that the magnitude of the credit crunch you’re contemplating is roughly comparable to the unusual weakness of private spending seen during the headwinds episode of the early 1990s. So I was curious. It is sort of interesting because you think that capital at banks going into this period is much stronger than going into the 1990–91 period. Corporate balance sheets, based just on the crude leverage ratios, are much healthier today than they were then. On the other hand, banks are a smaller share of the financial system, and you could say that the nonbank part looks kind of weak. The FHLB is growing very dramatically, taking up a fair amount of the room left by the shrinking of the nonbank sector. I don’t know. GSEs have less room to grow. It’s sort of mixed. It’s complicated. I was curious about how you thought about the comparison. You didn’t seem to like the comparison." FOMC20060510meeting--98 96,MR. POOLE.," Thank you, Mr. Chairman. I’m not going to try to help you on that one. [Laughter] I’m going to try to be very brief here because I want to reserve more of my fair share of the time to the policy discussion. One of the problems with the anecdotal reports, of course, is the unsystematic way in which we do them. I’m well aware that some of the answers you get depend on the way you phrase the questions. Some of my contacts say that the economy is doing fine, no real problems. One of my contacts from the trucking industry said that the economy looks pretty stable—“boringly normal” is the way he put it. I don’t have any contacts, though, who say that they see any sign of weakness. They’re not complaining about signs of weakness, and some of the contacts are saying that things are pretty doggone strong. So that’s my attempt to filter the observation. Now, let me just give you a couple of particularly interesting anecdotes. My Wal-Mart contact talked about construction costs. He said even in Indiana, which is not known as one of the great growth states in this country—" CHRG-111shrg54533--91 PREPARED STATEMENT OF TIMOTHY GEITHNER Secretary, Department of the Treasury June 18, 2009 Financial Regulatory Reform: A New FoundationIntroduction Over the past 2 years we have faced the most severe financial crisis since the Great Depression. Americans across the Nation are struggling with unemployment, failing businesses, falling home prices, and declining savings. These challenges have forced the government to take extraordinary measures to revive our financial system so that people can access loans to buy a car or home, pay for a child's education, or finance a business. The roots of this crisis go back decades. Years without a serious economic recession bred complacency among financial intermediaries and investors. Financial challenges such as the near-failure of Long-Term Capital Management and the Asian Financial Crisis had minimal impact on economic growth in the U.S., which bred exaggerated expectations about the resilience of our financial markets and firms. Rising asset prices, particularly in housing, hid weak credit underwriting standards and masked the growing leverage throughout the system. At some of our most sophisticated financial firms, risk management systems did not keep pace with the complexity of new financial products. The lack of transparency and standards in markets for securitized loans helped to weaken underwriting standards. Market discipline broke down as investors relied excessively on credit rating agencies. Compensation practices throughout the financial services industry rewarded short-term profits at the expense of long-term value. Households saw significant increases in access to credit, but those gains were overshadowed by pervasive failures in consumer protection, leaving many Americans with obligations that they did not understand and could not afford. While this crisis had many causes, it is clear now that the government could have done more to prevent many of these problems from growing out of control and threatening the stability of our financial system. Gaps and weaknesses in the supervision and regulation of financial firms presented challenges to our government's ability to monitor, prevent, or address risks as they built up in the system. No regulator saw its job as protecting the economy and financial system as a whole. Existing approaches to bank holding company regulation focused on protecting the subsidiary bank, not on comprehensive regulation of the whole firm. Investment banks were permitted to opt for a different regime under a different regulator, and in doing so, escaped adequate constraints on leverage. Other firms, such as AIG, owned insured depositories, but escaped the strictures of serious holding company regulation because the depositories that they owned were technically not ``banks'' under relevant law. We must act now to restore confidence in the integrity of our financial system. The lasting economic damage to ordinary families and businesses is a constant reminder of the urgent need to act to reform our financial regulatory system and put our economy on track to a sustainable recovery. We must build a new foundation for financial regulation and supervision that is simpler and more effectively enforced, that protects consumers and investors, that rewards innovation, and that is able to adapt and evolve with changes in the financial market. In the following pages, we propose reforms to meet five key objectives: 1. Promote robust supervision and regulation of financial firms. Financial institutions that are critical to market functioning should be subject to strong oversight. No financial firm that poses a significant risk to the financial system should be unregulated or weakly regulated. We need clear accountability in financial oversight and supervision. We propose: A new Financial Services Oversight Council of financial regulators to identify emerging systemic risks and improve interagency cooperation. New authority for the Federal Reserve to supervise all firms that could pose a threat to financial stability, even those that do not own banks. Stronger capital and other prudential standards for all financial firms, and even higher standards for large, interconnected firms. A new National Bank Supervisor to supervise all federally chartered banks. Elimination of the Federal thrift charter and other loopholes that allowed some depository institutions to avoid bank holding company regulation by the Federal Reserve. The registration of advisers of hedge funds and other private pools of capital with the SEC. 2. Establish comprehensive supervision of financial markets. Our major financial markets must be strong enough to withstand both systemwide stress and the failure of one or more large institutions. We propose: Enhanced regulation of securitization markets, including new requirements for market transparency, stronger regulation of credit rating agencies, and a requirement that issuers and originators retain a financial interest in securitized loans. Comprehensive regulation of all over-the-counter derivatives. New authority for the Federal Reserve to oversee payment, clearing, and settlement systems. 3. Protect consumers and investors from financial abuse. To rebuild trust in our markets, we need strong and consistent regulation and supervision of consumer financial services and investment markets. We should base this oversight not on speculation or abstract models, but on actual data about how people make financial decisions. We must promote transparency, simplicity, fairness, accountability, and access. We propose: A new Consumer Financial Protection Agency to protect consumers across the financial sector from unfair, deceptive, and abusive practices. Stronger regulations to improve the transparency, fairness, and appropriateness of consumer and investor products and services. A level playing field and higher standards for providers of consumer financial products and services, whether or not they are part of a bank. 4. Provide the government with the tools it needs to manage financial crises. We need to be sure that the government has the tools it needs to manage crises, if and when they arise, so that we are not left with untenable choices between bailouts and financial collapse. We propose: A new regime to resolve nonbank financial institutions whose failure could have serious systemic effects. Revisions to the Federal Reserve's emergency lending authority to improve accountability. 5. Raise international regulatory standards and improve international cooperation. The challenges we face are not just American challenges, they are global challenges. So, as we work to set high regulatory standards here in the United States, we must ask the world to do the same. We propose: International reforms to support our efforts at home, including strengthening the capital framework; improving oversight of global financial markets; coordinating supervision of internationally active firms; and enhancing crisis management tools. In addition to substantive reforms of the authorities and practices of regulation and supervision, the proposals contained in this report entail a significant restructuring of our regulatory system. We propose the creation of a Financial Services Oversight Council, chaired by Treasury and including the heads of the principal Federal financial regulators as members. We also propose the creation of two new agencies. We propose the creation of the Consumer Financial Protection Agency, which will be an independent entity dedicated to consumer protection in credit, savings, and payments markets. We also propose the creation of the National Bank Supervisor, which will be a single agency with separate status in Treasury with responsibility for federally chartered depository institutions. To promote national coordination in the insurance sector, we propose the creation of an Office of National Insurance within Treasury. Under our proposal, the Federal Reserve and the Federal Deposit Insurance Corporation (FDIC) would maintain their respective roles in the supervision and regulation of State-chartered banks, and the National Credit Union Administration (NCUA) would maintain its authorities with regard to credit unions. The Securities and Exchange Commission (SEC) and Commodity Futures Trading Commission (CFTC) would maintain their current responsibilities and authorities as market regulators, though we propose to harmonize the statutory and regulatory frameworks for futures and securities. The proposals contained in this report do not represent the complete set of potentially desirable reforms in financial regulation. More can and should be done in the future. We focus here on what is essential: to address the causes of the current crisis, to create a more stable financial system that is fair for consumers, and to help prevent and contain potential crises in the future. (For a detailed list of recommendations, please see Summary of Recommendations following the Introduction.) These proposals are the product of broad-ranging individual consultations with members of the President's Working Group on Financial Markets, Members of Congress, academics, consumer and investor advocates, community-based organizations, the business community, and industry and market participants.I. Promote Robust Supervision and Regulation of Financial Firms In the years leading up to the current financial crisis, risks built up dangerously in our financial system. Rising asset prices, particularly in housing, concealed a sharp deterioration of underwriting standards for loans. The Nation's largest financial firms, already highly leveraged, became increasingly dependent on unstable sources of short-term funding. In many cases, weaknesses in firms' risk-management systems left them unaware of the aggregate risk exposures on and off their balance sheets. A credit boom accompanied a housing bubble. Taking access to short-term credit for granted, firms did not plan for the potential demands on their liquidity during a crisis. When asset prices started to fall and market liquidity froze, firms were forced to pull back from lending, limiting credit for households and businesses. Our supervisory framework was not equipped to handle a crisis of this magnitude. To be sure, most of the largest, most interconnected, and most highly leveraged financial firms in the country were subject to some form of supervision and regulation by a Federal Government agency. But those forms of supervision and regulation proved inadequate and inconsistent. First, capital and liquidity requirements were simply too low. Regulators did not require firms to hold sufficient capital to cover trading assets, high-risk loans, and off-balance sheet commitments, or to hold increased capital during good times to prepare for bad times. Regulators did not require firms to plan for a scenario in which the availability of liquidity was sharply curtailed. Second, on a systemic basis, regulators did not take into account the harm that large, interconnected, and highly leveraged institutions could inflict on the financial system and on the economy if they failed. Third, the responsibility for supervising the consolidated operations of large financial firms was split among various Federal agencies. Fragmentation of supervisory responsibility and loopholes in the legal definition of a ``bank'' allowed owners of banks and other insured depository institutions to shop for the regulator of their choice. Fourth, investment banks operated with insufficient government oversight. Money market mutual funds were vulnerable to runs. Hedge funds and other private pools of capital operated completely outside of the supervisory framework. To create a new foundation for the regulation of financial institutions, we will promote more robust and consistent regulatory standards for all financial institutions. Similar financial institutions should face the same supervisory and regulatory standards, with no gaps, loopholes, or opportunities for arbitrage. We propose the creation of a Financial Services Oversight Council, chaired by Treasury, to help fill gaps in supervision, facilitate coordination of policy and resolution of disputes, and identify emerging risks in firms and market activities. This Council would include the heads of the principal Federal financial regulators and would maintain a permanent staff at Treasury. We propose an evolution in the Federal Reserve's current supervisory authority for BHCs to create a single point of accountability for the consolidated supervision of all companies that own a bank. All large, interconnected firms whose failure could threaten the stability of the system should be subject to consolidated supervision by the Federal Reserve, regardless of whether they own an insured depository institution. These firms should not be able to escape oversight of their risky activities by manipulating their legal structure. Under our proposals, the largest, most interconnected, and highly leveraged institutions would face stricter prudential regulation than other regulated firms, including higher capital requirements and more robust consolidated supervision. In effect, our proposals would compel these firms to internalize the costs they could impose on society in the event of failure.II. Establish Comprehensive Regulation of Financial Markets The current financial crisis occurred after a long and remarkable period of growth and innovation in our financial markets. New financial instruments allowed credit risks to be spread widely, enabling investors to diversify their portfolios in new ways and enabling banks to shed exposures that had once stayed on their balance sheets. Through securitization, mortgages and other loans could be aggregated with similar loans and sold in tranches to a large and diverse pool of new investors with different risk preferences. Through credit derivatives, banks could transfer much of their credit exposure to third parties without selling the underlying loans. This distribution of risk was widely perceived to reduce systemic risk, to promote efficiency, and to contribute to a better allocation of resources. However, instead of appropriately distributing risks, this process often concentrated risk in opaque and complex ways. Innovations occurred too rapidly for many financial institutions' risk management systems; for the market infrastructure, which consists of payment, clearing, and settlement systems; and for the Nation's financial supervisors. Securitization, by breaking down the traditional relationship between borrowers and lenders, created conflicts of interest that market discipline failed to correct. Loan originators failed to require sufficient documentation of income and ability to pay. Securitizers failed to set high standards for the loans they were willing to buy, encouraging underwriting standards to decline. Investors were overly reliant on credit rating agencies. Credit ratings often failed to accurately describe the risk of rated products. In each case, lack of transparency prevented market participants from understanding the full nature of the risks they were taking. The build-up of risk in the over-the-counter (OTC) derivatives markets, which were thought to disperse risk to those most able to bear it, became a major source of contagion through the financial sector during the crisis. We propose to bring the markets for all OTC derivatives and asset-backed securities into a coherent and coordinated regulatory framework that requires transparency and improves market discipline. Our proposal would impose record-keeping and reporting requirements on all OTC derivatives. We also propose to strengthen the prudential regulation of all dealers in the OTC derivative markets and to reduce systemic risk in these markets by requiring all standardized OTC derivative transactions to be executed in regulated and transparent venues and cleared through regulated central counterparties. We propose to enhance the Federal Reserve's authority over market infrastructure to reduce the potential for contagion among financial firms and markets. Finally, we propose to harmonize the statutory and regulatory regimes for futures and securities. While differences exist between securities and futures markets, many differences in regulation between the markets may no longer be justified. In particular, the growth of derivatives markets and the introduction of new derivative instruments have highlighted the need for addressing gaps and inconsistencies in the regulation of these products by the CFTC and SEC.III. Protect Consumers and Investors From Financial Abuse Prior to the current financial crisis, a number of Federal and State regulations were in place to protect consumers against fraud and to promote understanding of financial products like credit cards and mortgages. But as abusive practices spread, particularly in the market for subprime and nontraditional mortgages, our regulatory framework proved inadequate in important ways. Multiple agencies have authority over consumer protection in financial products, but for historical reasons, the supervisory framework for enforcing those regulations had significant gaps and weaknesses. Banking regulators at the State and Federal level had a potentially conflicting mission to promote safe and sound banking practices, while other agencies had a clear mission but limited tools and jurisdiction. Most critically in the run-up to the financial crisis, mortgage companies and other firms outside of the purview of bank regulation exploited that lack of clear accountability by selling mortgages and other products that were overly complicated and unsuited to borrowers' financial situation. Banks and thrifts followed suit, with disastrous results for consumers and the financial system. This year, Congress, the Administration, and financial regulators have taken significant measures to address some of the most obvious inadequacies in our consumer protection framework. But these steps have focused on just two, albeit very important, product markets--credit cards and mortgages. We need comprehensive reform. For that reason, we propose the creation of a single regulatory agency, a Consumer Financial Protection Agency (CFPA), with the authority and accountability to make sure that consumer protection regulations are written fairly and enforced vigorously. The CFPA should reduce gaps in Federal supervision and enforcement; improve coordination with the States; set higher standards for financial intermediaries; and promote consistent regulation of similar products. Consumer protection is a critical foundation for our financial system. It gives the public confidence that financial markets are fair and enables policy makers and regulators to maintain stability in regulation. Stable regulation, in turn, promotes growth, efficiency, and innovation over the long term. We propose legislative, regulatory, and administrative reforms to promote transparency, simplicity, fairness, accountability, and access in the market for consumer financial products and services. We also propose new authorities and resources for the Federal Trade Commission to protect consumers in a wide range of areas. Finally, we propose new authorities for the Securities and Exchange Commission to protect investors, improve disclosure, raise standards, and increase enforcement.IV. Provide the Government With the Tools It Needs To Manage Financial Crises Over the past 2 years, the financial system has been threatened by the failure or near failure of some of the largest and most interconnected financial firms. Our current system already has strong procedures and expertise for handling the failure of banks, but when a bank holding company or other nonbank financial firm is in severe distress, there are currently only two options: obtain outside capital or file for bankruptcy. During most economic climates, these are suitable options that will not impact greater financial stability. However, in stressed conditions it may prove difficult for distressed institutions to raise sufficient private capital. Thus, if a large, interconnected bank holding company or other nonbank financial firm nears failure during a financial crisis, there are only two untenable options: obtain emergency funding from the U.S. Government as in the case of AIG, or file for bankruptcy as in the case of Lehman Brothers. Neither of these options is acceptable for managing the resolution of the firm efficiently and effectively in a manner that limits the systemic risk with the least cost to the taxpayer. We propose a new authority, modeled on the existing authority of the FDIC, that should allow the government to address the potential failure of a bank holding company or other nonbank financial firm when the stability of the financial system is at risk. In order to improve accountability in the use of other crisis tools, we also propose that the Federal Reserve Board receive prior written approval from the Secretary of the Treasury for emergency lending under its ``unusual and exigent circumstances'' authority.V. Raise International Regulatory Standards and Improve International Cooperation As we have witnessed during this crisis, financial stress can spread easily and quickly across national boundaries. Yet, regulation is still set largely in a national context. Without consistent supervision and regulation, financial institutions will tend to move their activities to jurisdictions with looser standards, creating a race to the bottom and intensifying systemic risk for the entire global financial system. The United States is playing a strong leadership role in efforts to coordinate international financial policy through the G20, the Financial Stability Board, and the Basel Committee on Banking Supervision. We will use our leadership position in the international community to promote initiatives compatible with the domestic regulatory reforms described in this report. We will focus on reaching international consensus on four core issues: regulatory capital standards; oversight of global financial markets; supervision of internationally active financial firms; and crisis prevention and management. At the April 2009 London Summit, the G20 leaders issued an eight-part declaration outlining a comprehensive plan for financial regulatory reform. The domestic regulatory reform initiatives outlined in this report are consistent with the international commitments the United States has undertaken as part of the G20 process, and we propose stronger regulatory standards in a number of areas. CHRG-110shrg50369--64 Mr. Bernanke," We have already issued the HOEPA rules, which address unfair, deceptive acts and practices relating to mortgages, for comment. We are currently receiving comments on those. The new rules, which I alluded to, for the spring are under the FTC unfair, deceptive acts and practices code, and they would apply to credit cards, and possibly other things, but primarily credit cards. Senator Menendez. Thank you, Mr. Chairman. " CHRG-111shrg56262--16 Mr. Hoeffel," Thank you. I am testifying today on behalf of the Commercial Mortgage Securities Association. CMSA represents the collective voice of all market participants in the commercial real estate capital market finance industry, including lenders, issuers, investors, rating agencies, and servicers, among others. These participants come together to facilitate a transparent primary and secondary market for commercial mortgages. I am also an investor in CMBS, but I have more than two decades of experience as a commercial lender and a CMBS issuer. I would like to thank the Committee for the opportunity to share our views on securitization, which is crucial to borrower access to credit and our overall economy. This afternoon, I will focus specifically on securitized credit markets for commercial real estate, focusing on three issues: first, the enormous challenges facing the $3.5 trillion market for commercial real estate finance, of which about $850 billion is securitized; second, the unique structure of CMBS and the need to customized regulatory reforms accordingly to support recovery; and, finally, the need to restore the CMBS market to meet significant borrower demand. Today the commercial real estate market is facing a perfect storm based on three interconnected and pressing challenges. First, there is no liquidity or lending. In 2007, there were approximately $240 billion in CMBS loans made, approximately half of the total real estate lending market. CMBS issuance fell to only $12 billion in 2008, despite strong credit performance at the time and high borrower demand. It has now been well over a year since a new CMBS deal has been done. Second, there are significant loan maturities through 2010. In fact, hundreds of billions of dollars is coming due in the next 2 years. Capital refinance these loans is largely unavailable, and loan extensions are difficult to achieve. Third, the downturn in the U.S. economy persists. Commercial real estate is greatly impacted by the macroeconomic factors: high unemployment, low consumer confidence, poor business performance, and falling property values. This last point is especially important to highlight. Remember, commercial real estate did not cause the current liquidity crisis. It has been negatively affected by it now, 2 years into the crisis. Second, even within the commercial real estate finance industry, CMBS or securitization did not cause stress. In fact, nonsecuritized loans are now underperforming CMBS and are experiencing in some cases greater defaults. Ironically, securitization may be ultimately an exit strategy for these troubled loans. As financial policymakers, including the current and previous Administration, have rightfully pointed out, no recovery plan will be successful unless it helps restart the securitization markets. The IMF also asserts that securitization will assist withdrawal of Government interventions, employing private capital to fuel private lending. Today many recovery efforts in the commercial real estate market, such as TALF and PPIP, have been helpful. But they are in a nascent and delicate stage, as discussed in my written testimony. So it is important that regulatory reforms, including accounting changes, as George mentioned, must work to strengthen the securitized markets and to give private investors who bring their own capital to the table certainty you and confidence. Above all, in the commercial real estate context, there is a real concern that some of the reform proposals will be applied in a one-size-fits-all manner that could actually impede recovery. Specifically, there are a number of important distinctions between CMBS and other asset-based securities markets, and the upshot of these distinctions is that they help the CMBS market avoid problems of poor underwriting or inadequate transparency. These significant differences are in four major areas: First, the borrower. In CMBS, the borrower in most cases is a sophisticated business within income-producing property and contractual revenues from tenants as opposed to some situations in the subprime residential mortgage where a loan may have been underwritten for a borrower who could not document his income. Second, the structure of CMBS. There are only about 100 to 300 loans in a typical CMBS deal as opposed to thousands of loans in residential deals. This enables greater due diligence and analysis to be performed on CMBS pools by several different parties, including rating agencies and investors. Third, the existence of a third-party investor or B-piece buyer in the securitization process. Unlike other asset classes, CMBS has an investor who purchases a first loss position and conducts extensive due diligence as a result, which includes sit visits to every property. This investor also re-underwrites proposed loans in a potential pool, and they can negotiate to kick out any loans in which they do not wish to invest. Finally, greater transparency. CMBS market participants have significant access to loan, property, and bond level information at issuance and on an ongoing basis. In fact, the CMSA investor reporting package is used as a model for transparencies by other types of ABS markets. It is from this unique perspective that we approach regulatory reform proposals that will undoubtedly change the CMBS market. We do not necessarily oppose some of these proposals despite the fact that they will address practices that were typical in the subprime and residential securitization markets, not CMBS. Instead, we ask that policymakers ensure that such reforms are tailored to address the specific needs of each securitization asset class and to recognize the many safeguards that already exist in the CMBS market today. In this regard, two aspects of regulatory reform are of utmost interest to CMSA: a requirement that securitizers--that is, bond issuers and underwriters--retain at least 5 percent of the credit risk in any securitized loan pool; and a restriction of the ability of issuers to protect against or hedge this 5-percent retained risk. As is explained in more detail in my written testimony, the basic concern we have about both of these proposals is whether they will be applied in a one-size-fits-all manner. While we agree that it is important for the appropriate parties to keep skin in the game, CMBS deals are already structured to do this in a way that has worked well for the market and for the overall economy for years and can continue to serve the policy objective that is sought here. As discussed earlier, first loss buyers conduct their own extensive credit analysis on the loans, examining detailed information concerning every property before buying the highest-risk bonds in the CMBS securitization. If these reforms are not applied in a tailored fashion, the danger is that the reforms will end up hampering the ability of CMBS lenders to originate new loans, thereby limiting capital and the flow of credit at a time when our economy desperately needs it. Thank you. " CHRG-111shrg50564--137 Mr. Volcker," We do have--your staff can, I am sure, look at the report we have on that subject because it does try to describe the strengths and weakness of different approaches. And there is a pretty strong feeling, which is not the case in the United States historically, that similar functions should be subject to the same regulator and the same regulations, which is---- Senator Warner. So focused on function rather than on institution? " CHRG-111shrg62643--141 Mr. Bernanke," Well, I never specifically endorsed any particular program, size, composition, and so on---- Senator Menendez. But you then assisted to stimulate the economy. " Mr. Bernanke," ----but stimulus was certainly beneficial, or certainly was useful in the context of the weak economy we had at the beginning of last year. Senator Menendez. Well, if we had done nothing, would it have been worse? " CHRG-111hhrg54868--63 Mr. Dugan," Yes. First, you are missing something. We brought a number of enforcement actions against credit card banks, particularly the subprime credit card lenders, where we brought so many enforcement actions against them that they stopped doing business as national banks. Second, we enforced the rules that applied to credit card companies. The rules that you are talking about, the suggestions and the practices that caused Congress to pass a statute that applies to them, we will enforce those, too. But we can't make up rules. In fact, we are prohibited from adopting anything that looks like a rule if it is given to another agency by statute. Mr. Miller of North Carolina. Well, the statute now is that you can enforce the Federal Trade Commission's unfair and deceptive trade practices--acts and practices rule, and you can do that by enforcement action. " fcic_final_report_full--378 The FDIC’s decision would be hotly debated. Fed General Counsel Scott Alvarez told the FCIC that he agreed with Bair that “there should not have been intervention in WaMu.”  But Treasury officials felt differently: “We were saying that’s great, we can all be tough, and we can be so tough that we plunge the financial system into the Great Depression,” Treasury’s Neel Kashkari told the FCIC. “And so, I think, in my judgment that was a mistake. . . . [A]t that time, the economy was in such a perilous state, it was like playing with fire.”  WACHOVIA: “AT THE FRONT END OF THE DOMINOES AS OTHER DOMINOES FELL” Wachovia, having bought Golden West, was the largest holder of payment-option ARMs, the same product that had helped bring down WaMu and Countrywide. Con- cerns about Wachovia—then the fourth-largest bank holding company—had also been escalating for some time. On September , the Merrill analyst Ed Najarian downgraded the company’s stock to “underperform,” pointing to weakness in its op- tion ARM and commercial loan portfolios. On September , Wachovia executives met Fed officials to ask for an exemption from rules that limited holding companies’ use of insured deposits to meet their liquidity needs. The Fed did not accede; staff be- lieved that Wachovia’s cash position was strong and that the requested relief was a “want” rather than a “need.”  But they changed their minds after the Lehman bankruptcy, immediately launch- ing daily conference calls to discuss liquidity with Wachovia management. Depositor outflows increased. On September , the Fed supported the company’s request to use insured deposits to provide liquidity to the holding company. On September , a Saturday, Wells Fargo Chairman Richard M. Kovacevich told Robert Steel, Wa- chovia’s CEO and recently a Treasury undersecretary, that Wells might be interested in acquiring the besieged bank, and the two agreed to speak later in the week. The same day, Fed Governor Kevin Warsh suggested that Steel also talk to Goldman. As a former vice chairman of Goldman, Steel could easily approach the firm, but the ensu- ing conversations were short; Goldman was not interested.  Throughout the following week, it became increasingly clear that Wachovia needed to merge with a stronger financial institution. Then, WaMu’s failure on Sep- tember  “raised creditor concern about the health of Wachovia,” the Fed’s Alvarez told the FCIC. “The day after the failure of WaMu, Wachovia Bank depositors acceler- ated the withdrawal of significant amounts from their accounts,” Alvarez said. “In ad- dition, wholesale funds providers withdrew liquidity support from Wachovia. It ap- peared likely that Wachovia would soon become unable to fund its operations.”  Steel said, “As the day progressed, some liquidity pressure intensified as financial institu- tions began declining to conduct normal financing transactions with Wachovia.”  David Wilson, the Office of the Comptroller of the Currency’s lead examiner at Wachovia, agreed. “The whole world changed” for Wachovia after WaMu’s failure, he said.  The FDIC’s Bair had a slightly different view. WaMu’s failure “was practically a nonevent,” she told the FCIC. “It was below the fold if it was even on the front page . . . barely a blip given everything else that was going on.”  fcic_final_report_full--36 Even those who had profited from the growth of nontraditional lending practices said they became disturbed by what was happening. Herb Sandler, the co-founder of the mortgage lender Golden West Financial Corporation, which was heavily loaded with option ARM loans, wrote a letter to officials at the Federal Reserve, the FDIC, the OTS, and the OCC warning that regulators were “too dependent” on ratings agencies and “there is a high potential for gaming when virtually any asset can be churned through securitization and transformed into a AAA-rated asset, and when a multi-billion dollar industry is all too eager to facilitate this alchemy.”  Similarly, Lewis Ranieri, a mortgage finance veteran who helped engineer the Wall Street mortgage securitization machine in the s, said he didn’t like what he called “the madness” that had descended on the real estate market. Ranieri told the Commis- sion, “I was not the only guy. I’m not telling you I was John the Baptist. There were enough of us, analysts and others, wandering around going ‘look at this stuff,’ that it would be hard to miss it.”  Ranieri’s own Houston-based Franklin Bank Corporation would itself collapse under the weight of the financial crisis in November . Other industry veterans inside the business also acknowledged that the rules of the game were being changed. “Poison” was the word famously used by Country- wide’s Mozilo to describe one of the loan products his firm was originating.  “In all my years in the business I have never seen a more toxic [product],” he wrote in an in- ternal email.  Others at the bank argued in response that they were offering prod- ucts “pervasively offered in the marketplace by virtually every relevant competitor of ours.”  Still, Mozilo was nervous. “There was a time when savings and loans were doing things because their competitors were doing it,” he told the other executives. “They all went broke.”  In late , regulators decided to take a look at the changing mortgage market. Sabeth Siddique, the assistant director for credit risk in the Division of Banking Su- pervision and Regulation at the Federal Reserve Board, was charged with investigat- ing how broadly loan patterns were changing. He took the questions directly to large banks in  and asked them how many of which kinds of loans they were making. Siddique found the information he received “very alarming,” he told the Commis- sion.  In fact, nontraditional loans made up  percent of originations at Coun- trywide,  percent at Wells Fargo,  at National City,  at Washington Mutual, . at CitiFinancial, and . at Bank of America. Moreover, the banks expected that their originations of nontraditional loans would rise by  in , to . billion. The review also noted the “slowly deteriorating quality of loans due to loosening underwriting standards.” In addition, it found that two-thirds of the non- traditional loans made by the banks in  had been of the stated-income, minimal documentation variety known as liar loans, which had a particularly great likelihood of going sour.  The reaction to Siddique’s briefing was mixed. Federal Reserve Governor Bies re- called the response by the Fed governors and regional board directors as divided from the beginning. “Some people on the board and regional presidents . . . just wanted to come to a different answer. So they did ignore it, or the full thrust of it,” she told the Commission.  CHRG-111hhrg67816--113 Mr. Terry," And that is the point that I am getting to. I guess there are two sides of the coin that we can look at here and one is we can criticize the FTC over the last 8 years for not being aggressive enough. Eight years from now are we going to look back at the FTC when we streamline your rules and say you were overly aggressive and without specific congressional approval defining general practices as deceptive practices thereby freezing trade? " FOMC20081029meeting--270 268,MR. KOHN.," Thank you, Mr. Chairman. Like President Yellen, I support alternative A, the 50 basis point cut. I think it's the right response to the very, very substantial change in the economic outlook since the last meeting. We would have cut the nominal federal funds rate by 1 percentage point and real federal funds rates by something less than 1 percentage point depending on what you think is happening to inflation expectations. But surely inflation expectations are coming down--and coming down substantially. I think the incoming information, the weakness before the shock hit in mid-September (which to me suggests that we didn't have any insurance against that weakness at the time), the extraordinary tightening of financial conditions, and the downshift in spending that we've seen since mid-September all suggest that a 1 percentage point cut in the real rate, and even a little less than a 1 percentage point cut, would seem a very modest and moderate response to the shock. It's probably a down payment. If the staff is right, we will need more. I built more into my own forecast. But even if the economy is not as weak as the staff has built into the Greenbook, I think a substantial cut in the federal funds rate is entirely appropriate. All of us--without exception, I think--said that there were downside risks to their forecasts, and a number of us have cited the possibility of a very deep recession here. So I think we need to take action. We are starting with a situation in which the economy is declining. We are in recession. The unemployment rate is rising. Inflation is falling. There is a global recession in train. It seems to me, from a risk-management perspective, that the costs of not doing enough--the costs of being reluctant to lower rates and making that situation worse--are far larger than the costs of going a little too far because things turn around faster. I think we are in a situation in which it is almost impossible at this point to go too far. Mr. Chairman, we may have to take it back at some point in the future, but right now I think the 50 basis points is absolutely justified by the conditions in which we find ourselves. I was drawn, as the Vice Chairman was, to the staff simulation having to do with a more rapid financial recovery. I myself think that's a very small probability. But even if that's what happens, we'll know by December whether the financial markets are recovering faster. We can stop at 1 percent, if we're getting that recovery; and the outcomes, as the Vice Chairman noted, really aren't that bad in that recovery. So I think that even the small probability of a very sharp turnaround in the markets is still consistent with cutting rates another 50 basis points at this meeting. The fact that we are already low is not a reason to hold back. I don't agree with the ""keeping the powder dry"" kind of argument. I think the lessons of history, including from Japan, are that the closer you get to the zero lower bound the more aggressive you should be. If you let weakness build, that weakness will overwhelm your policy tools. The most effective use of the limited scope for policy easing is to be preemptive and stop weaknesses from building. I think a 50 basis point easing will have beneficial effects. I don't think that the markets will react very much. We won't see those beneficial effects. But if I can compare it with doing 25 or nothing at all, I think doing 25 or nothing at all would have adverse effects. With 25 or nothing, you'll get longer-term rates up, you'll get stock prices down, and you'll get an erosion of confidence at a time when we don't need it--that the central bank doesn't get how serious this situation is. I agree that the last easing was largely offset by the loss of confidence and the rise in uncertainty. I also agree that it might not feed through as directly and completely as it often does because banks are trying to rebuild and lenders are trying to rebuild profit margins. But I still think it will be effective. As I say, I convinced myself of that by asking about what would happen with the alternatives, and I think the alternatives would be far worse. We need to keep fine-tuning the TARP and the liquidity provision. We need fiscal stimulus. I agree with all of that. We need to move on lots of dimensions. But these things will not be sufficient in and of themselves to counter this. Monetary policy is a fairly blunt instrument, but we need to stimulate the spending wherever we can to do this. Some have expressed concern about circumstances forcing us to ease between meetings. We have done 50. Will that take us further? I think we need to make clear in our statement and our minutes--particularly in our minutes--that we do expect a weak economy going forward, at least a moderately softer economy, and that the process may call for further easing. I think it will call for further easing at the next FOMC meeting, but we can get to the next FOMC meeting and see. But it should take a substantial and unexpected deterioration relative to that path to justify an intermeeting action. So I think we are absolutely right to have a prejudice toward taking actions at meetings, when we can sit around and discuss things. The odds are high that we will need to go further, but we should do that at a meeting if we can. If we do have a very strong and substantial deterioration even relative to our weak outlook and we do end up moving between meetings, surely that move would not put us at a level that is unjustified by the circumstances. So I think we can deal with the intermeeting situation and not have the pressures of the market, the pressures of expectations, get us to a level at which we're ultimately uncomfortable. In short, I think it's a very serious situation. We need to do all we can to counter this situation. Now is not the time to hold back. Thank you, Mr. Chairman. " FinancialCrisisReport--66 WaMu’s internal documents indicate that the primary motivation behind its High Risk Lending Strategy was the superior “gain on sale” profits generated by high risk loans. 167 Washington Mutual management had calculated that higher risk loans were more profitable when sold or securitized. Prior to sale, higher risk loans also produced greater short term profits, because the bank typically charged the borrowers a higher rate of interest and higher fees. Higher risk home loans placed for sale were more profitable for WaMu, because of the higher price that Wall Street underwriters and investors were willing to pay for them. The profit that WaMu obtained by selling or securitizing a loan was known as the “gain on sale.” Gain on sale figures for the loans produced by the bank were analyzed and presented to the WaMu Board of Directors. On April 18, 2006, David Schneider, the President of WaMu Home Loans division, provided the Board of Directors a confidential presentation entitled, “Home Loans Discussion.” 168 The third slide in the presentation was entitled, “Home Loans Strategic Positioning,” and stated: “Home Loans is accelerating significant business model changes to achieve consistent, long term financial objectives.” 169 Beneath this heading the first listed objective was: “Shift from low-margin business to high-margin products,” 170 meaning from less profitable to more profitable loan products. The next slide in the presentation was entitled: “Shift to Higher Margin Products,” and elaborated on that objective. The slide listed the actual gain on sale obtained by the bank, in 2005, for each type of loan WaMu offered, providing the “basis points” (bps) that each type of loan fetched on Wall Street: 2005 WaMu Gain on Sale Margin by Product in bps 171 Government 13 Fixed 19 Hybrid/ARM 25 Alt A 40 Option ARM 109 Home Equity 113 Subprime 150 167 1/18/2005 Washington Mutual Inc. Washington Mutual Bank FA Finance Committee Minutes at JPM_WM06293964; see also 1/2005 “Higher Risk Lending Strategy Presentation,” submitted to Washington Mutual Board of Directors, at JPM_WM00302977, Hearing Exhibit 4/13-2a 168 4/18/2006 “Home Loans Discussion Board of Directors Meeting,” WaMu presentation, JPM_WM00690890-901, Hearing Exhibit 4/13-3. 169 Id. at 893 [emphasis in original removed]. 170 Id. 171 Id. at 894 [formatting as in the original]. CHRG-111shrg54789--172 PREPARED STATEMENT OF RICHARD BLUMENTHAL Attorney General, State of Connecticut July 14, 2009 I appreciate the opportunity to strongly support the Administration's proposal to create a Federal agency dedicated solely to protecting consumer interests in financial products and markets, and preserve and expand State consumer protection authority. The new agency--a consumer financial guardian--promises to be a powerful watchdog and protector, and a partner of State attorneys general in fighting for our citizens. The proposal marks a giant step toward restoring an historic Federal-State alliance in combating financial fraud and abuse. This Federal-State partnership was riven by excessive resort to Federal preemption--displacing State enforcement and replacing Federal-State collegiality and cooperation with relentless conflict. The new agency is a necessary and appropriate response to exploding complexity, scope, and scale of new financial instruments and markets--and exponentially increasing impact on ordinary citizens. It fills a deeply felt consumer need. Ever more slick and sophisticated marketing--often misleading and deceptive--cannot be battled successfully by States alone, or the existing Federal agencies. Creating a new agency to fight consumer cons and abuse in alliance with the States, the Federal Government can muster more potent and proactive policing and prosecution. A new consumer guardian--we need it, and now. New firepower, focus and drive, all are vital. The new agency will be more an enforcer, than a regulator. At the Federal level, the new agency would investigate law breaking and enable and assist Department of Justice prosecutions, both civil and criminal. Unfortunately, some opponents of this agency have misrepresented its purpose. The Financial Consumer Protection Agency will not ``regulate credit.'' It will not make choices for consumers or deny them access to products and services. Instead, one of its main missions will be to assure that consumers are informed in clear, layman's language of the terms and conditions of credit cards, mortgages, and loans. The point is to assure that consumers fully understand the financial realities and consequences of financial obligations, credit cards, or loans they are considering before they make commitments. As even experienced lawyers and consumer protection advocates can attest, anyone attempting to understand their credit card agreements all too frequently faces incomprehensible, consuming small print with huge consequences. This agency's purpose is to assure people have good information so they can make good financial decisions. Once they use that information and make decisions, they will have to live with the consequences.Federal Preemption Doctrine Disaster For far too long, States have been forced to the sidelines, standing helplessly, while credit card, mortgage, and financial rescue companies used Federal preemption as a shield to stop State consumer protection agencies from enforcing State laws against unfair and unscrupulous practices. Connecticut consumers have been scammed by fraudulent and unfair marketing schemes and products by companies who create or affiliate with national banks solely to avoid State consumer protection laws. Worse, Federal agencies have been complicit--aiding and abetting lawbreakers by supporting preemption claims when States sued to stop these unfair practices and recover consumer losses. Federal agencies went AWOL--not only disavowing their firepower but disarming State enforcers. They forced States from the battlefield and then abandoned it--in countless areas of consumer protection. They enabled and encouraged use of preemption as an impregnable shield to protect mortgage fraud, credit card abuses, securities scams, banking failure, and many deceptive and misleading snake oil pitches. The financial meltdown was foreseeable--and foreseen--by enforcement authorities who warned of irresponsible and reprehensible retreat and surrender in Federal law enforcement. There were warnings--including mine--about a regulatory black hole concerning hedge funds, derivatives, credit default swaps, excess leverage devices and other practices. I used this term--regulatory black hole--to characterize lack of oversight and scrutiny that enabled self dealing, excessive risk-taking, and other abuses that sabotaged the system. The national financial meltdown was directly due to massive Federal law enforcement failure--lax or dysfunctional Federal oversight and scrutiny of increasingly arcane, complex, opaque, risky practices and products. Federal law placed all enforcement and regulatory authority in an array of Federal agencies that were inept, underfunded, complacent or complicit. The result was a void or vacuum unprecedented since the Great Depression. Robust State investigatory and enforcement authority no doubt would have revealed unfair and illegal activities sooner and helped fill the gap left by Federal inaction and inertia. Putting State cops on the consumer protection beat would have sent a message--educating the public, deterring wrongdoing, punishing lawbreakers. Connecticut has been at the forefront of State efforts to protect consumers from unfair and fraudulent financial transactions. And two areas illustrate the obstacles that we and other States have faced under the current system. Tax preparers use the lure of instant cash to entice taxpayers--mostly low income--to borrow money at extremely high interest rates, using their tax refund to pay these loans. Recognizing that Connecticut could not regulate such usurious lending by national banks, our State sought to cap at 60 percent the interest charged on loans made through a tax preparer' or other facilitator of the loan. The statute was challenged by lenders who charge more than 300 percent annual interest rate. As a former United States Attorney, I can tell you that organized crime would offer a better deal. The Federal Second Circuit Court of Appeals held that Connecticut law could not be applied to national banks or their agents. Pacific Capital v. Connecticut, 542 F.3d 341 (2d Cir. 2008). As a result, consumers continue to pay astronomical interest rates for such refund anticipation loans. Second, even as gift cards have become increasingly popular in Connecticut and the country, consumers often see their cash value erode over time because of hidden inactivity fees or short expiration dates. In response, Connecticut prohibited both inactivity fees and expiration dates. Mall operators and retail chain stores avoided such consumer protection laws by merely contracting with national banks to issue gift cards. The Second Circuit Court of Appeals held that State consumer protection laws are preempted because the State measures affect a national bank rule. It ruled that Visa gift cards had expiration dates so the State could not prohibit them. SPGGC v. Blumenthal, 505 F.3d 183 (2d Cir. 2007). The result is pervasive consumer confusion because some gift cards issued by national banks may expire, but others have no such expiration dates. Other States have faced similar preemption obstacles to protecting consumers. My colleague in Minnesota began investigating Capital One's credit card marketing practices under the State's consumer protection laws. Capital One transferred all its credit card operations into a national bank, successfully halting the investigation, because Minnesota's consumer protection laws were preempted. Similarly, an Illinois investigation into Wells Fargo Financial's steering of minorities into high cost loans was stymied by Wells Fargo's transfer of those assets into a national bank.A Historic New Alliance I speak for other States in my enthusiastic and energetic support for section 1041 provisions of the Consumer Financial Protection Agency Act of 2009 that establish Federal law as a minimum standard for consumer protection, allowing States to enact laws and regulations ``if the protection such statute, regulation, order, or interpretation affords consumers is greater than the protection provided under this title, as determined by the [Consumer Financial Protection] agency.'' In addition, the proposal amends various Federal preemption statutes to unshackle the States, allowing enactment of consumer protections at the State level that may become a model for Federal, nationwide standards. This law exemplifies federalism at its best--State and Federal authorities working in common rather than conflict, and making the States laboratories for new, creative measures. Many of our most prominent Federal consumer protection laws were first adopted by States.A Federal Consumer Financial Super Cop I also support the establishment of the Consumer Financial Protection Agency, a Federal office dedicated solely to protection of ordinary citizens using the Federal savings and payment market. Currently, consumer credit products are regulated by at least seven different agencies whose primary focus is the proper operation of markets and the safety and soundness of institutions. While consumer protection is within their jurisdiction, it is far from their major focus. Nor does any existing agency dedicate significant or sufficient resources to this responsibility. They pay scant attention to consumer complaints, often reviewing such problems from an industry perspective rather than the consumer's. Indeed, these agencies face divided loyalties or even conflicts of interest--when high interest rates and astronomical credit card fees, for example, may be good for the bottom line, but bad for consumers. Given the understandable emphasis on safety and soundness, consumer protection not surprisingly receives Short shrift. The Consumer Financial Protection Agency would have broad authority to promulgate and enforce rules to protect consumers from unfair and deceptive practices and to ensure they understand terms and conditions. These regulations will encourage, not stifle, the development of financial products that well serve consumers. A vibrant, competitive market that is fair and honest is essential to consumers' and the Financial Industry's financial interests. Clear rules and consistent enforcement are vital prerequisites for innovation and wealth creation. To mix metaphors, what's needed is a more level playing field--essentially rational rules of the roads. When intersections become busy, they need to upgrade from stop signs to traffic lights to avoid car crashes, collisions and pile ups. As the proposal recognizes, joint proactive consumer protection enforcement by both Federal and State agencies--without preemption or exclusive jurisdiction--best serves consumer interests, especially as financial products and markets grow in complexity and number. State agencies--including State attorneys general and other consumer protection agencies--are often the first line of defense for consumers. Consumers are usually far more comfortable contacting their State officials rather than nameless faraway Federal agencies. I have seen firsthand the frustration of consumers when we have had to tell them that my office is legally powerless to help because of Federal preemption of State enforcement authority. Under the proposal, States may enact and enforce consumer protection laws that are consistent with Federal law. In addition, State attorneys general may enforce Federal rules and regulations in this area provided that the Federal Consumer Financial Protection Agency is notified of such enforcement action and has the opportunity to join or assume responsibility. This notification process seeks Federal-State coordination without necessarily allocating primacy to the Federal agency. State Attorneys General welcome the Federal Government as an ally rather than an adversary. Joint efforts can involve far more effective and more efficient use of our resources. Joint State and Federal enforcement efforts are neither new nor novel. States regularly work with each other and the Federal Government in recovering hundreds of millions of dollars in Medicaid and health care fraud, enforcing our respective antitrust laws against anticompetitive mergers and acquisitions or abuse of market power, and applying consumer protections laws against deceptive or misleading advertisements. I served for several years as chair of the National Association of Attorneys General Antitrust Executive Committee which included regular meetings with the heads of the Department of Justice Antitrust Division and the Federal Trade Commission. Successful collaborations once were common--against Microsoft for example--especially when the Federal Government was an active antitrust enforcer. There are plenty of successful models of joint action involving, for example, the Federal Trade Commission and the United States Department of Justice's Antitrust Division. Separating regulatory authority from consumer protection authority also has models at the State level. In Connecticut, for example, the Department of Banking regulates the banking industry while the Department of Consumer Protection through the Office of the Attorney General has broad consumer fraud enforcement authority. That authority extends to the banking industry. The Connecticut Supreme Court specifically applied our unfair and deceptive trade practices act to the banking industry. Mead v. Burns, 199 Conn. 651 (1986). I appreciate the industry's concern about two sets of agencies with enforcement authority. The industry justifiably wants predictability of regulation to properly plan product development and promotion. This bill will do so by creating a regulatory floor that applies nationwide. Most valuable would be predictability of vigilant and vigorous enforcement. The message must be that a revived and reinvigorated Federal-State alliance will punish any company that profits from illegal anticonsumer devices or unfair and deceptive practices. The predictable outcome is that anyone who cons or scams consumers in financial products will be prosecuted. Part of the genius of our Federal system is that it creates separate distinct sets of authority in Federal and State governments. Individual State experiments in solving problems and lawmaking can be models for Federal statutes as well as other States. Our United States Constitution assures that States cannot adopt rules inconsistent or conflicting with Federal authority. Finally, I urge the Committee to consider authorizing private rights of action against consumer fraud. Most State consumer protection statutes permit such private legal actions enabling victims to bring legal actions and recover damages, sometimes when State authorities may not do so. These initiatives supplement and strengthen State consumer protection enforcement efforts. They could similarly enhance and enlarge Federal enforcement efforts. I appreciate and applaud your and the Administration's dedication to protecting consumers in financial transactions. I commend this Committee's support of these efforts and offer my continuing assistance--along with other State attorneys general. Thank you. ______ FinancialCrisisReport--161 IV. REGULATORY FAILURE: CASE STUDY OF THE OFFICE OF THRIFT SUPERVISION Washington Mutual Bank (WaMu), with more than $300 billion in assets, $188 billion in deposits, over 2,300 branches in 15 states, and 43,000 employees, was by late 2008 the largest thrift under the supervision of the Office of Thrift Supervision (OTS) and among the eight largest financial institutions insured by the Federal Deposit Insurance Corporation (FDIC). The bank’s collapse in September 2008 came on the heels of the Lehman Brothers bankruptcy filing, accelerating the unraveling of the financial markets. WaMu’s collapse marked one of the most spectacular failures of federal bank regulators in recent history. In 2007, many of WaMu’s home loans, especially those with the highest risk profile, began experiencing increased rates of delinquency, default, and loss. After the subprime mortgage backed securities market collapsed in September 2007, Washington Mutual was unable to sell or securitize subprime loans and its loan portfolio began falling in value. By the fourth quarter of 2007, the bank recorded a loss of $1 billion, and then in the first half of 2008, WaMu lost $4.2 billion more. WaMu’s stock price plummeted against the backdrop of these losses and a worsening financial crisis elsewhere on Wall Street, which was witnessing the forced sales of Countrywide Financial Corporation and Bear Stearns, the government takeover of IndyMac, Fannie Mae and Freddie Mac, the bankruptcy of Lehman Brothers, the taxpayer bailout of AIG, and the conversion of Goldman Sachs and Morgan Stanley into bank holding companies. From 2007 to 2008, WaMu’s depositors withdrew a total of over $26 billion in deposits from the bank, triggering a liquidity crisis. On September 25, 2008, OTS placed Washington Mutual Bank into receivership, and the FDIC, as receiver, immediately sold it to JPMorgan Chase for $1.9 billion. Had the sale not gone through, Washington Mutual’s failure could have exhausted the FDIC’s entire $45 billion Deposit Insurance Fund. OTS records show that, during the five years prior to its collapse, OTS examiners repeatedly identified significant problems with Washington Mutual’s lending practices, risk management, and asset quality, and requested corrective action. Year after year, WaMu promised to correct the identified problems, but failed to do so. OTS, in turn, failed to respond with meaningful enforcement action, choosing instead to continue giving the bank inflated ratings for safety and soundness. Until shortly before the thrift’s failure in 2008, OTS regularly gave WaMu a CAMELS rating of “2” out of “5,” which signaled to the bank and other regulators that WaMu was fundamentally sound. Federal bank regulators are charged with ensuring that U.S. financial institutions operate in a safe and sound manner. However, in the years leading up to the financial crisis, OTS failed to prevent Washington Mutual’s increasing use of high risk lending practices and its origination and sale of tens of billions of dollars in poor quality home loans. The agency’s failure to adequately monitor and regulate WaMu’s high risk lending stemmed in part from an OTS regulatory culture that viewed its thrifts as “constituents,” relied on them to correct the problems identified by OTS with minimal regulatory intervention, and expressed reluctance to interfere with even unsound lending and securitization practices. OTS displayed an unusual amount of deference to WaMu’s management, choosing to rely on the bank to police itself. The reasoning appeared to be that if OTS examiners simply identified the problems at the bank, OTS could then rely on WaMu’s assurances that problems were corrected, with little need for tough enforcement actions. It was a regulatory approach with disastrous results. FinancialCrisisReport--25 During the years leading up to the financial crisis, lenders provided HELs and HELOCs to both prime and subprime borrowers. They were typically high risk loans, because most were issued to borrowers who already had a mortgage on their homes and held only a limited amount of equity. The HEL or HELOC was typically able to establish only a “second lien” or “second mortgage” on the property. If the borrower later defaulted and the home sold, the sale proceeds would be used to pay off the primary mortgage first, and only then the HEL or HELOC. Often, the sale proceeds were insufficient to repay the HEL or HELOC loan. In addition, some lenders created home loan programs in which a HEL was issued as a “piggyback loan” to the primary home mortgage to finance all or part of the borrower’s down payment. 29 Taken together, the HEL and the mortgage often provided the borrower with financing equal to 85%, 90%, or even 100% of the property’s value. 30 The resulting high loan-to-value ratio, and the lack of borrower equity in the home, meant that, if the borrower defaulted and the home had to be sold, the sale proceeds were unlikely to be sufficient to repay both loans. Alt A Loans. Another type of common loan during the years leading up to the financial crisis was the “Alt A” loan. Alt A loans were issued to borrowers with relatively good credit histories, but with aggressive underwriting that increased the risk of the loan. 31 For example, Alt A loans often allowed borrowers to obtain 100% financing of their homes, to have an unusually high debt-to-income ratio, or submit limited or even no documentation to establish their income levels. Alt A loans were sometimes referred to as “low doc” or “no doc” loans. They were originally developed for self employed individuals who could not easily establish their income by producing traditional W-2 tax return forms or pay stubs, and so were allowed to submit “alternative” documentation to establish their income or assets, such as bank statements. 32 The reasoning was that other underwriting criteria could be used to ensure that Alt A loans would be repaid, such as selecting only borrowers with a high credit score or with a property appraisal showing the home had substantial value in excess of the loan amount. According to GAO, from 2000 to 2006, the percentage of Alt A loans with less than full documentation of the borrower’s income or assets rose from about 60% to 80%. 33 29 7/28/2009 “Characteristics and Performance of Nonprime Mortgages,” GAO, Report No. GAO-09-848R at 9. 30 Id. GAO determined that, in 2000, only about 2.4% of subprime loans had a combined loan-to-value ratio, including both first and second home liens, of 100%, but by 2006, the percentage had climbed tenfold to 29.3%. 31 Id. at 1. GAO treated both low documentation loans and Option ARMs as Alt A loans. This Report considers Option ARMs as a separate loan category. 32 See id. at 14. 33 Id. CHRG-110shrg38109--60 Chairman Bernanke," Well, the housing market was actually quite weak during the recession itself. The decline in residential starts during 1991 was not quite as large, but in the same neighborhood, as what we have seen recently. During the recovery period, we did not have that particular pattern, but in many ways, it was a fairly similar expansion. Senator Bunning. Could you estimate how close we are to a full employment in the United States? " FinancialCrisisReport--605 In public statements and testimony regarding the financial crisis, Goldman has often highlighted its role as a market maker and downplayed its role as an underwriter or placement agent in the securitization markets. 2698 In the April 27, 2010 Subcommittee hearing, for example, Goldman executives repeatedly highlighted the firm’s role as market makers – buying and selling RMBS and CDO securities at the request of clients – while deemphasizing that the firm also originated new securities and affirmatively solicited clients to buy those new securities. In an exchange with Senator Susan Collins, for example, executives from Goldman’s Mortgage Department were asked questions about whether they were investment advisers with a fiduciary duty to their clients. While not denying this duty, they emphasized their role as market makers with more limited client obligations: 2699 Senator Collins: Thank you, Mr. Chairman. I would like to start my questioning by asking each of you a fundamental question. Investment advisers have a legal obligation to act in the best interests of their clients. Mr. Sparks, when you were working at Goldman, did you consider yourself to have a duty to act in the best interests of your clients? Mr. Sparks: Senator, I had a duty to act in a very straightforward way, in a very open way with my clients. Technically, with respect to investment advice, we were a market maker in that regard. But with respect to being a prudent and a responsible participant in the market, we do have a duty to do that. Senator Collins: Mr. Swenson? Mr. Swenson: I believe it is our responsibility as market makers to provide a market- level bid and offer to our clients and to serve our clients and helping them transact at levels that are fair market prices and help meet their needs. Mr. Tourre made similar representations in his prepared testimony to the Subcommittee: “Between 2004 and 2007, my job was primarily to make markets for clients. I made markets by connecting clients who wished to take a long exposure to an asset – meaning they anticipated the value of the asset would rise – with clients who wished to take a short exposure to an asset – meaning they anticipated the value of the asset would fall. I 2698 See, e.g., 3/1/2010 letter from Goldman’s legal counsel to the Financial Crisis Inquiry Commission, GS-PSI-01310 (discussing Goldman Sachs’ “Role as a market maker” in detail and distinguishing it, in a much shorter description, from its underwriting and placement roles). Although the letter acknowledged that Goldman acted as an underwriter and placement agent for RMBS and CDO transactions, it also suggested that those transactions were commonly designed in response to client inquiries and did not discuss efforts by the firm to solicit customers to buy the securities: “Goldman Sachs’ CDOs ... were initially created in response to the request of a sophisticated institutional investor that approached the firm specifically seeking that particular exposure. Reverse inquiries from clients were a common feature of this market.” 2699 April 27, 2010 Subcommittee Hearing Transcript at 26-27. was an intermediary between highly sophisticated professional investors – all of which were institutions. None of my clients were individual, retail investors.” 2700 FOMC20061212meeting--33 31,MR. STOCKTON.," I guess our basic feeling was that, if just the spending data had been weak, we would have probably had greater pause about downweighting the strength of the labor market segment. But we’ve also seen a weakness in industrial production, which is in physical product data as well. Then there’s considerable noise in labor productivity, and the unemployment rate is typically a lagging indicator. So we thought that for now we would give more weight to the spending data as providing a signal that we probably have entered a period of below-trend growth than to the signals given by the labor market, which as I indicated in my briefing could be read as at trend or maybe above trend. We’re looking for labor markets to be a bit of a lagging indicator this time around. We’re anticipating some slowing in labor demand going forward and some bounceback in the unemployment rate. But I wanted to make clear in my briefing that, although we didn’t dismiss the labor market, we did downweight it; and if our forecast is going to turn out to be right, we will have to see some slowing in labor markets relatively soon to confirm the basic story." CHRG-111hhrg67816--154 Mr. Green," And is there any restriction on what can be considered to go into your credit score either by practice or by rule or statute? " CHRG-110hhrg46591--47 Mr. Johnson," Thank you, Mr. Chairman. The current state of the U.S. financial regulatory system is a result of an extreme breakdown in confidence by the credit markets in this country and elsewhere so that U.S. regulatory authorities have determined it necessary to practically underwrite the entire process of credit provision to private borrowers. All significant U.S. financial institutions that provide credit have some form of access to Federal Reserve liquidity facilities at this time. All institutional borrowers through the commercial paper market are now supported by the Federal Reserve System. Many of the major institutional players in the U.S. financial system have recently been partially or fully nationalized. While it appears that the Federal Reserve, along with other central banks, have successfully addressed the fear factor regarding access to liquidity, there are lingering fears in the markets about the economic viability of many financial firms due to the poor asset quality of their balance sheets. All of these measures to restore confidence are the result of huge structural and behavioral flaws in the U.S. financial system that led to excessive expansion in subprime mortgage lending and other credit related derivative products. Because these structural problems have encouraged distorted behavior over a long period of time, it will take some time to completely restore confidence in these credit markets. However, over time, as failed financial institutions are resolved through private market mergers or asset acquisitions and government takeovers and restructurings, confidence in the U.S. credit system should be gradually restored. Unfortunately, this will likely be very costly to U.S. taxpayers. Over the longer term, the public, I think, should be very concerned about the implications of the legislative and regulatory efforts to deal with this crisis of confidence. From my perspective, permanent government control over the credit allocation process is economically inefficient and potentially even more unstable. One of the major reasons why excesses developed in housing finance was a failure of Federal regulators to adequately supervise the behavior of bank holding companies. Specifically, the emergence of structured investment vehicles (SIVs), an off-balance sheet innovation by bank holding companies to avoid the capital requirements administered by the Federal Reserve, set in motion a virtual explosion of toxic mortgage financings. While the overall structure of bank capital reserve requirements was sound relative to bank balance sheets, supervisors were simply oblivious to bank exposures off the balance sheet. If bank supervisors could not police the previous and much less pervasive regulatory structure, you can imagine the impossibility of policing a vastly more extensive and complicated structure. Again, while bank capital requirements are reasonably well-designed today, it is supervision that is a problem. The U.S. financial system has been the envy of the world. Its ability to innovate and disburse capital to create wealth in the United States and around the globe is unprecedented. A new book by my colleague, David Smick, entitled, ``The World is Curved,'' documents the astonishing benefits the U.S. financial system has provided in the process of globalization. The book also clearly describes the dangers presented by regulatory and structural weaknesses today. It would be a mistake to roll back the clock on the gains made in U.S. finance over the last several decades. As the current crisis of confidence subsides and stability is restored, U.S. regulators should develop clear transition plans to exit from direct investments in private financial institutions and attempt to roll back extended guarantees to credit markets beyond the U.S. banking system. Successfully supervising the entire U.S. credit allocation process is simply impossible without dramatically contracting the system. More resources and effort should be put into supervision of bank holding companies. Financial regulators should focus on the full transparency of securitization development and clearing systems. Accurate disclosure of risk is the key to effective and sound private sector credit allocation. Reforms following these type principles should help maintain U.S. prominence in global finance and enhance living standards both domestically and internationally. Thank you, Mr. Chairman. [The prepared statement of Mr. Johnson can be found on page 121 of the appendix.] " CHRG-110hhrg46596--202 Mr. Kashkari," Thank you, Congressman. The answer is yes, absolutely. And I am going to give you, if you will permit me, a two-part answer. First, we continue to work very hard looking at the various proposals that we have received and that we have developed ourselves working with the Federal Reserve, also consulting with the transition team to identify the right approach that is going to help homeowners without creating a windfall to hedge fund investors. We want to balance it so that the homeowners are getting the benefit, not the investors, number one. Number two, we are trying to bring all of the tools in the Federal Government to bear on this problem. And so, for example, the work that we did with Fannie Mae and Freddie Mac by establishing a streamlined loan modification protocol for Fannie Mae and Freddie Mac, the advantage of that, Congressman, is that most of the agreements that govern the subprime loans out there refer back to the Fannie and Freddie underwriting--excuse me, the Fannie and Freddie servicing standards. So by using Fannie and Freddie, we have been able, with their regulator, FHFA, to establish effectively a new industry-wide standard for loan modifications. So we are looking at what we can do under the TARP, but we are also looking at what other tools we have outside the TARP. We want to bring all of the tools to bear and use the right tool for the right job. " CHRG-111shrg52619--121 Mr. Dugan," I understand that, and I believe that we were too late getting to the notion, all of us, about getting at stated income practices and low-documentation loans. We did get to it, but it was after the horse had left the barn in a number of cases, and we should have gotten there earlier. The point I was just trying to make to you, though, is that as these things were leaving the institution, they were less of a risk to that institution from a safety and soundness point of view. " FOMC20080430meeting--77 75,MR. STOCKTON.," A lot bigger than just the rise in expectations, and the fed funds rate, of course, would have to rise considerably. On the inventory side of the forecast--again, you put your finger on the principal reason that inventories are as weak as they are in the near term, which is that we think there will be a pretty sizable spending response to the tax rebates but we don't see that as showing up fully in activity in large measure because we think firms are going to understand that this will be a one-time increase in demand. So they will be somewhat cautious about responding with higher production to that demand and will, especially in the context of a relatively weak economy, be more content with having that run down inventories than actually with ramping up production immediately. Now, that's guesswork on our part. Again, I feel pretty comfortable with that basic story, but it is going to require some fairly negative inventory figures shortly. There is a technical factor here as well. We have occasionally cited a residual seasonality in imports, and in the second quarter that residual seasonality pushes down imports a lot. But we see no residual seasonality in GDP, so we take it out of inventories. That has been a standard feature of our forecast for the past few years. Nathan and his crew have communicated quite frequently with the BEA complaining about the fact that they have a seasonal adjustment process that takes a relatively flat series and creates lots of noise. [Laughter] It does not seem as though it is probably the best thing, but it exaggerates the downward movement in inventories. If I had to cite something that would make me nervous about the weakness in our near-term outlook, I do worry that the inventory liquidation in our forecast is large. The decline in the inventory�sales ratio in our forecast looks a lot like the decline in the inventory� sales ratio that we saw in 2001 and 2002. So it's not out of line with past cyclical behavior, but it's an aggressive drop. " CHRG-111hhrg56847--25 Mr. Ryan," Let us go over the monetary policy and global currency policy. The ECB is essentially engaged in quantitative easing. I know that they would argue that that is not per se their policy objective, but their objective is obviously liquidity for sovereign credit markets. The Federal Reserve has been engaged in a similar process lately. So we have now two reserve currencies engaged in a quantitative easing, the spirit of a quantitative easing policy. Gold hit an all-time high yesterday, which I think most people would view as a vote of no confidence against fiat currencies. I am interested in what does that price signal tell you and what is your view on the long-term repercussions with respect to weak currency policies? I suppose one could argue that we don't have a weak dollar because everybody else is so much weaker. But with this kind of quantitative easing policy in place, we have sort of removed one of the firewalls that have separated our monetary and fiscal policy and that has probably changed investor impressions looking into the future with respect to the stability and strength of our currency. What is your view on that? " CHRG-111shrg57322--886 Mr. Blankfein," I think that the investors that we are dealing with, on the long side or on the short side, know what they want to acquire and probably if they asked a sales person his or her opinion, that sales person owes a duty of honesty. But otherwise, the sales person is representing what that security is and what the position in that security will accomplish. And as far as whether something is a weak security or going bad, we are selling securities all the time that are weak, that we ourselves don't like. It is just a function of the price in the market. I bet some of those securities, and I don't know specifically, which are the subject of those comments can be bought today for a willing buyer and a seller at cents on the dollar. As long as people know--I think there are people who are making rational decisions today to buy securities for pennies on the dollar because they think it will go up, and the sellers of those securities are happy to get the pennies because they think they will go down. Senator Levin. I understand that. We are talking where you were the seller of the security and you, Goldman Sachs--believe it is a piece of crap, where you---- " FinancialCrisisReport--43 A third problem, exclusive to state regulators, was a 2005 regulation issued by the OCC to prohibit states from enforcing state consumer protection laws against national banks. 91 After the New York State Attorney General issued subpoenas to several national banks to enforce New York’s fair lending laws, a legal battle ensued. In 2009, the Supreme Court invalidated the OCC regulation, and held that states were allowed to enforce state consumer protection laws against national banks. 92 During the intervening four years, however, state regulators had been effectively unable to enforce state laws prohibiting abusive mortgage practices against federally- chartered banks and thrifts. Systemic Risk. While bank and securities regulators focused on the safety and soundness of individual financial institutions, no regulator was charged with identifying, preventing, or managing risks that threatened the safety and soundness of the overall U.S. financial system. In the area of high risk mortgage lending, for example, bank regulators allowed banks to issue high risk mortgages as long as it was profitable and the banks quickly sold the high risk loans to get them off their books. Securities regulators allowed investment banks to underwrite, buy, and sell mortgage backed securities relying on high risk mortgages, as long as the securities received high ratings from the credit rating agencies and so were deemed “safe” investments. No regulatory agency focused on what would happen when poor quality mortgages were allowed to saturate U.S. financial markets and contaminate RMBS and CDO securities with high risk loans. In addition, none of the regulators focused on the impact derivatives like credit default swaps might have in exacerbating risk exposures, since they were barred by federal law from regulating or even gathering data about these financial instruments. F. Government Sponsored Enterprises Between 1990 and 2004, homeownership rates in the United States increased rapidly from 64% to 69%, the highest level in 50 years. 93 While many highly regarded economists and officials argued at the time that this housing boom was the result of healthy economic activity, in retrospect, some federal housing policies encouraged people to purchase homes they were ultimately unable to afford, which helped to inflate the housing bubble. Fannie Mae and Freddie Mac. Two government sponsored entities (GSE), the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac), were chartered by Congress to encourage homeownership primarily by providing a secondary market for home mortgages. They created that secondary market by purchasing loans from lenders, securitizing them, providing a guarantee that they would make up the cost of other requirements, the rules prohibited lenders “from making loans based on collateral without regard to [the borrower’s] repayment ability,” required lenders to “verify income and obligations,” and imposed “more stringent restrictions on prepayment penalties.” The rules also required lenders to “establish escrow accounts for taxes and mortgage related insurance for first-lien loans.” In addition, the rules “prohibit[ed] coercion of appraisers, define[d] inappropriate practices for loan servicers, and require[d] early truth in lending disclosures for most mortgages.”). 91 12 CFR § 7.4000. 92 Cuomo v. Clearing House Association , Case No. 08-453, 129 S.Ct. 2710 (2009). 93 U.S. Census Bureau, “Table 14. Homeownership Rates by Area: 1960 to 2009,” http://www.census.gov/hhes/www/housing/hvs/annual09/ann09t14.xls. any securitized mortgage that defaulted, and selling the resulting mortgage backed securities to investors. Many believed that the securities had the implicit backing of the federal government and viewed them as very safe investments, leading investors around the world to purchase them. The existence of this secondary market encouraged lenders to originate more loans, since they could easily sell them to the GSEs and use the profits to increase their lending. CHRG-111hhrg56847--51 Mr. Bernanke," Absolutely we are going to respond. We did a series of surveys and questionnaires to try to understand what the pay practices were and whether they were consistent with safe and sound banking and good incentive structures. As the report says, we found that many banks have not modified their practices from what they were before the crisis. We anticipate an interagency guidance on this matter within the next few weeks. So we will be putting out a set of criteria and a set of expectations very shortly, and we will be pushing the banks to move as quickly as possible to restructure their compensation packages so that they will not be engendering excessive risk taking. We will be doing that very quickly. We hope to have a public report about this near the end of this year or early next year. But I want to assure you that the actions we will be taking will not wait for the report. We will be immediately working with the banks, and we have been working with the banks already to get them to modify their compensation practices. " CHRG-111hhrg56847--111 Mr. Bernanke," Well, we are concerned about it. Clearly, it is a very weak point in the economy. For many banks, particularly smaller- and medium-sized banks, it is a problem. We have done a number of things. The Federal Reserve worked with the Treasury to develop a program to try to restart the commercial mortgage-backed security market. Beyond that, we have issued guidance to banks and commercial real estate, and we are trying to work with them to restructure commercial real estate loans and to find ways to manage troubled loans. So we are doing the best we can with the banks and with the markets. There seems to be, I would say, a few glimmers of hope in this area. There is some stabilization of price in some markets, for example, but it does remain a very serious concern, and we are watching it very carefully. " CHRG-111shrg56376--107 Mr. Tarullo," Well, I think you point out the problem. You have systemically risky institutions addressed, you have regulated institutions that are already regulated, and then you have consumer. But if you have a practice which is troublesome, then there ought to be a mechanism for somebody to be making an evaluation of that practice. And then perhaps if the Council saw that one of its members had authority to regulate, it could suggest it. Congress could also think about giving some sort of default or back-up authority to the Council in the event that no one had---- Senator Warner. Very quickly, because the senior Senator from New York is anxious. " FinancialCrisisReport--149 Long Beach regularly made changes to the compensation plan, but the basic volume incentives remained. In the 2007 incentive plan, which took effect after the collapse of the subprime market, the volume requirements were even greater than 2004 requirements. In 2007, the Tier 1 represented 1-9 qualified loans and up to $1,499,999 funded; Tier 2 was 10-13 qualified loans and between $1,500,000 and $2,399,000 funded; Tier 3 was 14-35 qualified loans and between $2,400,000 and $5,999,999 funded; Tier 4 was 36 or more loans and $6,000,000 or more funded. 554 (b) WaMu Loan Consultants Like Long Beach, at WaMu loan officers were compensated for the volume of loans closed and loan processors were compensated for speed of loan closing rather than a more balanced scorecard of timeliness and loan quality. According to the findings and recommendations from an April 2008 internal investigation into allegations of loan fraud at WaMu: “A design weakness here is that the loan consultants are allowed to communicate minimal loan requirements and obtain various verification documents from the borrower that [are] need[ed] to prove income, employment and assets. Since the loan consultant is also more intimately familiar with our documentation requirements and approval criteria, the temptation to advise the borrower on means and methods to game the system may occur. Our compensation and reward structure is heavily tilted for these employees toward production of closed loans.” 555 An undated presentation obtained by the Subcommittee entitled, “Home Loans Product Strategy, Strategy and Business Initiatives Update,” outlines WaMu’s 2007 Home Loans Strategy and shows the decisive role that compensation played, while providing still more evidence of WaMu’s efforts to execute its High Risk Lending Strategy: “2007 Product Strategy Product strategy designed to drive profitability and growth -Driving growth in higher margin products (Option ARM, Alt A, Home Equity, Subprime) … 553 Id. 554 Documents regarding Long Beach compensation, Hearing Exhibit 4/13-59b. 555 4/4/2008 WaMu Memorandum of Results, “AIG/UG and OTS Allegation of Loan Frauds Originated by [name redacted],” at 11, Hearing Exhibit 4/13-24. -Recruit and leverage seasoned Option ARM sales force, refresh existing training including top performer peer guidance -Maintain a compensation structure that supports the high margin product strategy” 556 FinancialCrisisReport--163 Washington Mutual. 595 In connection with the hearing, the Subcommittee released a joint memorandum from Chairman Levin and Ranking Member Coburn summarizing the investigation to date into the role of the regulators overseeing WaMu. That memorandum stated: “Federal bank regulators are supposed to ensure the safety and soundness of individual U.S. financial institutions and, by extension, the U.S. banking system. Washington Mutual was just one of many financial institutions that federal banking regulators allowed to engage in such high risk home loan lending practices that they resulted in bank failure and damage to financial markets. The ineffective role of bank regulators was a major contributor to the 2008 financial crisis that continues to afflict the U.S. and world economy today.” On March 16, 2011, the FDIC sued the three top former executives of Washington Mutual for pursuing a high risk lending strategy without sufficient risk management practices and despite their knowledge of a weakening housing market. 596 The FDIC complaint stated: “Chief Executive Officer Kerry K. Killinger (“Killinger”), Chief Operating Officer Stephen J. Rotella (“Rotella”), and Home Loans President David C. Schneider (“Schneider”) caused Washington Mutual Bank (“WaMu” or “the Bank”) to take extreme and historically unprecedented risks with WaMu’s held-for-investment home loans portfolio. They focused on short term gains to increase their own compensation, with reckless disregard for WaMu’s longer term safety and soundness. Their negligence, gross negligence and breaches of fiduciary duty caused WaMu to lose billions of dollars. The FDIC brings this Complaint to hold these three highly paid senior executives, who were chiefly responsible for WaMu’s higher risk home lending program, accountable for the resulting losses.” 595 See “Wall Street and the Financial Crisis: Role of the Regulators,” before the U.S. Senate Permanent Subcommittee on Investigations, S.Hrg. 111-672 (April 16, 2010) (hereinafter “April 16, 2010 Subcommittee Hearing”). 596 The Federal Deposit Insurance Corporation v. Kerry K. Killinger, Stephen J. Rotella, David C. Schneider , et al., Case No. 2:11-CV-00459 (W.D. Wash.), Complaint (March 16, 2011), at http://graphics8.nytimes.com/packages/pdf/business/conformedcomplaint.pdf (hereinafter “FDIC Complaint Against WaMu Executives”). CHRG-110shrg50416--45 Mr. Kashkari," That is correct. Senator Shelby. It has been suggested that some of the banks receiving funds under the program of the $125 billion do not need it and did not want it. Was requiring participation by the nine banks simply a symbolic gesture intended to mask the financial weaknesses of some of the banks? In other words, why would you want to push money on people that did not need it? In fact, if they did need it, that is what the program was about. " CHRG-111shrg57319--198 Mr. Melby," I do. I remember receiving the report, and, again, this was written by the Corporate Credit Review group. My only reaction would be to the first bullet regarding your comment earlier about the control weaknesses existed for some time. In my view, this is the same issue that has been reported not only by Risk Mitigation but, again, in our reports as well. Senator Levin. Mr. Cathcart, do you have any comment on this? " CHRG-111hhrg48868--897 Mr. Liddy," We had risk management practices in place. They generally were not allowed to go up into the Financial Products business. It was-- " CHRG-110shrg50409--16 Mr. Bernanke," We will be looking specifically at the whole range of issues about transparency, practices, positions, and so on. " CHRG-111shrg57319--275 Mr. Beck," Yes, we did. Senator Coburn. OK. Did you alter your securitization practices based on that knowledge? " FOMC20081029meeting--162 160,CHAIRMAN BERNANKE., Learning theory in practice. Thank you very much. Very helpful. All right. Mr. Morin. CHRG-111hhrg51592--64 Chairman Kanjorski," Okay. Well, do you think it is the responsibility of a rating agency to practice due diligence? " CHRG-111hhrg58044--310 CENTER Ms. Wu. Mr. Chairman, Representative Hensarling, and members of the subcommittee, thank you very much for inviting me here today. I am testifying on behalf of the low-income clients of the National Consumer Law Center. And, Mr. Chairman, thank you for holding this hearing about the use of credit reports in areas beyond lending, such as employment and insurance. And we also thank you for inviting us to speak about the need to fix a scrivener's error in the Fair Credit Reporting Act. The use of credit reports in employment is a growing practice, with nearly half of employers involved in it. It's a practice that is harmful and unfair to American workers. For that reason, we strongly support H.R. 3149, and we thank Chairman Gutierrez and Congressman Steve Cohen for introducing it. This bill would restrict the use of credit reports in employment to only those positions for which it is truly warranted, such as those requiring national security or FDIC-mandated clearance. We oppose the unfettered use of credit histories and support H.R. 3149 for a number of reasons. The first and foremost is the profound absurdity of the practice. Considering credit histories in hiring creates a vicious Catch-22 for job applicants. A worker loses her job, and is likely to fall behind on her bills due to lack of income. She can't rebuild her credit history if she doesn't have a job, and she can't get a job if she has bad credit. Commentators have called this a financial death spiral, as unemployment leads to worse credit records, which, in turn, make it harder for the worker to get a job. Second, the use of credit histories in hiring discriminates against African-American and Latino job applicants. We have heard how study after study has documented, as a group, these groups have lower credit scores, including the FTC study that did find the disparities in credit scoring. These are groups that have been disproportionately affected by predatory credit practices, such as the marketing of subprime mortgages and auto loans and, as a result, have suffered higher foreclosure rates, all of which have damaged their credit histories. The Equal Employment Opportunity Commission has expressed concerns over the use of credit histories in employment, and recently sued one company over the practice. Third, there is no evidence that credit history predicts job performance. The sole study on this issue has concluded there isn't even a correlation. Even industry representatives have admitted, ``At this point we don't have any research to show any statistical correlation between what's in somebody's credit report and their job performance, or likelihood to commit fraud.'' Finally, as we have testified here before, the consumer reporting system suffers from high rates of inaccuracy, rates that are unacceptable for purposes as important as employment. And the estimates range from 3 percent, which is the industry estimate, to 12 percent, from the FTC studies, to 37 percent in an online survey. In an environment with 10 percent unemployment, a 3 percent error rate in credit reports affects 6 million American workers, and it's not acceptable. And, remember, a consumer who has an error in her credit report, and is able to fix it--which is very difficult--can reapply for credit. But very few employers are going to voluntarily hold up a hiring process for one or more months to allow an applicant to correct an error in the credit report. The issue at stake is whether workers are fairly judged on their ability to perform a job, or whether they're discriminated against because of their credit history. Oregon recently signed a bill into law restricting this practice. Other States are considering it, and Congress should do the same and pass H.R. 3149. The second issue I want to talk about is a scrivener's error. The amendments of 2003 may have inadvertently deprived consumers of a 30-year-old pre-existing right they had to enforce the FCRA's adverse action notice requirement. This is the notice given when credit or insurance or employment is denied, based on an unfavorable credit report. That was intended to limit the remedies for a totally new notice--the risk-based pricing notice--at 1681m(h). However, due to ambiguous drafting, a number of courts have interpreted this limitation to apply to the entirety of section 1681m of the FCRA, including the pre-existing adverse action notice. Congress can easily and should fix the scrivener's error, because it was never part of the legislative bargain struck by FACTA. In fact, FACTA's legislative history indicates that Congress had absolutely no intention of abolishing any private enforcement of the adverse action notice requirement, and an uncodified section specifically states that nothing in FACTA ``shall be construed to affect any liability under section 616 or 617 of the Fair Credit Reporting Act''--that is the private enforcement provisions--``that existed on the day before the date of the enactment of this act.'' And there is more evidence that Congress didn't intentionally abolish the private enforcement. If it had done so, the banking and credit industry would have trumpeted that change. In fact, the industry has never made that claim, with only the American Banker noting that FACTA perhaps inadvertently eliminated the existing right of consumers and State officials to sue for violations of the adverse action provisions. Even 4 years later, in a hearing before the full committee, my fellow testifiers today declined to claim that FACTA had intentionally abolished this private remedy. Now, despite the clear legislative history, several dozen courts have, unfortunately, held that FACTA abolished this private remedy, depriving hundreds of consumers of their rights. We think that the documented cases are perhaps only the tip of the iceberg, so we assume that customers' damage has-- " FOMC20081216meeting--504 502,MR. PARKINSON.," I think the conduits were more important in some asset classes than others. In credit cards, for example, the conduits were pretty important. But even there they were important in recent years. I think they were important in recent years because spreads kept on coming down and down and deterred the real money investors that traditionally invested in these products--they were no longer interested. Yet the underwriters were able to keep the game going at those low spreads by resorting to selling to conduits and securities lenders and those sorts of things. So over time, if we could deal with some of the issues around confidence and ratings and the other things that may be deterring the real money investors from entering the market, there is a hope of bringing them back and going back not to 2007, when it was conduits and that kind of stuff, but to, say, 2002, when you had real money investors buying these securities. " FinancialCrisisInquiry--59 And looking back, I also think, as a business, you have to look at what you did right, what you did wrong. And if you’re not continually analyzing and improving it, you will not get better. So I’ve already mentioned the biggest mistakes we made. In mortgage underwriting, somehow we just missed, you know, that home prices don’t go up forever and that it’s not sufficient to have stated income in home prices. HOLTZ-EAKIN: If you’ve been doing—you have been doing stress tests prior to the crisis? DIMON: Yes. HOLTZ-EAKIN: Did you do a stress test that showed housing prices falling? DIMON: No. I would say that was probably one of the big misses. We stressed almost everything else, but we didn’t see home prices going down 40 percent. And that’s now part of the stress test. HOLTZ-EAKIN: OK. Thank you. Mr. Mack, you’ve answered about beefing up the... MACK: Sure. HOLTZ-EAKIN: FinancialCrisisInquiry--67 It has been suggested that this lack of accountability could be remedied, if all the firms and individuals involved in the creation of financial instruments had to, quote, “eat their own cooking,” requiring, for example, that their fees be taken not in cash, but in significant part in the securities they created, which they would be required to hold until maturity unhedged. So if a bond were issued that was to pay 7 percent interest per year for five years, then repay the capital investment, the originators would receive their compensation on the same basis. If the investment banker who led the underwriting was entitled to a million- dollar bonus, he or she would receive the million dollars worth of securities, yielding $70,000 per year in income for the five years, receiving the million in cash at the end of the fifth year. If the security failed to perform as represented, just like the investors, the originators would lose their expected annual income and the expected principal amount of their bonus. Alternatively, some have suggested that investors should have a put for 18 to 30 months, during which time if the security failed to perform, investors would be entitled to a refund, requiring the issuer and the underwriting investment bank to buy back the financial instrument. These suggestions are in no way intended to punish the responsible individuals, but rather to improve the quality of the diligence they exercise in the origination of the security, knowing that their financial future, just like that of the purchasing investors, is tied to the success or failure of the security to perform as they represent it will perform. And I would ask each of you whether you think that the volume created of illiquid toxic securities that contributed significantly to the global financial crisis could have been materially reduced by some such mechanism of placing financial responsibility where it belongs on those who originate financial instruments. And I would respectfully request that you attempt to answer not as leaders of four of the world’s most prominent financial institutions focused on maximizing your firm’s profits, but just like the commissioners on this panel, as Americans struggling to identify the root causes of this devastating financial crisis, and potential remedies to avoid its repetition. Mr. Mack? FinancialCrisisReport--557 DD. Abacus 2007-AC1 Abacus 2007-AC1 was a $2 billion synthetic CDO whose reference obligations were BBB rated mid and subprime RMBS securities issued in 2006 and early 2007. 2482 It was a static CDO, meaning once selected, its reference obligations did not change. 2483 It was the last in a series of 16 Abacus CDOs referencing RMBS securities designed by Goldman. Goldman served as the underwriter or placement agent, 2484 the lead manager, 2485 and the protection buyer, 2486 and also acted in other roles related to the CDO. 2487 Unlike previous Abacus CDOs, Abacus 2007-AC1 used a third party to select its assets, referring to it as the portfolio selection agent. 2488 Designing Single Tranche CDOs. Abacus CDOs were known as single tranche CDOs, a structure pioneered by Goldman through its Abacus platform. 2489 Goldman used this structure to design customized CDOs for clients interested in assuming a specific type and amount of investment risk. An Abacus CDO could be issued with a single tranche, designed in coordination with a client who could select the assets the client wished to reference, the size of the investment, and the amount of subordination or cushion before the single tranche of securities would be exposed 2482 See 3/23/2007 Goldman document, “Abacus 2007-AC1, ” at 11, GS MBS-E-002807082, Hearing Exhibit 4/27- 120; Securities and Exchange Commission v. Goldman Sachs, Case No. 10-CV-3229 (S.D.N.Y.), Complaint (April 16, 2010), at 1, 6 (hereinafter “SEC Complaint against Goldman Sachs ”) . 2483 4/2/2007 email from Fabrice Tourre, “ABACUS 07-AC1, ” GS MBS-E-002011152 (Abacus 2007-AC1 assets are “fully-identified, with no reinvestment, removals, substitutions or discretionary trading ”). 2484 Goldman internal documents sometimes describe it as the underwriter for Abacus 2007-AC1, and sometimes as the placement agent. Compare 2/18/2008 Goldman document, “CDO Transactions (July 1, 2006 - December 31, 2007) in which Goldman Sachs acted as underwriter,” GS M BS 0000004337, to 3/12/2007 Goldman memorandum to Mortgage Capital Committee, “ABACUS Transaction sponsored by ACA,” at 2, GS M BS-E-002406025, Hearing Exhibit 4/27-118 ( “Goldman is solely working as agent but retains the option to underwrite the risk as principal.”). 2485 2/27/2007 email from Curtis W illing, “ABACUS 2007 AC1, Ltd. -- New Issue Announcement (144a/RegS), ” GS MBS-E-009209654. 2486 3/12/2007 Goldman memorandum to Mortgage Capital Committee, “ABACUS Transaction sponsored by ACA,” at 6, GS MBS-E-002406025, Hearing Exhibit 4/27-118 ( “Goldman is acting as principal as a protection buyer . . . as well as taking other principal roles.”). 2487 Goldman ’s additional roles included acting as the basis swap counterparty, the basis swap calculation agent, the collateral put provider, the collateral put calculation agent, the collateral disposal agent, the credit default swap calculation agent, and the initial purchaser. 2/18/2008 Goldman document, “CDO Transactions (July 1, 2006 - December 31, 2007) in which Goldman Sachs acted as underwriter,” GS MBS 0000004337; 3/12/2007 Goldman Sachs memorandum to Mortgage Capital Committee, “ABACUS Transaction sponsored by ACA,” GS MBS-E- 002406025, Hearing Exhibit 4/27-118. 2488 3/12/2007 Goldman memorandum to Mortgage Capital Committee, “ABACUS Transaction sponsored by ACA,” GS MBS-E-002406025, Hearing Exhibit 4/27-118; April 27, 2010 Subcommittee Hearing at 421. 2489 Goldman considered its Abacus platform, which commenced in 2004, to be “market-leading. ” 4/2/2007 email from Fabrice Tourre, “ABACUS 07-AC1, ” GS MBS-E-002011152; 2/27/2007 Goldman email, “ABACUS-2007- AC1 – M arketing Points (INTERNAL ONLY) [T-Mail],” GS MBS-E-008042545, Hearing Exhibit 4/27-116. See also 6/2007 Goldman document, “CDO Platform Overview, ” at 31, GS M BS-E-001918722 ( “ABACUS is the Goldman brand name for single-tranche CLN [credit linked note] issuances referencing portfolios comprised entirely of structured products. ”); 4/2006 Goldman presentation “Overview of Structured Products,” GS MBS-E-016067482. to loss. 2490 Abacus also enabled investors to short a selected group of RMBS or CDO securities at the same time. Goldman used the Abacus CDOs not only to sell short positions to investors, but also to carry out its own shorts. As summarized in one Goldman Mortgage Capital Committee Memorandum, the Abacus design allowed “Goldman to short spreads in our core structured products business in large size.” 2491 Between 2004 and 2007, Goldman issued 16 Abacus deals referencing RMBS securities, including Abacus 2007-AC1, which together had an aggregate value of $13 billion. 2492 fcic_final_report_full--318 In response to these losses, the Office of Thrift Supervision, WaMu’s regulator, re- quested that the thrift address concerns about asset quality, earnings, and liquidity— issues that the OTS had raised in the past but that had not been reflected in supervisory ratings. “It has been hard for us to justify doing much more than con- stantly nagging (okay, ‘chastising’) through ROE [Reports of Examination] and meet- ings, since they have not really been adversely impacted in terms of losses,”  the OTS’s lead examiner at the company had commented in a  email. Indeed, the nontradi- tional mortgage portfolio had been performing very well through  and . But with WaMu now taking losses, the OTS determined on February , , that its condition required a downgrade in its rating from a  to a , or “less than sat- isfactory.”  In March, the OTS advised that WaMu undertake “strategic initiatives”— that is, either find a buyer or raise new capital. In April, WaMu secured a  billion investment from a consortium led by the Texas Pacific Group, a private equity firm.  But bad news continued for thrifts. On July , the OTS closed IndyMac Bank in Pasadena, California, making that company the largest-ever thrift to fail. On July , , WaMu reported a . billion loss in the second quarter. WaMu’s depositors withdrew  billion over the next two weeks.  And the Federal Home Loan Bank of San Francisco—which, as noted, had historically served with the other  Federal Home Loan Banks as an important source of funds for WaMu and others—began to limit WaMu’s borrowing capacity. The OTS issued more downgrades in various as- sessment categories, while maintaining the overall rating at . As the insurer of many of WaMu’s deposits, the FDIC had a stake in WaMu’s condition, and it was not as generous as the OTS in its assessment. It had already dropped WaMu’s rating significantly in March , indicating a “high level of concern.”  The FDIC expressly disagreed with the OTS’s decision to maintain the  overall rating, recommending a  instead.  Ordinarily,  would have triggered a formal en- forcement action, but none was forthcoming. In an August  interview, William Isaac, who was chairman of the FDIC from  until , noted that the OTS and FDIC had competing interests. OTS, as primary regulator, “tends to want to see if they can rehabilitate the bank and doesn’t want to act precipitously as a rule.” On the other hand, “The FDIC’s job is to handle the failures, and it—generally speaking— would rather be tougher . . . on the theory that the sooner the problems are resolved, the less expensive the cleanup will be.”  FDIC Chairman Sheila Bair underscored this tension, telling the FCIC that “our examiners, much earlier, were very concerned about the underwriting quality of WaMu’s mortgage portfolio, and we were actively opposed by the OTS in terms of go- ing in and letting our [FDIC] examiners do loan-level analysis.”  CHRG-111hhrg48873--184 Mr. Bernanke," The loans we make have to be fully secured and collateralized. We have practical limits in terms of our ability to manage monetary policy. So there are, obviously, limits. We have reported extensively to the Congress on all the actions that we have taken, and the actions we have taken have been solely and entirely for the purpose of protecting the American economy from the effects of financial collapse. " CHRG-110shrg46629--100 Chairman Bernanke," Certainly Senator. Just one word on your initial comment. I agree with you that legitimate subprime lending is beneficial. It gives people access to homeownership and access to credit. So the real trick for us is to write rules, to write regulations that will screen out the abusive practices and the improper practices while preserving this market. I think that is a very challenging task. Senator Bennett. If I just might, a witness in a previous hearing said not all predatory lending is subprime. " CHRG-111hhrg51698--367 Mr. Scott," Mr. Chairman, could I have 30 seconds to ask a follow-up question? I wanted to ask a follow-up question to Mr. Taylor who brought up a point about ICE and clearing. Your testimony asked that the CFTC should make ICE and its clearing members adhere to the practice of margining futures to future settlements and options to options settlement. What has ICE done differently and how has it impacted cotton trading, for example? And if it is a different practice, do other exchanges behave similarly or not? " CHRG-111hhrg56766--209 Mr. Bernanke," Unfortunately, the construction was probably overinflated for a period, and now it is quite weak. I wouldn't conjecture to see a big return of construction, either of residential or commercial, for some time. We still have a lot of unsold homes, for example, a lot of high vacancy rates, and also high vacancy rates in commercial real estate, so there is not, at this point, a lot of demand for new construction. " FOMC20070321meeting--130 128,MR. KOHN.," Vincent, on exhibit 2, the two-year Treasury spread over the target federal funds rate, for a while we have been discounting the tendency of the ten-year rate to be below the fed funds rate because term premiums have been unusually low, so we’ve said it’s not as indicative of expected weakness. Are term premiums low for the two-year rate, or do we know?" FinancialCrisisReport--147 The President’s Club annual trip was the pinnacle of WaMu awards to its top producing loan consultants. One loan consultant interviewed by the Subcommittee described it as an incredible experience, with first class airfare, daily gifts, lavish food, and top entertainment for both employees and their spouses. 547 It was also an opportunity to meet WaMu’s top executives, including Mr. Killinger, Mr. Rotella, and Mr. Schneider. It sent a powerful message about the priority that WaMu placed on loan volume and sales of higher risk loans. (2) Paying for Speed and Volume The Long Beach and Washington Mutual compensation systems encouraged high volumes of risky loans but provided little or no incentive to ensure high quality loans that complied with the bank’s credit requirements. WaMu loan officers or their sales associates typically interacted directly with customers interested in obtaining loans. Some also were allowed to accept loans brought to them by third party lenders or mortgage brokers. Long Beach account executives dealt only with third party lenders or mortgage brokers; they did not deal directly with customers. After reaching agreement on a loan, the WaMu or Long Beach loan officers or executives completed the loan application and sent it to a loan processing center where the application was reviewed by an underwriter and, if approved, underwent further processing and brought to a loan closing. Long Beach and Washington Mutual loan officers received more money per loan for originating higher risk loans and for exceeding established loan targets. Loan processing personnel were compensated according to the speed and number of the loans they processed. Loan officers and their sales associates received still more compensation if they charged borrowers higher interest rates or points than required in bank rate sheets specifying loan prices, or included prepayment penalties in the loan agreements. That added compensation created incentives to increase loan profitability, but not loan quality. A 2008 OTS review elaborated: “[T]he review defines an origination culture focused more heavily on production volume rather than quality. An example of this was a finding that production personnel were allowed to participate in aspects of the income, employment, or asset verification process, a clear conflict of interest. … Prior OTS examinations have raised similar issues 546 April 13, 2010 Subcommittee Hearing at 16-17. 547 Subcommittee interview of Brian Minkow (2/16/2010). including the need to implement incentive compensation programs to place greater emphasis on loan quality.” 548 (a) Long Beach Account Executives FinancialCrisisInquiry--26 And many of the securities that you sold to institutional investors, other folks went bad within months of issuance. Now, one expert in structured financing said, “The simultaneous selling of securities to customers and shorting them because they believe they are going to default is the most cynical use of credit information that I’ve seen.” Do you believe that was a proper legal, ethical practice? And would the firm continue to do that practice? Or do you believe that’s the kind of practice that undermines confidence in the marketplace? BLANKFEIN: Well, the way it’s—let me—the short answer is this is the practice of a market maker. And I would like to explain this. But the answer is I do think that the behavior is improper, and we regret the result—the consequence that people have lost money in it, but I just want to explain—and this is a very important—and I appreciate the opportunity to do this because there’s so much press swirling around this that I really want—I really need to explain. In our market-making function, we are a principal. We represent the other side of what people want to do. We are not a fiduciary. We are not an agent. Of course, we have an obligation to fully disclose what an instrument is and to be honest in our dealings, but we are not managing somebody else’s money. When we sell something as a principal—which is what we are as a market maker—the next minute, that item will have gone up—in which case we’ll wish we hadn’t sold it that minute—or it will go down—in which case, we’ll actually be glad we did for our own P&L and sorry for the person who bought it. But we are market makers in that. In most of these cases, the person who came to us came to us for the exposure that they wanted to have. CHRG-110hhrg41184--111 Mr. Bernanke," Well, Congressman, as you pointed out, we have two different authorities. We have the Reg Z Truth in Lending authority, which is disclosure authorities, and we have already put out a rule for comment. It was a very extensive rule that involved consumer testing and several years of efforts to put together. I think that proposal is going to improve disclosures a lot. But we also have this Unfair Deceptive Acts and Practices authority, which allows us to ban--not just failure to disclose--but allows us to ban specific practices, which are unfair or deceptive for the consumer, and I think-- " FinancialCrisisReport--116 Mr. Cathcart told the Subcommittee that this change created further separation between him and his risk managers, and compromised the independence of risk management. 409 He testified at the Subcommittee hearing: Mr. Cathcart: The chairman adopted a policy of what he called double reporting, and in the case of the Chief Risk Officers, although it was my preference to have them reporting directly to me, I shared that reporting relationship with the heads of the businesses so that clearly any of the Chief Risk Officers reporting to me had a direct line to management apart from me. Senator Coburn: And was that a negative or a positive in terms to the ultimate outcome in your view? 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. 410 The subordination of risk management to sales was apparent at WaMu in many other ways as well. Tony Meola, the head of home loans sales, reported directly to David Schneider. He had direct access to Mr. Schneider and often pushed for more lenient lending standards. According to Ms. Feltgen, the sales people always wanted more lenient standards and more mortgage products, and Mr. Meola advocated for them. 411 One example was the 80/20 loan, which consisted of a package of two loans issued together, an 80% LTV first lien and a 20% LTV second lien, for a total CLTV of 100%. Ms. Feltgen said she was nervous about the product, as a 100% CLTV was obviously very risky. WaMu’s automatic underwriting system was not set up to accept such loans, but Mr. Meola wanted permission to “side step” the systems issue. 412 Mr. Schneider approved the product, and Ms. Feltgen ultimately signed off on it. She told the Subcommittee that it was a high risk 409 Id. 410 April 13, 2010 Subcommittee Hearing at 34. 411 Subcommittee Interview of Cheryl Feltgen (2/6/2010). 412 See 2/2006 WaMu internal email chain, “FW: 80/20,” JPM_WM03960778. product, but was priced accordingly, and that it might have been successful if housing prices had not declined. 413 FinancialCrisisReport--481 Loan Repurchase Campaign. In addition to its sales and writedowns, the Mortgage Department intensified its efforts to identify and return defaulted or otherwise deficient loans to the originating lender from which they had been purchased in exchange for a refund of the purchase price. Altogether in 2006 and 2007, Goldman made about $475 million in repurchase claims for securitized loans, and recovered about $82 million. 2032 It also made about $40 million in repurchase claims for unsecuritized loans, and recovered about $17 million. 2033 In the years leading up to the financial crisis, most subprime loan purchase agreements provided that if a loan experienced an early payment default (EPD), meaning the borrower failed to make a payment within three months of the loan’s purchase, or if the loan breached certain representations or warranties, such as representations related to the loan’s characteristics or documentation, the loan could be returned or “put back” to the seller which was then obligated to repurchase it. In late 2006, as subprime loans began to experience accelerated rates of EPDs and fraud, 2034 Wall Street firms began to intensify their efforts to return those loans for refunds. Some subprime lenders began to experience financial distress due to unprecedented waves of repurchase requests that drained their cashflows. 2035 Although Goldman, either directly or through a third party due diligence firm, routinely conducted due diligence reviews of the mortgage loan pools it bought from lenders or third party brokers for use in its securitizations, those reviews generally examined only a sample of the loans 2031 2/13/2007 email from Richard Ruzika to Gary Cohn, “Catch Up, ” GS MBS-E-019794071. Mr. Cohn forwarded Mr. Ruzika ’s report to M essrs. Blankfein and W inkelried. Id. See also 6/8/2007 email from Kevin Gasvoda, “Project Omega - Mortgages MTM of Resids, ” GS MBS-E-013411815 (working on potential deal to sell marked- down mortgage residuals). 2032 2033 2034 See Goldman Sachs response to Subcommittee QFR at PSI_QFR_GS0039. Id. Using loan data, the U.S. mortgage industry had developed anticipated default rates, including EPDs, for different mortgage classes, such as subprime, Alt A, and prime loans. These default rates, however, were based in large part on past loan underwriting practices and loan types that bore little resemblance to the loans issued in the years leading up to the financial crisis, as explained in Chapter V of this Report. In 2006, subprime loans began to experience higher than anticipated EPD rates, and lenders were hit by unanticipated repurchase demands they could not afford to pay. The first EPD-related mortgage lender failures occurred in late 2006, and bankruptcies continued throughout 2007. 2035 See, e.g., 3/26/2007 “Subprime Mortgage Business,” Goldman presentation to Board of Directors, at 3-5, GS MBS-E-005565527 at 532, Hearing Exhibit 4/27-22 (timeline showing Ownit, a subprime lender, filed for bankruptcy on December 28, 2006, and list of subprime related businesses bankrupted, suspended, closed, sold, or put up for sale). and did not attempt to identify and weed out all deficient mortgages. 2036 Instead, Goldman purchased loan pools with the expectation that they would incur a certain rate of defaults. In late 2006, however, like other Wall Street firms, Goldman began to see much higher than anticipated delinquency and default rates in the loan pools in its inventory and warehouse accounts, and in the subprime RMBS and CDO securitizations it originated. 2037 Defaulted loans generally could not be sold or securitized, and had to be terminated through foreclosure proceedings or sold in so-called “scratch and dent” pools that generally produced less money than the loans cost to buy. In addition, defaulted loans meant that the borrowers who took out those loans stopped making loan payments to the securitized loan pool, reducing the cashflow into the related securities. RMBS and CDO securities whose underlying assets incurred high rates of loan delinquencies and defaults experienced reduced cashflows, lost value, and sometimes failed altogether, resulting in substantial losses for investors. CHRG-111shrg57321--181 Mr. McDaniel," As I said, we are interested in---- Senator Kaufman. What would you attribute the incredible growth during this period to, great management practices? " FOMC20070628meeting--354 352,CHAIRMAN BERNANKE., So the practical implication is that it really wouldn’t be legitimate if we agree with that to dissent on the description of the economy or inflation. FOMC20070628meeting--273 271,MR. KOHN.," Yes. As Vincent pointed out, we’ll have another round, a practice round this time and maybe even another one." CHRG-109shrg24852--49 Chairman Greenspan," Well, Senator, actually all of these loans, properly used, are not bad instruments. In other words, they give the consumers, the mortgagors, indeed the mortgagees as well, a broader set of instruments which can be employed, so there is greater consumer choice. Our concern is that a number of these instruments are being used to enable people to purchase homes who would otherwise not have been able to do so. In other words, they are stretching to make the payments, and that is not good lending practice for banks or other purveyors of mortgages, and certainly it is not good practice on the part of pending homeowners. It is a concern to us. Fortunately, it is not a large enough part of the market to create serious systemic problems, but it is an issue, and we at the Federal Reserve and other banking supervisors are looking at that. We are examining these issues, and we are making decisions as to what, if any, guidance to the banking system we would endeavor to convey. Senator Allard. So just to follow up on that, you do not see any need for any kind of legislative remedy or anything at this point in time? " CHRG-110hhrg46591--341 Mr. Garrett," I thank the chairman and I thank you all here for your testimony. One of the things, obviously, that has led to the macro issue, the credit problem issue they are currently experiencing as indicated earlier, is the problems in the mortgage sector. I thought I would take a moment to discuss an alternative to our current mortgage securitization process, and I think one of your members mentioned it before, just very briefly, and that is covered bonds. Covered bonds, as you know, have been used effectively in Europe for centuries and recently were introduced in the United States. Basically, they are debt instruments created from high-quality assets and they are held--and this important--on the bank's balance sheet and secured by a pool, and that is why it is called a covered pool of mortgages. And so in contrast to mortgage securitization where loans are made and then sold off to investors, a covered bond is a debt instrument issued by the lending institutions to the investors. And this debt is then backed or covered by that pool of typically high-rated AAA mortgages, and they then act as the collateral for the investor in the case of a bank failure. This structure keeps the mortgages on a lending institution's balance sheet. And that also provides for greater accountability, if you will, as to the high underwriting standards. And they have the potential to aid and return liquidity to the mortgage marketplace we are in today through improved underwriting and accountability. I will just say as an aside, I dropped in a bill, H.R. 6659, the Equal Treatment of Covered Bonds Act of 2008, and this legislation will clear up some of the ambiguities in the current law and codify several existing parameters of the market. It enshrines in the investment tool the law that will provide greater certainty, stability, and permanency for covered bonds. In addition, the spreads would be narrower, which will encourage more institutions to enter into the covered bond marketplace. And it is a goal to provide an environment through its legislation in which the market would be able to flourish, as it used to be, and produce increased liquidity. So legislation covered bonds provide for a greater sense of legal security than ones through regulations. And so, Mr. Ryan, I will throw that out to you. I know SIFMA announced at the end of July, in the summer, that it was creating a U.S. covered bonds traders committee, possible investors that would support the growth of covered bonds market in the United States and play an active role in fostering and strengthening this market. I know that there have been a lot of other things going on as far as other proposals and recommendations that you have been talking on. But I would ask you, first of all, how is the committee going, what do you see for the future? And then I have another couple of questions. " FOMC20070509meeting--55 53,MR. POOLE.," Thank you, Mr. Chairman. The anecdotal reports that I have accumulated since we last met are almost—I guess I should eliminate “almost”—are unambiguously on the soft side. I emphasize “soft,” which I think is a better word than “weak,” except perhaps with my trucking industry contact, who says that volume in both March and April is down 6 percent over a year ago and does not know exactly what is happening. Trucking company bankruptcies are up sharply—24 percent above a year ago. Truck shipping rates are weak—for the first quarter they were up just slightly year over year, and in the second quarter they were down a couple of percentage points. My contact says that the volume declines are general across the country and widespread across industry segments. The company has reduced capacity and will continue to do so, and others in the industry are doing the same thing. So there is a big inventory of used trucks sitting out there in the market, and some of these trucks are being sold abroad. In the package delivery business are FedEx and UPS. I mention the names of those companies because it is obvious who is in the package delivery business; you cannot really disguise that. [Laughter] FedEx says that the business is coming in a little below plan and that its volume in less-than-truckload business is flat. Others are down. Domestic express volume is down 2 percent year over year. The ground package network is growing substantially—a lot of that is diversion from the express business because ground delivery is cheaper. FedEx may be delaying some of its expansion projects, putting them off three to twelve months—not fundamentally changing its long- run expansion plans but delaying some capital expenditures, which are expected to be down 10 percent from the earlier plan for this year but still up 10 percent over the previous fiscal year. My contact expressed confidence that the slowdown is temporary; he expects a pickup in the August- September timeframe. FedEx has no difficulty in hiring the people the company needs except in accounting and audit fields. I heard essentially the same story from UPS. Ground volume there is up about 2 percent year over year. UPS is having to discount rates after putting through price increases last year. Cap-ex is up somewhat in ’07 compared with ’06. Profit margins are under huge pressure; the pricing environment is very competitive. I developed a new contact in the QSR industry. Now, you may not know what the QSR industry is, but it stands for “quick serve restaurants.” Other people call it fast food. [Laughter] In the restaurant business, the casual dining industry is a more discretionary kind of outlay, and that traffic is down 7 percent year over year. Traffic in the QSR industry is down 5 to 6 percent. This is across the industry, all the different companies in that business. They have been putting through price increases of roughly 3 percent. So in terms of dollar volume, their comps are down—in the 3 percent to 4 percent area. My contact from a large U.S. bank notes that the economy is in a soft patch that may be extended for a while and that business cash flow and balance sheets are solid. There is something of a mystery as to why cap-ex is not stronger. From proprietary, internal data on credit card usage, I learned that the growth of credit card usage is slowing; it had been about 5 percent year over year and is down to 4 percent. On an early reading of the April data, “distinctly weak” was the comment. Particularly, non-auto sales may have declined—I guess we get the retail sales number on Friday. It is likely that April retail sales are weak. Talking about credit demand, a lot of the demand for C&I loans, according to my contact, is really not the standard C&I type of thing but instead is being driven primarily by merger and acquisition activity, hedge funds, private equity, and state and local government borrowing. Credit quality remains very high. On the outlook, my take is that the economy has slowed, and the real issue is whether we have a temporary soft patch from which the economy will recover on its own or whether this is the beginning of a cumulative weakness. It is often the case, particularly if you think about some of the models of business cycles, that weakness after a time can feed on itself and become cumulative. I do not think that we know enough to be able to make really a solid estimate on that. I would note that we likely do not have an inventory complication, which has been so important in past business- cycle developments. Inventories seem to be pretty well controlled on the whole. Also, output is certainly being supported by the stock market and by a weaker dollar. I would also note the unabated growth in the monetary aggregates, both MZM and M2—we see no sign of traditional downturn behavior from those measures. I will stop there. Thank you." CHRG-110hhrg41184--88 Mr. Meeks," Thank you, Mr. Chairman. It is good to be with you, Chairman Bernanke. You know, sometimes you get some of these conditions, and you do one thing and it helps, you do something else and it hurts. And such is the situation that I think that we are currently in. It seems to me that if you move aggressively to cut interest rates and stimulate the economy, then you risk fueling inflation, on top of the fact that we have a weak dollar and a trade deficit. You know, you have to go into one direction or the other. Which direction are you looking at focusing on first? " FOMC20070918meeting--60 58,MR. STOCKTON.," That is basically correct. I mean, we expect some recovery. We weren’t expecting that August figure to prevail through the forecast period. If that were to occur, we would be looking at an even weaker outlook than we are seeing. Again, in all these things, I don’t want to make it sound too precise, but we do think underwriting standards and the cost of consumer credit are likely to increase, and that rise is likely to impinge on consumer spending. In our models, the fed funds rate shows up in our consumption equation. We have some consumption equations that we run with consumer credit rates. They don’t actually do any better than our standard equation. So we have added a little for something that we think is outside the model on consumption, probably operating through the credit channel. But I don’t want to deny that in some sense, again, if we saw a significant rebound in consumer sentiment from its current levels into the low 90s, it would be inconsistent with what we are currently forecasting." CHRG-110hhrg44901--73 Mr. Bernanke," Well, on commercial real estate, this was an area where the Federal Reserve and other Federal bank regulators issued guidance several years ago requiring banks that held very high concentrations of commercial real estate to make sure that they were underwriting properly, that they had good risk management. And I believe that guidance, which some people complained about at the time, I think that is going to help us in the near term as we face the situation. Certainly as the economy weakens there is going to be a somewhat weaker performance of commercial real estate. But to this point, we are not seeing anything remotely like, you know, what we have seen in the mortgage market. But it is obviously something we are going to have to keep our eye on. Ms. Pryce. Can you comment on anything that is happening at the Fed in terms of future planning out for other contingencies? You know what I mean. So that we have less of, you know, a reactionary mode in the future? " FOMC20060328meeting--231 229,MR. FISHER.," Mr. Chairman, this issue of tightening is kind of like Pascal’s wager about the existence of God, and our personal gain–loss ratio as central bankers indicates an answer in the affirmative. That is, I do think Vice Chairman Geithner made a very good point about expectations and about the expectations of how we will perform our duties. Despite the question I asked earlier about row 4, I am in favor of further tightening. I am in favor because I believe that the tightening that we’ve done, although we don’t yet have answers to the question we’ve asked about lags, doesn’t seem to have done much harm in terms of slowing the pace of economic expansion. I would like to build a reserve that we can then subtract from if we need to respond to weakness. And so I am in favor of tightening, and I am in favor of continued tightening because (1) it seems not to be doing great damage to economic growth, which is stout, (2) I’d like to have something to give back when we see weakness, and (3) I’d like to ward off inflation. I have only one request on the wording, and that is that we insert the word “global” before “resource utilization.” [Laughter] Thank you. I never give up." CHRG-110hhrg34673--58 Mr. Bernanke," Congressman, we have found that it is very difficult to write rules in advance that strike out entire practices under all circumstances. We find it is more effective to be flexible and work on a case-by-case basis. It is one of these things like, ``You know it when you see it.'' And so what we have done rather than write specific rules, is to work with the FDIC to develop a set of principles, and there has been much talk lately about principles-based regulation. One of the principles on which we are making these decisions provides guidance to the banking agencies for implementing to take action against unfair and deceptive acts and practices, and we believe that set of principles provides full authority for not only us, but also the OCC and other agencies to take actions to prevent unfair and deceptive acts or practices. So, for example, the OCC has recently taken substantial action, I think it was a credit card case, based on this, and they were not inhibited from taking those actions because of any lack of rulemaking. Again, whether an act is unfair and deceptive depends often frequently on the context and circumstances. " FinancialCrisisReport--162 Over the five-year period reviewed by the Subcommittee, OTS examiners identified over 500 serious deficiencies in WaMu operations. Yet OTS did not once, from 2004 to 2008, take a public enforcement action against Washington Mutual, even when the bank failed to correct major problems. Only in late 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, but neither action was sufficient 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 at the bank. 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. OTS not only failed to prevent Washington Mutual from engaging in unsafe and unsound lending practices, it gave its tacit approval and allowed high risk loans to proliferate. As long as Washington Mutual was able to sell off its risky loans, neither OTS nor the FDIC expressed concerns about the impact of those loans elsewhere. By not sounding the alarm, OTS and the FDIC enabled WaMu to construct a multi-billion-dollar investment portfolio of high risk mortgage assets, and also permitted WaMu to sell hundreds of billions of dollars in high risk, poor quality loans and securities to other financial institutions and investors in the United States and around the world. Similar regulatory failings by OTS, the FDIC, and other agencies involving other lenders repeated these problems 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 these losses were a proximate cause of the financial crisis. A. Subcommittee Investigation and Findings of Fact To analyze regulatory oversight of Washington Mutual, the Subcommittee subpoenaed documents from OTS, the FDIC, and WaMu, including bank examination reports, legal pleadings, reports, internal memoranda, correspondence, and email. The Subcommittee also conducted over two dozen interviews with OTS, FDIC, and WaMu personnel, including the FDIC Chairman, OTS Director, OTS and the FDIC senior examiners assigned to Washington Mutual, and senior WaMu executives. The Subcommittee also spoke with personnel from the Offices of the Inspector General (IG) at the FDIC and the Department of Treasury, who were engaged in a joint review of WaMu’s failure. In addition, the Subcommittee spoke with nearly a dozen experts on a variety of banking, accounting, regulatory, and legal issues. On April 16, 2010, the Subcommittee held a hearing at which OTS, the FDIC, and IG officials provided testimony; released 92 hearing exhibits; and released the FDIC and Treasury IGs’ joint report on CHRG-111shrg55739--17 Mr. Barr," So let me just say, we tried to draw a line in our proposal. We have tried to be quite clear that the Government should not be in the business of designing the methodologies for the rating agencies or validating them in any way, because we think that will just increase reliance on them. We have been quite clear that they need to disclose whatever due diligence they do so that there is transparency so that investors know when they get a rating--the rating company would say, ``We didn't do any due diligence on this rating,'' or the rating company would have to say, ``The due diligence we did consisted of calling our buddy.'' Or hopefully when the transparency kicks in, the rating agency would have to say, ``We did real due diligence. We had a third party, and they can certify they actually checked loan files.'' And I think that with that level of transparency, it will be very hard for--harder for rating agencies to continue a practice of--at least a mixed practice with respect to the kind of due diligence they have done. " CHRG-111hhrg54872--115 The Chairman," The gentleman from Kansas. Mr. Moore of Kansas. Thank you, Mr. Chairman. Mr. John, on page 4 of your testimony, you say the CFPA proposed list was filled with poorly considered departures from existing law and practices that are as likely to damage consumers' interest has improved them. You suggest a council of consumer financial regulators would be sufficient. Do you really think existing law and practice, in your words, worked to prevent the financial crisis last year, sir? " fcic_final_report_full--26 Officials in Cleveland and other Ohio cities reached out to the federal government for help. They asked the Federal Reserve, the one entity with the authority to regulate risky lending practices by all mortgage lenders, to use the power it had been granted in  under the Home Ownership and Equity Protection Act (HOEPA) to issue new mortgage lending rules. In March , Fed Governor Edward Gramlich, an ad- vocate for expanding access to credit but only with safeguards in place, attended a conference on the topic in Cleveland. He spoke about the Fed’s power under HOEPA, declared some of the lending practices to be “clearly illegal,” and said they could be “combated with legal enforcement measures.”  Looking back, Rokakis remarked to the Commission, “I naively believed they’d go back and tell Mr. Greenspan and presto, we’d have some new rules. . . . I thought it would result in action being taken. It was kind of quaint.”  In , when Cleveland was looking for help from the federal government, other cities around the country were doing the same. John Taylor, the president of the Na- tional Community Reinvestment Coalition, with the support of community leaders from Nevada, Michigan, Maryland, Delaware, Chicago, Vermont, North Carolina, New Jersey, and Ohio, went to the Office of Thrift Supervision (OTS), which regu- lated savings and loan institutions, asking the agency to crack down on what they called “exploitative” practices they believed were putting both borrowers and lenders at risk.  The California Reinvestment Coalition, a nonprofit housing group based in Northern California, also begged regulators to act, CRC officials told the Commis- sion. The nonprofit group had reviewed the loans of  borrowers and discovered that many individuals were being placed into high-cost loans when they qualified for better mortgages and that many had been misled about the terms of their loans.  FinancialCrisisReport--168 During the year, OTS examiners issued “findings memoranda,” which set forth particular examination findings, and required a written response and corrective action plan from WaMu management. The memoranda contained three types of findings. The least severe was an “observation,” defined as a “weakness identified that is not of regulatory concern, but which may improve the bank’s operating effectiveness if addressed. … Observations may or may not be reviewed during subsequent examinations.” The next level of finding was a “recommendation,” defined as a “secondary concern requiring corrective action. … They may be included in the Report of Examination … Management’s actions to address Recommendations are reviewed at subsequent or follow-up examinations.” The most severe type of finding was a “criticism,” defined as a “primary concern requiring corrective action … often summarized in the ‘Matters Requiring Board Attention’ … section of the Report of Examination. … They are subject to formal follow-up by examiners and, if left uncorrected, may result in stronger action.” 606 The most serious OTS examination findings were elevated to Washington Mutual Bank’s Board of Directors by designating them as a “Matter Requiring Board Attention” (MRBA). MRBAs were set forth in the ROE and presented to the Board in an annual meeting attended by OTS and FDIC personnel. Washington Mutual tracked OTS findings, along with its own responses, through an internal system called Enterprise Risk Issue Control System (ERICS). ERICS was intended to help WaMu manage its relationship with its regulators by storing the regulators’ findings in one central location. In one of its more unusual discoveries, the Subcommittee learned that OTS also came to rely largely on ERICS to track its dealings with WaMu. OTS’ reliance on WaMu’s tracking system was a unique departure from its usual practice of separately tracking the status of its past examination findings and a bank’s responses. 607 The FDIC also participated in the examinations of Washington Mutual. Because WaMu was one of the eight largest insured banks in the country, the FDIC assigned a full-time Dedicated Examiner to oversee its operations. Typically, the FDIC examiners worked with the primary regulator and participated in or relied upon the examinations scheduled by that regulator, rather than initiating separate FDIC examinations. At least once per year, the FDIC examiner performed an evaluation of the institution’s risk to the Deposit Insurance Fund, typically relying primarily on the annual Report on Examination (ROE) issued by the primary regulator and the ROE’s individual and composite CAMELS ratings for the institution. After reviewing the ROE as well as other examination and financial information, the FDIC examiner reviewed the CAMELS ratings for WaMu to ensure they were appropriate. 606 Descriptions of these terms appeared in OTS findings memoranda. See, e.g., 6/19/2008 OTS Findings Memorandum of Washington Mutual Bank, at Bisset_John-00046124_002, Hearing Exhibit 4/16-12a. 607 See April 16, 2010 Subcommittee Hearing at 21 (information supplied by Treasury IG Thorson for the record). CHRG-111hhrg48874--206 Mr. Menzies," Thank you, Mr. Chairman. Thank you, Ranking Member Bachus. It is certainly my honor to be here. As you said, I am president of Easton Bank and Trust from the beautiful Eastern Shore of Maryland. I am especially proud to be the new chairman of the Independent Community Bankers of America. We are a $170 million bank on the Eastern shore, a community bank, a Subchapter S bank. I am thrilled to represent some 8,000 banks from around this Nation and our 5,000 members in the ICBA to talk about exploring the balance between increased credit availability and prudent lending standards. Notwithstanding Mr. Long's concern that community banks are overextended, and community banks need to be prepared for a worse environment, the vast majority of community banks are well capitalized, well managed institutions, actively participating in the economic recovery by lending to small and medium-sized businesses and consumers in their communities. Community banks represent thousands of communities throughout the Nation and they make relationship-based decisions. We do not make decisions based solely on scoring models or rating agencies, algorithms or computer simulations. However, the community bank regulatory climate is causing many community banks to unnecessarily restrict lending activities. For one, there appears to be a disconnect between the banking regulators in Washington who are promoting lending, and we are hearing this, and the field examination staff who require overly aggressive write-down's and reclassifications of viable commercial real estate loans and other assets. Yes, Mr. Bachus, what they are saying at the top is not reaching the bottom. Community bankers report that examiners require write-down's or classifications of performing loans due to the value of collateral irrespective of the income or the cash flow or the liquidity of the borrower. By placing loans on non-accrual, even though the borrower is current on payments, discounting entirely the value of guarantors, substituting the examiner judgment for that of the appraiser, and de-valuing loans merely because it is lying in or close to an area of high foreclosure levels, this all reduces credit available to communities. What we expect is examiners to be more thorough and careful with their examinations during an economic downturn. Based on what we have heard from our members, we believe that in many cases, examiners have gone too far. Excessively through exams that result in potentially unnecessary losses of earnings and capital can have an adverse impact on the ability of community banks to lend, since community banks are the prime engine behind small business lending, any contraction of lending further exacerbates the current economic downturn and impedes the flow of loans to creditworthy borrowers. Community banks are not de-leveraging. We are leveraging up and we need to continue to leverage up. ICBA does appreciate the recent overtures from banking regulators to improve the examination environment for better communications between banks and regulators, and the education of agency field staffs on the consequences of overly restrictive examination practices on credit availability. We have several recommendations in our written testimony that would create a regulatory environment that promotes community bank lending. I would like to highlight a few. Number one, examiners must take a long-term view toward real estate held by banks as collateral on loans and not demand aggressive write-down's and reclassifications of loans because illiquid or dysfunctional markets have forced sales. Real estate assets are long-term assets, and should not be based upon the short-term business cycle valuations that we are facing today. Number two, unlike some large money center in regional banks, the hallmark of community bank loan underwriting is a personal relationship with the borrowers we lend to, and character does in fact count in community bank lending. During this economic crisis, regulators should allow a bank to hold a small basket of character loans from borrowers who have a strong record of meeting contractual obligations and where there are other indicators that support the repayment of that loan. Loans in the basket would be exempt from strict underwriting standards and could not be criticized by examiners as long as they are performing. The amount of loans that could be held in such a basket might be a percentage of capital. Three, the examination in the field process should be strengthened to make it easier for bankers to appeal without fear of examination retaliation. Agency ombudsman determinations should be strengthened and the ombudsman made more independent. Four, the FDIC should find an alternative, and we are pleased they are seeking an alternative, to the 20 basis points special assessment which would consume much of bank earnings in 2009 and further constrain lending. The special assessment should include a systematic risk premium and be based on assets. I have never lost based on deposits and liabilities. Five, OTTI accounting rules are distorting the true value of financial firms and needlessly exacerbating the credit crisis. This does not serve the best interest of investors or the economy. We appreciate the committee's efforts to resolve this accounting issue. We believe FASB's recent proposal could be a positive step in resolving mark-to-market problems. We will be providing further suggestions and clarifications to the FASB. If there is time later, I would be happy to comment about this subject to performing loans, I have strong opinions about the meaning of a ``performing loan'' in today's regulatory world. Thank you so much for this opportunity. [The prepared statement of Mr. Menzies can be found on page 151 of the appendix.] " CHRG-111shrg55479--57 Mr. Castellani," Senator, in fact, many of the Roundtable companies do and have adopted many of the practices that are in your proposal. The difference-- Senator Schumer. And you cite that with pride. " CHRG-110hhrg46591--75 Mr. LaTourette," Thank you. Mr. Chairman, Mr. Seligman is practically jumping out of his chair to comment on the mark to market. " CHRG-111hhrg56776--13 Mr. Volcker," I appreciate your invitation to address important questions concerning the link between monetary policy and Federal Reserve responsibilities for the supervision and regulation of financial institutions. Before addressing the specific questions you have posed, I would like to make clear my long-held view, a view developed and sustained by years of experience in the Treasury, the Federal Reserve, and in private finance. Monetary policy and concerns about the structure and condition of banks in the financial system more generally are inextricably intertwined, and if you need further proof of that proposition, just consider the events of the last couple of years. Other agencies, certainly including the Treasury, have legitimate interests in regulatory policy, but I do insist that neither monetary policy nor the financial system will be well served if our central bank is deprived from interest in and influence over the structure and performance of the financial system. Today, conceptual and practical concerns about the extent, the frequency, and the repercussions of economic and financial speculative excesses have come to occupy our attention. The so-called ``bubbles'' are indeed potentially disruptive of economic activity. Then important and interrelated questions arise for both monetary and supervisory policies. Judgment is required about if and when an official response, some form of intervention is warranted. If so, is there a role for monetary policy, for regulatory actions, or for both? How can those judgments and responses be coordinated and implemented in real time in the midst of crisis in a matter of days? The practical fact is the Federal Reserve must be involved in those judgments and that decision-making, beyond this broad responsibility for monetary policy and its influence on interest rates. It is the agency that has the relevant technical experience growing out of working in the financial markets virtually every day. As a potential lender of last resort, the Fed must be familiar with the condition of those to whom it lends. It oversees and participates in the basic payment system, domestically and internationally. In sum, there is no other official institution that has the breadth of institutional knowledge, the expertise, and the experience to identify market and institutional vulnerabilities. It also has the capability to act on very short notice. The Federal Reserve, after all, is the only agency that has financial resources at hand in amounts capable of emergency response. More broadly, I believe the experience demonstrates conclusively that the responsibilities of the Federal Reserve with respect to maintaining economic and financial stability require close attention to manage beyond the specific confines of monetary policy, if we interpret monetary policy narrowly, as influencing monetary aggregates and short-term interest rates. For instance, one recurring challenge in the conduct of monetary policy is to take account of the attitudes and approaches of banking supervisors as they act to stimulate or to restrain bank lending, and as they act to adjust capital standards of financial institutions. The need to keep abreast of rapidly developing activity in other financial markets, certainly including the markets for mortgages and derivatives, has been driven home by the recent crisis. None of this to my mind suggests the need for regulatory and supervisory authority to lie exclusively in the Federal Reserve. In fact, there may be advantages in some division of responsibilities. A single regulator may be excessively rigid and insensitive to market developments, but equally clearly, we do not want competition and laxity among regulators aligning with particular constituencies or exposed to narrow political pressures. We are all familiar in the light of all that has happened with weaknesses in supervisory oversight, with failures to respond to financial excesses in a timely way and with gaps in authority. Those failings spread in one way or another among all the relevant agencies, not excepting the Federal Reserve. Both law and practice need reform. However these issues are resolved, I do believe the Federal Reserve, our central bank, with the broadest economic responsibility, with a perceived mandate for maintaining financial stability, with the strongest insulation against special political or industry pressures, must maintain a significant presence with real authority in regulatory and supervisory matters. Against that background, I respond to the particular points you raised in your invitation. I do believe it is apparent that regulatory arbitrage and the fragmentary nature of our regulatory system did contribute to the nature and extent of the financial crisis. That crisis exploded with a vengeance outside the banking system, involving investment banks, the world's largest insurance company, and government-sponsored agencies. Regulatory and supervisory agencies were neither reasonably equipped nor conscious of the extent of their responsibilities. Money market funds growing over several decades were essentially a pure manifestation of regulatory arbitrage. Attracting little supervisory attention, they broke down under pressure, a point of significant systemic weakness, and the remarkable rise of the subprime mortgage market developed through a variety of channels, some without official oversight. There are large questions about the role and supervision of the two hybrid public/private organizations that came to dominate the largest of all our capital markets, that for residential mortgages. Undeniably, in hindsight, there were weaknesses and gaps in the supervision of well-established financial institutions, including banking institutions, major parts of which the Federal Reserve carries direct responsibility. Some of those weaknesses have been and should have been closed by more aggressive regulatory approaches, but some gaps and ineffective supervision of institutions owning individual banks and small thrifts were loopholed, expressly permitted by legislation. As implied by my earlier comments, the Federal Reserve, by the nature of its core responsibilities, is thrust into direct operational contact with financial institutions and markets. Beyond those contacts, the 12 Federal Reserve banks exercising supervisory responsibilities provide a window into both banking developments and economic tendencies in all regions of the country. In more ordinary circumstances, intelligence gleaned on the ground about banking attitudes and trends will supplement and color forecasts and judgments emerging from other indicators of economic activity. When the issue is timely identification of highly speculative and destabilizing bubbles, a matter that is both important and difficult, then there are implications for both monetary and supervisory policy. Finally, the committee has asked about the potential impact of stripping the Federal Reserve of direct supervisory and regulatory power over the banks and other financial institutions, and whether something can be learned about the practices of other nations. Those are not matters that permit categorical answers good for all time. International experience varies. Most countries maintain a position, often a strong position, and a typically strong position for central banks' financial supervision. In some countries, there has been a formal separation. At the extreme, all form of supervisory regulatory authority over financial institutions was consolidated in the U.K. into one authority, with rather loose consultative links to the central bank. The approach was considered attractive as a more efficient arrangement, avoiding both agency rivalries and gaps or inconsistencies in approach. The sudden pressure of the developing crisis revealed a problem in coordinating between the agency responsible for the supervision, the central bank, which needed to take action, and the Treasury. The Bank of England had to consider intervention with financial support without close and confident appraisals of the vulnerability of affected institutions. As a result, I believe the U.K. itself is reviewing the need to modify their present arrangements. For reasons that I discussed earlier, I do believe it would be a really grievous mistake to insulate the Federal Reserve from direct supervision of systemically important financial institutions. Something important but less obvious would also be lost if the present limited responsibilities for smaller member banks were to be ended. The Fed's regional roots would be weaker and an useful source of information lost. I conclude with one further thought. In debating regulatory arrangements and responsibilities appropriate for our national markets, we should not lose sight of the implications for the role of the United States in what is in fact a global financial system. We necessarily must work with other nations and their financial authorities. The United States should and does still have substantial influence in those matters, including agreement on essential elements of regulatory and supervisory policies. It is the Federal Reserve as much as and sometimes more than the Treasury that carries a special weight in reaching the necessary understandings. That is a matter of tradition, experience, and of the perceived confidence in the authority of our central bank. There is a sense of respect and confidence around the world, matters that cannot be prescribed by law or easily replaced. Clearly, changes need to be made in the status quo. That is certainly true within the Federal Reserve. I believe regulatory responsibilities should be more clearly focused and supported. The crisis has revealed the need for change within other agencies as well. Consideration of broader reorganization of the regulatory and supervisory arrangements is timely. At the same time, I urge in your deliberations that you do recognize what would be lost, not just in the safety and soundness of our national financial system, but in influencing and shaping the global system, if the Federal Reserve were to be stripped of its regulatory and supervisory responsibilities, and no longer be recognized here and abroad as ``primus inter pares'' among the agencies concerned with the safety and soundness of our financial institutions. Let us instead strengthen what needs to be strengthened and demand high levels of competence and performance that for too long we have taken for granted. Thank you, ladies and gentlemen. [The prepared statement of Chairman Volcker can be found on page 100 of the appendix.] " CHRG-111shrg54789--178 FINANCIAL PROTECTION AGENCY Although a Consumer Financial Protection Agency (CFPA) would not be a panacea for all current regulatory ills, it would correct many of the most significant structural flaws that exist, realigning the regulatory architecture to reflect the unfortunate lessons that have been learned in the current financial crisis and sharply increasing the chances that regulators will succeed in protecting consumers in the future. A CFPA would be designed to achieve the regulatory goals of elevating the importance of consumer protection, prompting action to prevent harm, ending regulatory arbitrage, and guaranteeing regulatory independence.A. Put consumer protection at the center of financial regulation. Right now, four Federal regulatory agencies are required both to ensure the solvency of the financial institutions they regulate and to protect consumers from lending abuses. \32\ Jurisdiction over consumer protection statutes is scattered over several more agencies, with rules like RESPA and TILA, which both regulate mortgage disclosures, in different agencies.--------------------------------------------------------------------------- \32\ The Office of the Comptroller of the Currency (OCC) and Office of Thrift Supervision (OTC) charter and supervise national banks, and thrifts, respectively. State chartered banks can choose whether to join and be examined and supervised by either the Federal Reserve System or the Federal Deposit Insurance Corporation (FDIC). The FTC is charged with regulating some financial practices (but not safely and soundness) in the nonbank sector, such as credit cards offered by department stores and other retailer.--------------------------------------------------------------------------- Within agencies in which these functions are combined, regulators have often treated consumer protection as less important than their safety and soundness mission or even in conflict with that mission. \33\ For example, after more than 6 years of effort by consumer organizations, Federal regulators are just now contemplating incomplete rules to protect consumers from high-cost ``overdraft'' loans that financial institutions often extend without the knowledge of or permission from consumers. Given the longstanding inaction on this issue, it is reasonable to assume that regulators were either uninterested in consumer protection or viewed restrictions on overdraft loans as an unnecessary financial burden on banks that extend this form of credit, even if it is deceptively offered and financially harmful to consumers. In other words, because regulators apparently decided that their overriding mission was to ensure that the short-term balance sheets of the institutions they regulated were strong, they were less likely to perceive that questionable products or practices (like overdraft loans or mortgage prepayment penalties) were harmful to consumers.--------------------------------------------------------------------------- \33\ Occasionally, safety and soundness concerns have led regulators to propose consumer protections, as in the eventually successful efforts by Federal banking agencies to prohibit ``rent-a-charter'' payday lending, in which payday loan companies partnered with national or out-of-State banks in an effort to skirt restrictive State laws. However, from a consumer protection point-of-view, this multiyear process took far too long. Moreover, the outcome would have been different if the agencies had concluded that payday lending would be profitable for banks and thus contribute to their soundness.--------------------------------------------------------------------------- As mentioned above, recent history has demonstrated that this shortsighted view of consumer protection and bank solvency as competing objectives is fatally flawed. If regulatory agencies had acted to prevent loan terms or practices that harmed consumers, they would also have vastly improved the financial solidity of the institutions they regulated. Nonetheless, the disparity in agencies' focus on consumer protection versus ``safety and soundness'' has been obvious, both in the relative resources that agencies devoted to the two goals and in the priorities they articulated. These priorities frequently minimized consumer protection and included reducing regulatory restrictions on the institutions they oversaw. \34\--------------------------------------------------------------------------- \34\ For example, in 2007 the OTS cited consumer protection as part of its ``mission statement'' and ``strategic goals and vision.'' However, in identifying its eight ``strategic priorities'' for how it would spend its budget in Fiscal Year 2007, only part of one of these priorities appears to be directly related to consumer protection (``data breaches''). On the other hand, OTS identified both ``Regulatory Burden Reduction'' and ``Promotion of the Thrift Charter'' as major strategic budget priorities. Office of Thrift Supervision, ``OMB FY2007 Budget and Performance Plan,'' January 2007.--------------------------------------------------------------------------- Though the link between consumer protection and safety and soundness is now obvious, the two functions are not the same, and do conflict at times. In some circumstances, such as with overdraft loans, a financial product might well be profitable, even though it is deceptively offered and has a financially devastating effect on a significant number of consumers. \35\--------------------------------------------------------------------------- \35\ Testimony of Travis Plunkett, Legislative Director, Consumer Federation of America and Edmund Mierzwinski, Consumer Program Director, U.S. PIRG, Before the Subcommittee on Financial Institutions and Consumer Credit of the U.S. House of Representatives, Committee of Financial Services, March 19, 2009.--------------------------------------------------------------------------- Until recently, regulatory agencies have also focused almost exclusively on bank examination and supervision to protect consumers, which lacks transparency. This process gives bank regulators a high degree of discretion to decide what types of lending are harmful to consumers, a process that involves negotiating behind-the-scenes with bank officials. \36\ Given that multiple regulators oversee similar institutions, the process has also resulted in different standards for products like credit cards offered by different types of financial institutions. In fact, widespread abusive lending in the credit markets has discredited claims by bank regulators like the Comptroller of the Currency that a regulatory process consisting primarily of supervision and examination results in a superior level of consumer protection compared to taking public enforcement action against institutions that violate laws or rules. \37\ Financial regulatory enforcement actions are a matter of public record which has a positive impact on other providers who might be engaged in the same practices and provides information to consumers on financial practices sanctioned by regulators.--------------------------------------------------------------------------- \36\ ``Findings made during compliance examinations are strictly confidential and are not made available to the public except at the OCC's discretion. Similarly, the OCC is not required to publish the results of its safety-and-soundness orders . . . . Thus, the OCC's procedures for compliance examinations and safety-and-soundness orders do not appear to provide any public notice or other recourse to consumers who have been injured by violations identified by the OCC.'' Testimony of Arthur E. Wilmarth, Jr., Professor of Law, George Washington University Law School, before the Subcommittee on Financial Institutions and Consumer Credit of the House Financial Services Committee, April 26, 2007. \37\ `` . . . ours is not an `enforcement-only' compliance regime--far better to describe our approach as `supervision first, enforcement if necessary,' with supervision addressing so many early problems that enforcement is not necessary,'' Testimony of John C. Dugan, Comptroller of the Currency, before the Committee on Financial Services of the U.S. House of Representatives, June 13, 2007.--------------------------------------------------------------------------- Additionally, the debate about the financial and foreclosure crisis often overlooks the fact that predatory lending practices and the ensuing crisis have had a particularly harsh impact on communities of color. African Americans and Latinos suffered the brunt of the predatory and abusive practices found in the subprime market. While predatory and abusive lending practices were not exclusive to the subprime market, because of lax regulation in that sector, most abuses were concentrated there. Several studies have documented pervasive racial discrimination in the distribution of subprime loans. One such study found that borrowers of color were more than 30 percent more likely to receive a higher-rate loan than White borrowers even after accounting for differences in creditworthiness. \38\ Another study found that high-income African Americans in predominantly Black neighborhoods were three times more likely to receive a subprime purchase loan than low-income White borrowers. \39\--------------------------------------------------------------------------- \38\ See Bocian, D.G., K.S. Ernst, and W. Li, ``Unfair Lending: The Effect of Race and Ethnicity on the Price of Subprime Mortgages,'' Center for Responsible Lending, May 2006. \39\ ``Unequal Burden: Income and Racial Disparities in Subprime Lending in America'' (Washington, DC: HUD, 2000).--------------------------------------------------------------------------- African Americans and Latinos receive a disproportionate level of high cost loans, even when they quality for a lower rate and/or prime mortgage. Fannie Mae and Freddie Mac estimated that up to 50 percent of those who ended up with a sub prime loan would have qualified for a mainstream, ``prime-rate'' conventional loan in the first place. \40\ According to a study conducted by the Wall Street Journal, as much as 61 percent of those receiving subprime loans would ``qualify for conventional loans with far better terms.'' \41\ Moreover, racial segregation is linked with the proportion of subprime loans originated at the metropolitan level, even after controlling for percent minority, low credit scores, poverty, and median home value. \42\ The resulting flood of high cost and abusive loans in communities of color has artificially elevated the costs of homeownership, caused unprecedented high rates of foreclosures, and contributed to the blight and deterioration of these neighborhoods. It is estimated that communities of color will realize the greatest loss of wealth as a result of this crisis, since Reconstruction.--------------------------------------------------------------------------- \40\ See the Center for Responsible Lending's ``Fact Sheet on Predatory Mortgage Lending'', at http://www.responsiblelending.org/pdfs/2b003-mortgage2005.pdf, and ``The Impending Rate Shock: A Study of Home Mortgages in 130 American Cities'', ACORN, August 15, 2006, available at www.acorn.org. \41\ See ``Subprime Debacle Traps Even Very Creditworthy'', Wall Street Journal, December 3, 2007. \42\ Squires, Gregory D., Derek S. Hyra, and Robert N. Renner, ``Segregation and the Subprime Lending Crisis'', Paper presented at the 2009 Federal Reserve System Community Affairs Research Conference, Washington, DC (April 16, 2009).--------------------------------------------------------------------------- A CFPA, by contrast, would have as its sole mission the development and effective implementation of standards that ensure that all credit products offered to borrowers are safe and not discriminatory. The agency would then enforce these standards for the same types of products in a transparent, uniform manner. Ensuring the safety and fairness of credit products would mean that the CFPA would not allow loans with terms that are discriminatory, deceptive or fraudulent. The agency should also be designed to ensure that credit products are offered in a fair and sustainable manner. In fact, a core mission of the CFPA would be to ensure the suitability of classes of borrowers for various credit products, based on borrowers' ability to repay the loans they are offered--especially if the cost of loans suddenly or sharply increase, and that the terms of loans do not impose financial penalties on borrowers who try to pay them off. As we've learned in the current crisis, focusing exclusively on consumer and civil rights protection would often be positive for lenders' stability and soundness over the long term. However, the agency would be compelled to act in the best interest of consumers even if measures to restrict certain types of loans would have a negative short-term financial impact on financial institutions.B. Prevent regulatory arbitrage. Act quickly to prevent unsafe forms of credit. The present regulatory system is institution centered, rather than consumer centered. It is structured according to increasingly irrelevant distinctions between the type of financial services company that is lending money, rather than the type of product being offered to consumers. Right now, financial institutions are allowed (and have frequently exercised their right) to choose the regulatory body that oversees them and to switch freely between regulatory charters at the Federal level and between State and Federal charters. Many financial institutions have switched charters in recent years seeking regulation that is less stringent. Two of the most notorious examples are Washington Mutual and Countrywide, \43\ which became infamous for promoting dangerous sub-prime mortgage loans on a massive scale. \44\ Both switched their charters to become thrifts regulated by the Office of Thrift Supervision (OTS). At the Federal level, where major agencies are funded by the institutions they oversee, this ability to ``charter shop,'' has undeniably led regulators like the OTS to compete to attract financial institutions by keeping regulatory standards weak. It has also encouraged the OTS and OCC to expand their preemptive authority and stymie efforts by the States to curb predatory and high-cost lending. The OCC in particular appears to have used its broad preemptive authority over State consumer protections and its aggressive legal defense of that authority as a marketing tool to attract depository institutions to its charter. \45\--------------------------------------------------------------------------- \43\ Of course, following their stunning collapses, Countrywide was acquired by Bank of America and Washington Mutual by Chase, both in regulator-ordered winding-downs. \44\ In fact, several other large national banks have chosen in recent years to convert their State charter to a national charter. Charter switches by JPMorgan Chase, HSBC, and Bank of Montreal (Harris Trust) alone in 2004-05 moved over $1 trillion of banking assets from the State to the national banking system, increasing the share of assets held by national banks to 67 percent from 56 percent, and decreasing the State share to 33 percent from 44 percent. Arthur E. Wilmarth, Jr., ``The OCC's Preemption Rules Threaten to Undermine the Dual Banking System, Consumer Protection and the Federal Reserve Board's role in Bank Supervision'', Proceedings of the 42nd Annual Conference on Bank Structure and Competition (Fed. Res. Bank of Chicago, 2006) at 102, 105-106. \45\ For a detailed analysis, see brief amicus curiae of Center for Responsible Lending et al. in the case currently before the Supreme Court, Cuomo v. Clearinghouse and OCC (08-453) available at http://www.abanet.org/publiced/preview/briefs/pdfs/07-08/08-453_PetitionerAmCu10ConsumerProtectionOrgs.pdf (last visited 21 June 2009) at pp. 20-39.--------------------------------------------------------------------------- When agencies do collaborate to apply consumer protections consistently to the institutions they regulate, the process has been staggeringly slow. As cited in several places in this testimony, Federal regulators dithered for years in implementing regulations to stop unfair and deceptive mortgage and credit card lending practices. One of the reasons for these delays has often been that regulators disagree among themselves regarding what regulatory measures must be taken. The course of least resistance in such cases is to do nothing, or to drag out the process. Although the credit card rule adopted late last year by Federal regulators was finalized over protests from the OCC, these objections were likely one of the reasons that Federal regulators delayed even beginning the process of curbing abusive credit card lending practices until mid-2008. The ``charter shopping'' problem would be directly addressed through the creation of a single CFPA with regulatory authority over all forms of credit. Federal agencies would no longer compete to attract institutions based on weak consumer protection standards or anemic enforcement of consumer rules. The CFPA would be required to focus on the safety of credit products, features and practices, no matter what kind of lender offered them. As for regulatory competition with States, it would only exist to improve the quality of consumer protection. Therefore, the CFPA should be allowed to set minimum national credit standards, which States could then enforce (as well as victimized consumers). States would be allowed to exceed these standards if local conditions require them to do so. If the CFPA sets ``minimum'' standards that are sufficiently strong, a high degree of regulatory uniformity is likely to result. With strong national minimum standards in place, States are most likely to act only when new problems develop first in one region or submarket. States would then serve as an early warning system, identifying problems as they develop and testing policy solutions, which could then be adopted nationwide by the CFPA if merited. Moreover, the agency would have a clear incentive to stay abreast of market developments and to act in a timely fashion to rein in abusive lending because it will be held responsible for developments in the credit market that harm consumers.C. Create an independent regulatory process. The ability of regulated institutions to ``charter shop'' combined with aggressive efforts by Federal regulators to preempt State oversight of these institutions has clearly undermined the independence of the OTS and OCC. This situation is made worse by the fact that large financial institutions like Countrywide were able to increase their leverage over regulators by taking a significant chunk of the agency's budget away when it changed charters and regulators. The OTS and OCC are almost entirely funded through assessments on the institutions they regulate (see Appendix 4). The ability to charter shop combined with industry funding has created a significant conflict-of-interest that has contributed to the agencies' disinclination to consider upfront regulation of the mortgage and consumer credit markets. Given that it supervises the largest financial institutions in the country, the OCC's funding situation is the most troublesome. More than 95 percent of the OCC's budget is financed by assessments paid by national banks, and the twenty biggest national banks account for nearly three-fifths of those assessments. Large, multistate banks were among the most outspoken supporters of the OCC's preemption regulations and were widely viewed as the primary beneficiaries of those rules. In addition to its preemption regulations, the OCC has frequently filed amicus briefs in Federal court cases to support the efforts of national banks to obtain court decisions preempting State laws. The OCC's effort to attract large, multistate banks to the national system have already paid handsome dividends to the agency . . . . Thus, the OCC has a powerful financial interest in pleasing its largest regulated constituents, and the OCC therefore faces a clear conflict of interest whenever it considers the possibility of taking an enforcement action against a major national bank. \46\--------------------------------------------------------------------------- \46\ Testimony of Arthur E. Wilmarth. Jr., Professor of Law, George Washington University Law School, before the Subcommittee on Financial Institutions and Consumer Credit of the House Financial Services Committee, April 26, 2007. The leadership sofa CFPA would be held to account based on its ability to inform consumers and help protect them from unsafe products. In order to function effectively, the leadership would need to show expertise in and commitment to consumer protection. Crucial to the success of the agency would be to ensure that its funding is adequate, consistent and does not compromise this mission. Congress could also ensure that the method of agency funding that is used does not compromise the CFPA's mission by building accountability mechanisms into the authorizing statute and exercising effective oversight of the agency's operations. (See Section 4 below.) Recent history has demonstrated that even an agency with an undiluted mission to protect consumers can be undermined by hostile or negligent leadership or by Congressional meddling on behalf of special interests. However, unless the structure of financial services regulation is realigned to change not just the focus of regulation but its underlying philosophy, it is very unlikely that consumers will be adequately protected from unwise or unfair credit products in the future. The creation of a CFPA is necessary because it ensures that the paramount priority of Federal regulation is to protect consumers, that the agency decision making is truly independent, and that agencies do not have financial or regulatory incentives to keep standards weaker than necessary.SECTION 3: ERRORS OF OMISSION AND COMMISSION BY THE FEDERAL BANK CHRG-111hhrg52406--210 Mr. Bachus," I said I associate you all with subprime lending just because of the last few years, but you are actually concerned with all sorts of lending practices. Ms. Keest. Certainly. We work on credit cards. We work on payday loans, and we are affiliated with the financial institution that does mortgage lending, small business lending and that has retail credit union operations. " FOMC20061212meeting--111 109,MR. LACKER.," My second question is about the statement. Many market participants, as you noted, expect very little change in the tenor of the statement’s characterization of the real economy. Do you believe that the markets would view the way alternative B was originally crafted as expressing more concern than the median analyst about real weakness, and do you view exhibit 5 as expressing less concern—as a more moderated signal?" FOMC20070321meeting--64 62,MR. STOCKTON.," It’s a combination of two bets that are probably both risky. One is that in fact productivity will continue and that what we’ve seen more recently is a little more pronounced cyclical sag in productivity growth and not a sign that underlying structural productivity is weaker than we’re estimating. The second bet is that, on the supply side, the growth in the labor force will be relatively weak. Therefore, we will not need to have as much employment growth—" CHRG-111shrg55117--52 Mr. Bernanke," To try to achieve full employment and the price stability, yes. Senator Bunning. OK. The last question then, since my time is running out. Yesterday, you made it clear that you think the Fed has the tools to stop the coming inflation by controlling all the new money you have printed. You may be right, but do you have the will, as former Chairman Volcker did, to tighten even if the economy is still weak? " CHRG-111shrg57320--86 Mr. Thorson," In some cases, the regulator, if they find an indicator of fraud, they can make a referral and will, and I have no doubt that they do. And, in fact, obviously, people inside the bank could also do that, not necessarily--I mean, there are all kinds of avenues to do that, anonymously and otherwise but, as a regulator or as a bank employee or, frankly, almost anybody associated with this, if I had ever found a W-2 that had been redacted, I figure we hit a gold mine. Senator Kaufman. Especially engaged in a business practice which both of you admit is---- " CHRG-111shrg51290--58 Mr. Bartlett," Yes, I do, Mr. Chairman. Mr. Chairman, lending decisions should not be made by political correctness or by government fiat or by a law or by regulation. Those lending decisions should be based on safety and soundness, good underwriting standards and consumer protection, and every time we get into an attempt to have that, then we sort of skew the outcome. So subprime lending is in and of itself not bad. It is a good thing. We had a large number of terrible abuses, but it shouldn't be therefore outlawed. Second, loans, though, and mortgages should be made for the benefit of consumers by a competitive marketplace where 8,000 lenders or 15,000 lenders compete against each other for the consumers' business. And then those lenders should be regulated for safety and soundness and for consumer protection. But the regulation should not be to design the exact terms and conditions of the loan, as in, well, I think this is what a good loan should be and somebody else says, I think this. The marketplace will do the best job. And then last, and I have some considerable experience with CRA as both a mayor and as a member of the other body, the purpose of CRA has worked quite well. It can be clumsy and so there are exceptions to that, but CRA is the government's requirement that regulated lenders, depository institutions, figure out how they should be making good loans in low-income neighborhoods because that was not occurring prior to CRA in large part, I regret to say, but it was not. So that is the purpose of CRA. That should be kept. It shouldn't be expanded to some other purpose or contracted for other purposes. But that was the underlying purpose and I think that is why the CRA debate is outside this debate that we are having today. " CHRG-111hhrg54872--230 Mr. Ellison," I saw some other heads nodding. Ms. Bowdler, do you think that the CFPA could be beneficial to community banks? Ms. Bowdler. Yes, absolutely. Again, a lot of the products that are offered there, those are the kinds of--those are the kinds of products and practices that we want to promote. There is a lot of concern about the inefficiencies that this might create, but it is really hard to imagine less choices being available to our families or the market operating even more efficiently for our families. Again, in my written statement I walk through how exactly that has been happening, but they have not had choices, and the market has not been working well for them. So this is an opportunity again to get those good practices and good products out there and give them a chance to compete, which they have not had. " CHRG-111shrg57319--455 Mr. Rotella," Mr. Chairman, when I was hired in 2005, the Chief Operating Officer position was a brand new position at WaMu. Part of the reason for that position being created were substantial problems that had come up in the mortgage business prior to my arrival. As I mentioned in my oral statement, in 2003 and 2004, there were some substantial issues in market risk management. Mr. Vanasek earlier mentioned a systems project that had to be written off. And I just add at the end of my comment on this, the company bought a number of mortgage companies over the course of about 2000 through 2005. There were 12 mortgage origination systems when I joined. There were a number of servicing systems. The operation needed a lot of work. Senator Levin. OK. During the prior panels, we went through a number of documents and audit reports describing problems with Long Beach. If you will take a look at Exhibit 8b,\1\ please, page 3. This is a joint report in 2004 by the FDIC and the State of Washington after a visit to WaMu in 2003. And here is what it said about Long Beach.--------------------------------------------------------------------------- \1\ See Exhibit 8b, which appears in the Appendix on page 389.--------------------------------------------------------------------------- ``40% . . . of the 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.'' That is 950 of the 4,000. ``800 were deemed unsaleable, and the remainder contained deficiencies requiring remediation prior to sale.'' Do you remember those problems at Long Beach in 2003, Mr. Killinger? " CHRG-111hhrg48873--266 Secretary Geithner," And we are working on putting those out so that we will have some clear standards to the American people to govern these compensation practices going forward. " FOMC20070131meeting--21 19,MR. POOLE., Okay. So the alternate would serve until the next president was in office. That has certainly been the practice; my question was about the wording. Thank you. CHRG-111shrg382--32 Mr. Tarullo," To members of the Basel Committee---- Senator Bayh. These are just best practices basically made to the different countries that comprise the---- " CHRG-111hhrg48867--52 Mr. Ryan," We think it is practical that, at least here and in Europe, there will be some risk retention. So we are cozied up to that requirement. How much, we are still debating. " CHRG-111hhrg55814--289 Mr. Manzullo," You realize that what this new piece of legislation attempts to do is exactly what the CFPA would do on safeguarding activities and practices? Maybe you do not realize that but it-- " CHRG-111hhrg58044--397 Mr. Cohen," And if something operates in practice to make it de facto or in its application a racial barrier and a racial discrimination, then we should cure that as well, should we not, sir? " CHRG-111hhrg53238--137 The Chairman," He was, as is the practice, as the gentleman knows, the witness suggested by the Republicans, which is I think an important part of our trying to get through this all. Next is Mrs. Biggert. " CHRG-111hhrg58044--348 Mr. Hensarling," And is the Obama Administration not enforcing those? Ms. Wu. And the practices that have a disparate impact are prohibited. And we think that the use of credit histories-- " CHRG-111hhrg53245--146 The Chairman," Credit cards, home mortgages, unfair and deceptive practices? Ms. Rivlin. Yes, not very much. I do not think the Fed did that well. " fcic_final_report_full--524 This does not solve all the major problems with the AH goals. In the sense that the goals enable the government to direct where a private company extends credit, they are inherently a form of government credit allocation. More significantly, the competition among the GSEs, FHA and the banks that are required under the CRA to find and acquire the same kind of loans will continue to cause the same underpricing of risk on these loans that eventually brought about the mortgage meltdown and the financial crisis. This is discussed in the next section and the section on the CRA. 4. Competition Between the GSEs and FHA for Subprime and Alt-A Mortgages One of the important facts about HUD’s management of the AH goals was that it placed Fannie and Freddie in direct competition with FHA, an agency within HUD. This was already noted in some of the Fannie documents cited above. Fannie treated this as a conflict of interest at HUD, but there is a strong case that this competition is exactly what HUD and Congress wanted. It is important to recall the context in which the GSE Act was enacted in 1992. In 1990, Congress had enacted the Federal Credit Reform Act. 138 One of its purposes was to capture in the government’s budget the risks to the government associated with loan guarantees, and in effect it placed a loose budgetary limit on FHA guarantees. For those in Congress and at HUD who favored increased mortgage lending to low income borrowers and underserved communities, this consequence of the FCRA may have been troubling. What had previously been a free way to extend support to groups who were not otherwise eligible for conventional mortgages—which generally required a 20 percent downpayment and the indicia of willingness and ability to pay—now appeared to be potentially restricted. Requiring the GSEs to take up the mantle of affordable housing would have looked at the time like a solution, since Fannie and Freddie had unlimited access to funds in the private markets and were off-budget entities. Looked at from this perspective, it would make sense for Congress and HUD to place the GSEs and FHA in competition, just as it made sense to put Fannie and Freddie in competition with one another for affordable loans. With all three entities competing for the same kinds of loans, and with HUD’s control of both FHA’s lending standards and the GSEs’ affordable housing requirements, underwriting requirements would inevitably be reduced. HUD’s explicit and frequently expressed interest in reducing mortgage underwriting standards, as a means of making mortgage credit available to low income borrowers, provides ample evidence of HUD’s motives for creating this competition. 137 Federal Housing Finance Agency, 2010-2011 Enterprise Housing Goals; Enterprise Book-Entry Procedures; Final Rule, 12 CFR Parts 1249 and 1282, Federal Register , September 14, 2010, p.55892. 138 Title V of the Congressional Budget Act of 1990. Under the FCRA, HUD must estimate the annual cost of FHA’s credit subsidy for budget purposes. The credit subsidy is the net of its estimated receipts reduced by its estimated payments. FinancialCrisisReport--381 The CDO Origination Desk was headed by Peter Ostrem. 1536 This desk structured and originated most of Goldman’s CDOs and CLOs, excluding Abacus. The CDO Desk was primarily an underwriting desk that arranged for the issuance of new securities which had not yet been sold in the marketplace. Because of its underwriting focus, the CDO Desk’s activities required a higher level of disclosure to customers regarding newly issued securities than was ordinarily required of a secondary trading desk, which buys and sells only pre-existing securities. 1537 Goldman maintained an inventory of RMBS and CDO securities to carry out activities for its clients and proprietary trading for the firm. The Structured Product (SP) Syndicate and ABS Finance Desk was headed by Bunty Bohra and Curtis Probst. 1538 This desk was often referred to simply as the “Syndicate.” It coordinated Goldman’s sales efforts and the issuance of different securities across different desks. In the middle of 2007, the Mortgage Department was restructured. One key change was that the CDO Origination Desk was moved into the secondary trading area under the SPG Trading Desk. Mr. Lehman was designated as head of the CDO Origination Desk, with assistance from Mr. Swenson. 1539 As a result, the SPG Trading Desk had responsibility for selling new Goldman-originated CDO securities as well as engaging in secondary trading of pre- existing CDOs and RMBS securities, related credit default swaps (CDS), ABX trading, correlation trading, property derivatives, CMBS, and other asset backed securities. 1540 In 2006 and 2007, the Residential Whole Loan Trading Desk underwrote 93 RMBS worth $72 billion. 1541 The CDO Origination Desk acted as a placement agent and underwrote approximately 27 mortgage based CDOs worth $28 billion. 1542 Of the 27 CDOs, 84% were hybrid CDOs, 15% were synthetic, and only about 1% were cash CDOs with physical assets. 1543 The mortgage-based CDOs included 8 CDOs on the Abacus platform, with $5 billion in issued securities; 1544 a $2 billion synthetic CDO known as Hudson Mezzanine 2006-1; a $300 million synthetic CDO known as Anderson Mezzanine 2007-1; and $1 billion hybrid CDO known as Timberwolf I. 1536 “North America Mortgages, ” chart prepared by Goldman, GS MBS-E-007818849 (showing organization of Mortgage Department). In 2006, Mr. Ostrem co-headed the CDO Origination Desk with David Rosenblum, who was primarily involved in the CLO aspects of the desk ’s activities. Mr. Rosenblum was in the process of leaving the Mortgage Department for a position in the Credit business in late 2006, though he continued to have some responsibilities with respect to the CDO Origination Desk. 1537 See discussion of the disclosure obligations of broker-dealers, underwriters, and placement agents, above. The Correlation Trading Desk, which also arranged for the issuance of new CDOs had the same obligations as the CDO desk when issuing a new CDO. 1538 “North America Mortgages, ” chart prepared by Goldman, GS MBS-E-007818849 (showing organization of Mortgage Department). 1539 1540 1541 1542 1543 1544 “Mortgages Organizational Structure,” chart prepared by Goldman Sachs, GS MBS-E-010872812. Id. Undated chart prepared by Goldman for the Subcommittee, GS-PSI-00172. Undated chart prepared by Goldman for the Subcommittee, GS MBS 0000021129 and GS MBS 0000004276. Id. Id. (3) Overview of Goldman Sachs Case Study CHRG-110shrg50369--2 Chairman Dodd," The Committee will come to order. I am pleased to call the Committee to order this morning. Today, the Committee will hear the testimony of Federal Reserve Chairman Ben Bernanke on the outlook of the Nation's economy, the Fed's conduct of monetary policy, and the status of important consumer protection regulations that are under the Fed's jurisdiction. This is Chairman Bernanke's second appearance before the Committee this year. Mr. Chairman, it is good to have you with us, and, again, it is 2 weeks ago and now again today here. You are becoming a regular here, and so we appreciate your appearance before the Committee. When Chairman Bernanke was first before the Committee 2 weeks ago, I laid out the facts of what I consider to be our Nation's very serious, if not perilous, economic condition. Growth is slowing, inflation is rising, consumer confidence is plummeting, while indebtedness is deepening. And just as ominously, the credit markets have experienced significant disruptions. Consumers are unable or unwilling to borrow. Lenders are unable or unwilling to lend. There is a palpable sense of uncertainty and even fear in the markets with a crisis of confidence that has spread beyond the mortgage markets to markets in student loans. And I noted this morning--by the way, 2 weeks ago I pointed out that Michigan was indicating some serious problems with student lending, and this morning I am reading where Pennsylvania today--you may have seen the article--may decide to also curtail student loans as a result of this growing economic situation. We have also seen the problem with credit cards, government bonds, and corporate finance. Unfortunately, the crisis of confidence does not just exist by American consumers and lenders. It increasingly appears that there is a crisis of confidence among the rest of the world in the United States economy. Yesterday, the dollar reached its lowest level since 1973, when the dollar was first allowed to float freely. And the Fed's own monetary report details an alarming fact. Foreign entities have not only stopped purchasing U.S. securities; they have actually been selling them because they have lost, it appears, confidence in their value. Now, I am going to be raising some questions, Mr. Chairman, about that, and I will be interested in your observations about these reports in the Monetary Policy Report. As I have said previously, the catalyst of the current economic crisis I believe very strongly is the housing crisis. Overall, 2007 was the first year since data has been kept that the United States had an annual decline in nationwide housing prices. A recent Moody's report forecast that home values will drop in 2008 by 10 percent to 15 percent, and others are predicting similar declines in 2009 as well. This would be the first time since the Great Depression that national home prices have dropped in consecutive years. We have all witnessed in the past where regionally there have been declines in home prices, but to have national numbers like this is almost unprecedented, certainly in recent history. If the catalyst of the current economic crisis is the housing crisis, then the catalyst of the housing crisis is the foreclosure crisis. This week, it was reported that foreclosures in January were up 57 percent compared to a year ago and continue to hit record levels. When all is said and done, over 2 million Americans could lose their homes as a result of what Secretary Paulson has properly and accurately described as ``bad lending practices.'' These are lending practices that no sensible banker, I think, would ever engage in. Reckless, careless, and sometimes unscrupulous actors in the mortgage lending industry essentially allowed banks--rather, essentially allowed loans to be made that they knew hard-working, law-abiding borrowers would never be able to repay. Let me add here very quickly, because I think it is important to make the point here, that we are not talking about everyone here at all. We are talking about some who engaged in practices that I think were unscrupulous or bad lending practices. But many institutions acted very responsibly, and I would not want the world to suggest here that this Committee believed that this was an indictment on all lending institutions. And engaged--those who did act improperly engaged in practices that the Federal Reserve under its prior leadership, in my view, and this administration did absolutely nothing to effectively stop. The crisis affects more than families who lose their homes. Property values for each home within a one-eighth square mile of a foreclosed home could drop on an average as much as $5,000. This will affect somewhere between 44 to 50 million homes in our country. So the ripple effect beyond the foreclosed property goes far beyond that and has a contagion effect, in my view, in our communities all across this country beyond the very stark reality of those who actually lose their homes, the effect of others watching the value of their properties decline, not to mention what that means to local tax bases, supporting local police and fire, and a variety of other concerns raised by this issue. I certainly want to commend the Fed Chairman--I said so yesterday publicly, Mr. Chairman; I do so again this morning--for candidly acknowledging the weakness in the economy and for actively addressing those weaknesses by injecting liquidity and cutting interest rates. I also am pleased that the administration and the Congress were able to reach agreement on a stimulus package, and our hope is--while some have argued this is not big enough or strong enough, our collective hope is this will work, will have some very positive impact on the economy. Certainly this will have some support, we hope, for working families who are bearing the brunt of these very difficult times. However, I think more needs to be done to address the root cause of our economic problems. Any serious effort to address our economic woes should include, I think, an effort to take on the foreclosure crisis. And, again, there are various ideas out there on how we might do this more effectively, and certainly the Chairman and others have offered some ideas and suggestions. Senator Shelby and I have been working and talking--and Mel Martinez and others who are involved in these issues--about ways in which we can in the coming days do constructive things in a positive way to indicate and show not only our concern about the issue but some very strong ideas on how we can right this and restore that confidence I talked about earlier. We on this Committee have already taken some steps to address these problems. We have passed the FHA modernization legislation through the Committee and the Senate and continue to work to make it law. We had a very good meeting yesterday, I would point out, Senator Shelby and I and the leadership of the House Financial Services Committee, I say to you, Mr. Chairman, in hopes that we can come to some very quick conclusion on that piece of legislation and move it along here. We appropriated close to $200 million to facilitate foreclosure prevention efforts by borrowers and lenders, and I want to commend Senator Schumer and others who have been involved in this idea of counseling and ideas to minimize the impact of this problem as well. In addition, the recently enacted stimulus package that I mentioned already includes a temporary increase in the conforming loan limits for GSEs to try to address the problems that have spread throughout the credit market and the jumbo mortgage market. And while this temporary increase is helpful, we still need to implement broad GSE reform. And as I have said previously, I am committed to doing that, and we will get that done. I have spoken about my belief in the need for additional steps to mitigate the foreclosure crisis in a reasonable and thoughtful manner. These steps include targeting some community development block grant assistance to communities in a targeted way to help them to counter the impact of foreclosed and abandoned properties in their communities. And they include establishing a temporary homeownership loan initiative, which I have raised and others have commented on, either using existing platforms or a new entity that can facilitate mortgage refinancing. But it is not just the Congress that needs to do more, and, again, the Fed needs, in my view, to be as vigilant a financial regulator as it has been a monetary policymaker. That includes breaking with its past and becoming more vigilant about policing indefensible lending practices. And, again, I commend the Chairman of the Federal Reserve--we have talked about this here--on the proposed regulations that you have articulated that would follow on the HOEPA legislation. And while I have expressed some disappointment about how far they go in certain areas here, the Chairman and I have talked about this a bit. We will be involved in the comment period here and are looking forward to finalizing those regulations, and hopefully at least shutting the door on this kind of a problem re-emerging in the coming months and years. So I want to thank you, Mr. Chairman, and your colleagues and urge them to consider some of the stronger measures, and we will offer some additional comments on them. Despite these unprecedented challenges, I think all of us here on this Committee, Republicans and Democrats, remain confident in the future of the American economy, and our concerns that will be raised here this morning should not reflect anything but that confidence in the future. We may need to change some of our policies, regulations, and priorities, but we strongly believe that the ingenuity, productivity, and capability of the American worker and the entrepreneur ought never to be underestimated in this country. And we remain firm and committed to doing everything we can to strengthen those very points. So I look forward to working with my good friend, Senator Shelby, and other Members of the Committee to do what we can here to play our role in all of this in a constructive way, to work with you, Mr. Chairman, and the Federal Reserve, the Secretary of the Treasury, and others of the financial institution regulators to see what we can do in the short term to get this moving in a better direction. So, with that, let me turn to Senator Shelby for his opening comments, and then we will try to get to some questions. And I will leave opening comments for the go-around and question period so we can get to a question-and-answer period here to make this as productive a session as possible. But we thank you again for being with us. CHRG-111hhrg56778--10 Mr. Greenlee," Thank you. Chairman Kanjorski, Ranking Member Garrett, and members of the subcommittee, thank you for the opportunity to discuss the supervision and oversight of insurance companies. As you are aware, in this country the primary supervision and regulation of insurance companies is vested with the States. The Federal Reserve does serve as the consolidated supervisor of bank holding companies and financial holding companies established under the Gramm-Leach-Bliley Act, some of which are affiliated with insurance companies. The Federal Reserve is also the primary Federal regulator of State member banks, many of which are engaged in the sale of insurance products. Of the approximately 550 foreign and domestic financial holding companies supervised by the Federal Reserve, 33 are engaged in insurance underwriting activities. As the consolidated supervisor of bank holding companies and financial holding companies, the Federal Reserve routinely conducts inspections of these organizations to ensure that the consolidated organization remains strong and the holding company and its non-bank affiliates do not pose a threat to the company's insured depository institution subsidiaries. To further our supervisory efforts, we issued enhanced guidance on consolidated supervisory expectations in 2008 that underscored the importance of examiners evaluating firm-wide risk exposures. We also reiterated the importance of Federal Reserve supervisors working with the primary regulator of a bank holding company's insured depository institutions as well as State insurance supervisors and other functional regulators. Recent experience shows the need for the consolidated supervision of bank holding companies in addition to and distinct from the supervision of the organization's bank or functionally regulated subsidiaries. Large organizations increasingly operate and manage their businesses on an integrated basis with little regard for the corporate boundaries that typically define the jurisdictions of individual, functional supervisors. Indeed, the crisis has highlighted the financial, managerial, operational, and reputational linkages among the bank, securities, commodity, insurance, and other units of financial firms. With respect to financial holding companies engaged in insurance activities, our consolidated supervisory framework involves the same principles used for bank holding companies more broadly. This begins with an assessment of the potential risk insurance activities pose to the consolidated organization and its depository affiliates. We make appropriate adjustments to our assessment of the firm's risk management practices and overall financial condition to account for the unique risks and the nature of insurance products on underwriting activities. As part of our process, we routinely communicate with the appropriate insurance regulatory authorities about the nature of and risk posed by a firm's insurance activities. To facilitate this information sharing, we established memoranda of understanding with the insurance regulators in all 50 States, the District of Columbia, and Puerto Rico. We also communicate with international insurance supervisors as appropriate. The Federal Reserve also has taken several steps to support our supervisory staff and understanding the risk arising from insurance activities. We have designed and implemented training programs, and have developed a variety of insurance-related examiner tools. We also collaborated with the NAIC on three published reports to facilitate better communication and understanding of banking and insurance regulatory framework risks and capital requirements. In closing, the current financial crisis has clearly demonstrated that risk to the financial system can arise not only in the banking sector, but also from the activities of other financial firms, such as investment banks or insurance companies that traditionally have not been subject to the type of regulation and consolidated supervision applicable to bank holding companies. As Chairman Bernanke stated yesterday, it is important to close this gap in our regulatory structure, and legislative action is needed that would subject all systemically important financial institutions to the same framework for consolidated prudential supervision that currently applies to bank holding companies. I would like to thank the committee for holding this important hearing, and I am happy to answer any questions that you may have. Thank you. [The prepared statement of Mr. Greenlee can be found on page 71 of the appendix.] " CHRG-110shrg50415--33 Mr. Morial," I wanted to add one other point. When Fannie and Freddie sort of followed the market, they relaxed a critical underwriting rule that they had followed for years, and that was the rule that they would purchase mortgages where the homebuyer had been through pre-purchase counseling as a mandatory requirement. And my understanding is that that rule got relaxed to some extent because they had pressure from the sellers who said, ``I can sell to somebody else now. I do not need to sell to you, and all of your sort of requirements are too burdensome for the type of business that we want to do.'' So it is an affirmation of what this Committee has strongly supported twice in the last year, and that is, an increase in investment in homeownership counseling. I think any view toward a new system, if you will, for housing finance in this country ought to place heavy emphasis on pre-purchase homeownership counseling. I believe the data will show that the default rates and the foreclosure rates are less where purchasers have had the benefit of homebuyer education prior to purchase. " CHRG-111hhrg48867--86 Mr. Ryan," I would like to make a comment that goes to the chairman's question and your comment about the uniqueness of all of us having a view on retention, and put this in perspective. Securitization, as the chairman noted, is an essential ingredient in how we provide financing for consumers in this country. In 2007, about $2.8 trillion. We are now inching along at very little; the business is basically dormant. So when people are complaining about credit availability for consumers, a large part of that is because securitization is basically dormant. As you approach whatever you are going to be doing on securitization, I would urge you to think through not only the retention issue--and retention is very complicated, how much, by whom--and we all know what we are trying to achieve here, which is basically to incent people such that they are not originating or underwriting for assets. But when you look at retention, think more broadly. Think about transparency. Think about how these securities are structured, valuation. Think also about the credit rating agencies, because that is an integral part of fixing this situation. We need modification there. Thank you. " CHRG-111hhrg55809--123 Mr. Bernanke," Commercial real estate remains a very serious problem. It depends, to some extent, as you point out, by category. Construction loans, for example, are particularly weak. Within other categories, you know, hotels and office buildings and apartment buildings, there are differences in the situation. But we are concerned both because the fundamental is weakening and because the financing situation is bad. For example, the commercial mortgage-backed securities market is still not really open. It could provide a source of a lot of stress, particularly for small and regional banks that have a very heavy concentration in commercial real estate. So we are working hard to work with the banks. And we have, as you know, our TALF program which is going to try to restart the commercial mortgage-backed securities. " FinancialCrisisReport--65 The December 2004 presentation also defined higher risk lending on the basis of expanded underwriting criteria and multiple risk layering: “Expanded Criteria -‘No Income’ loan documentation type -All Manufactured Housing loans … Multiple Risk Layering in SF[R] and 1 st lien HEL/HELOC loans -Higher A- credit score or lacking LTV as strong compensating factor and -An additional risk factor from at least three of the following: -Higher uncertainty about ability to pay or ‘stated income’ documentation type -higher uncertainty about willingness to pay or collateral value[.]” 165 This document indicates that WaMu considered a mortgage to be higher risk if it lacked documentation regarding the borrower’s income, described as a “no income” or “stated income” loan. WaMu held billions of dollars in loans on its balance sheet. 166 Those assets fluctuated in value based on the changes in the interest rate. Fixed rate loans, in particular, incurred significant interest rate risk, because on a 30-year fixed rate mortgage, for example, WaMu agreed to receive interest payments at a certain rate for 30 years, but if the prevailing interest rate went up, WaMu’s cost of money increased and the relative value of the fixed mortgages on its balance sheet went down. WaMu used various strategies to hedge its interest rate risk. One way to incur less interest rate risk was for WaMu to hold loans with variable interest rates, such as Hybrid ARMs typical of WaMu’s subprime lending, or Option ARMs, WaMu’s flagship “prime” product. These adjustable rate mortgages paid interest rates that, after the initial fixed rate period expired, were typically pegged to the Cost of Funds Index (COFI) or the Monthly Treasury Average (MTA), two common measures of prevailing interest rates. 163 See, e.g., 10/8/1999 “Interagency Guidance on High LTV Residential Real Estate Lending,” http://www.federalreserve.gov/boarddocs/srletters/1993/SR9301.htm, and discussion of high LTV loans in section D(2)(b), below. 164 12/21/2004 “Asset Allocation Initiative: Higher Risk Lending Strategy and Increased Credit Risk Management,” Washington Mutual Board of Directors Presentation, JPM_WM04107995-8008 at 7999, Hearing Exhibit 4/13-2b. 165 Id. This slide lists only the two additional risk factors quoted, despite referring to “at least three of the following.” 166 See 9/25/2008 “OTS Fact Sheet on Washington Mutual Bank,” Dochow_Darrel-00076154_001 (“Loans held: $118.9 billion in single-family loans held for investment – this includes $52.9 billion in payment option ARMs and $16.05 billion in subprime mortgage loans”). (4) Gain on Sale CHRG-111shrg51290--60 STATEMENT OF STEVE BARTLETT President and Chief Executive Officer, Financial Services Roundtable March 3, 2009 Chairman Dodd, Ranking Member Shelby and Members of the Senate Banking Committee. I am Steve Bartlett, President and Chief Executive Officer of the Financial Services Roundtable. The Roundtable is a national trade association composed of the nation's largest banking, securities, and insurance companies. Our members provide a full range of financial products and services to consumers and businesses. Roundtable member companies provide fuel for America's economic engine, accounting directly for $85.5 trillion in managed assets, $965 billion in revenue, and 2.3 million jobs. On behalf of the members of the Roundtable, I wish to thank you for the opportunity to participate in this hearing on the role of consumer protection regulation in the on-going financial crisis. Many consumers have been harmed by this crisis, especially mortgage borrowers and investors. Yet, the scope and depth of this crisis is not simply a failure of consumer protection regulation. As I will explain in a moment, the root causes of this crisis are found in basic failures in many, but not all financial services firms, and the failure of our fragmented financial regulatory system. I also believe that this crisis illustrates the nexus between consumer protection regulation and safety and soundness regulation. Consumer protection and safety and soundness are intertwined. Prudential regulation and supervision of financial institutions is the first line of defense for protecting the interests of all consumers of financial products and services. For example, mortgage underwriting standards not only help to ensure that loans are made to qualified borrowers, but they also help to ensure that the lender gets repaid and can remain solvent. Given the nexus between the goals of consumer protection and safety and soundness, we do not support proposals to separate consumer protection regulation and safety and soundness regulation. Instead, we believe that the appropriate response to this crisis is the establishment of a better balance between these two goals within a reformed and more modern financial regulatory structure. Moreover, I would like to take this opportunity to express the Roundtable's concerns with the provision in the Omnibus Appropriations bill that would give State attorneys generals the authority to enforce compliance with the Truth-in-Lending Act (TILA) and would direct the Federal Trade Commission to write regulations related to mortgage lending. As I will explain further, we believe that one of the fundamental problems with our existing financial regulatory system is its fragmented structure. This provision goes in the opposite direction. It creates overlap and the potential for conflict between the Federal banking agencies, which already enforce compliance with TILA, and State AGs. It also creates overlap and the potential conflict between the Federal banking agencies, which are responsible for mortgage lending activities, and the Federal Trade Commission. While it may be argued that more ``cops on the beat'' can enhance compliance, more ``cops'' that are not required to act in any coordinated fashion will simply exacerbate the regulatory structural problems that contributed to the current crisis. My testimony is divided into three parts. First, I address ``What Went Wrong.'' Second, I address ``How to Fix the Problem.'' Finally, I take this opportunity to comment on the lending activities of TARP-assisted firms, and the Roundtable's continuing concerns over the impact of fair value accounting.What Went Wrong The proximate cause of the current financial crisis was the nation-wide collapse of housing values, and the impact of that collapse on individual homeowners and the holders of mortgage-backed securities. The crisis has since been exacerbated by a serious recession. The root causes of the crisis are twofold. The first was a clear breakdown in policies, practices, and processes at many, but not all, financial services firms. Poor loan underwriting standards and credit practices, excessive leverage, misaligned incentives, less than robust risk management and corporate governance are now well known and fully documented. Corrective actions are well underway in the private sector as underwriting standards are upgraded, credit practices reviewed and recalibrated, leverage is reduced as firms rebuild capital, incentives are being realigned, and some management teams have been replaced, while whole institutions have been intervened by supervisors or merged into other institutions. So needed corrective actions are being taken by the firms themselves. More immediately, we need to correct the failures that the crisis exposed in our complex and fragmented financial regulatory structure. Crises have a way of revealing structural flaws in regulation, supervision, and our regulatory architecture that have long-existed, but were little noticed until the crisis exposed the underlying weaknesses and fatal gaps in regulation and supervision. This one is no different. It has revealed significant gaps in the financial regulatory system. It also revealed that the system does not provide for sufficient coordination and cooperation among regulators, and that it does not adequately monitor the potential for market failures, high-risk activities, or vulnerable interconnections between firms and markets that can create systemic risk and result in panics like we saw last year and the crisis that lingers today. The regulation of mortgage finance illustrates these structural flaws in both regulation and supervision. Many of the firms and individuals involved in the origination of mortgage were not subject to supervision or regulation by any prudential regulator. No single regulator was held accountable for identifying and recommending corrective actions across the activity known as mortgage lending to consumers. Many mortgage brokers are organized under State law, and operated outside of the regulated banking industry. They had no contractual or fiduciary obligations to brokers who referred loans to them. Likewise, many brokers were not subject to any licensing qualifications and had no continuing obligations to individual borrowers. Most were not supervised in a prudential manner like depository institutions engaged in the same business line. The Federal banking regulators recognized many of these problems and took actions--belatedly--to address the institutions within their jurisdiction, but they lacked to power to reach all lenders. Eventually, the Federal Reserve Board's HOEPA regulations did extend some consumer protections to a broader range of lenders, but the Board does not have the authority to ensure that those lenders are engaged in safe and sound underwriting practices or risk management. The process of securitization suffered from a similar lack of systemic oversight and prudential regulation. No one was responsible for addressing the over-reliance investors placed upon the credit rating agencies to rate mortgage-backed securities, or the risks posed to the entire financial system by the development of instruments to transfer that risk worldwide.How to Fix the Problem How do we fix this problem? Like others in the financial services industry, the members of the Financial Services Roundtable have been engaged in a lively debate over how to better protect consumers by addressing the structural flaws in our current financial regulatory system. While our internal deliberations continue, we have developed a set of guiding principles and a ``Draft Financial Regulatory Architecture'' that is intended to close the gaps in our existing financial regulatory system. We are pleased that the set of regulatory reform principles that President Obama announced last week are broadly consistent and compatible with the Roundtable's principles for much needed reforms. Our first principle in our 2007 Blueprint for U.S. Financial Modernization was to ``treat consumers fairly.'' Our current principles for regulatory reform this year build on that guiding principle and call for: 1) a new regulatory architecture; 2) common prudential and consumer and investor protection standards; 3) balanced and effective regulation; 4) international cooperation and national treatment; 5) failure resolution; and 6) accounting standards. Our plan also seeks to encourage greater coordination and cooperation among financial regulators, and to identify systemic risks before they materialize. We also seek to rationalize and simplify the existing regulatory architecture in ways that make more sense in our modern, global economy. The key features of our proposed regulatory architecture are as follows. Financial Markets Coordinating Council To enhance coordination and cooperation among the many and various financial regulatory agencies, we propose to expand membership of the President's Working Group on Financial Markets (PWG) and rename it as the Financial Markets Coordinating Council (FMCC). We believe that this Council should be established by law, in contrast to the existing PWG, which has operated under a Presidential Executive Order since 1988. This would permit Congress to oversee the Council's activities on a regular and ongoing basis. We also believe that the Council should include representatives from all major Federal financial agencies, as well as individuals who can represent State banking, insurance, and securities regulation. This Council could serve as a forum for national and State financial regulators to meet and discuss regulatory and supervisory policies, share information, and develop early warning detections. In other words, it could help to better coordinate policies within our still fragmented regulatory system. We do not believe that the Council should have independent regulatory or supervisory powers. However, it might be appropriate for the Council to have some ability to review the goals and objectives of the regulations and policies of Federal and State financial agencies, and thereby ensure that they are consistent.Federal Reserve Board To address systemic risk, we believe the Federal Reserve Board (Board) should be authorized to act as a market stability regulator. As a market stability regulator, the Board should be responsible for looking across the entire financial services sector to identify interconnections that could pose a risk to our financial system. To perform this function, the Board should be empowered to collect information on financial markets and financial services firms, to participate in joint examinations with other regulators, and to recommend actions to other regulators that address practices that pose a significant risk to the stability and integrity of the U.S. financial services system. The Board's authority to collection information should apply not only to depository institutions, but also to all types of financial services firms, including broker/dealers, insurance companies, hedge funds, private equity firms, industrial loan companies, credit unions, and any other financial services firms that facilitate financial flows (e.g., transactions, savings, investments, credit, and financial protection) in our economy. Also, this authority should not be based upon the size of an institution. It is possible that a number of smaller institutions could be engaged in activities that collectively pose a systemic risk.National Financial Institutions Regulator To reduce gaps in regulation, we propose the consolidation of several existing Federal agencies into a single, National Financial Institutions Regulator (NFIR). This new agency would be a consolidated prudential and consumer protection agency for banking, securities and insurance. More specifically, it would charter, regulate and supervise (i) banks, thrifts, and credit unions, currently supervised by the Office of the Thrift Supervision, the Office of the Comptroller of the Currency, and the National Credit Union Administration; (ii) licensed broker/dealers, investment advisors, investment companies, futures commission merchants, commodity pool operators, and other similar intermediaries currently supervised by the Securities and Exchange Commission or the Commodities Futures Trading Commission; and (iii) insurance companies and insurance producers that select a Federal charter. The AIG case illustrates the need for the Federal Government to have the capacity to supervise insurance companies. Also, with the exception of holding companies for banks, the NFIR would be the regulator for all companies that control broker/dealers or national chartered insurance companies. The NFIR would reduce regulatory gaps by establishing comparable prudential standards for all of these of nationally chartered or licensed entities. For example, national banks, Federal thrifts and federally licensed brokers/dealers that are engaged in comparable activities should be subject to comparable capital and liquidity standards. Similarly, all federally chartered insurers would be subject to the same prudential and market conduct standards. In the area of mortgage origination, we believe that the NFIR's prudential and consumer protection standards should apply to both national and State lenders. Mortgage lenders, regardless of how they are organized, should be required to retain some of the risk for the loans they originate (keep some ``skin-in-the-game''). Likewise, mortgage borrowers, regardless of where they live or who their lender is, should be protected by the same safety and soundness and consumer standards. As noted above, we believe that is it important for this agency to combine both safety and soundness (prudential) regulation and consumer protection regulation. Both functions can be informed, and enhanced, by the other. Prudential regulation can identify practices that could harm consumers, and can ensure that a firm can continue to provide products and services to consumers. The key is not to separate the two, but to find an appropriate balance between the two.National Capital Markets Agency To focus greater attention on the stability and integrity of financial markets, we propose the creation of a National Capital Markets Agency through the merger of the Securities and Exchange Commission (SEC) and the Commodities Futures Trading Commission (CFTC), preserving the best features of each agency. The NCMA would regulate and supervise capital markets and exchanges. As noted above, the existing regulatory and supervisory authority of the SEC and CFTC over firms and individuals that serve as intermediaries between markets and customers, such as broker/dealers, investment companies, investment advisors, and futures commission merchants, and other intermediaries would be transferred to the NFIR. The NCMA also should be responsible for establishing standards for accounting, corporate finance, and corporate governance for all public companies.National Insurance Resolution Authority To protect depositors, policyholders, and investors, we propose that the Federal Deposit Insurance Corporation (FDIC) would be renamed the National Insurance and Resolution Authority (NIRA), and that this agency act not only as an insurer of bank deposits, but also as the guarantor of retail insurance policies written by nationally chartered insurance companies, and a financial backstop for investors who have claims against broker/dealers. These three insurance systems would be legally and functionally separated. Additionally, this agency should be authorized to act as the receiver for large non-bank financial services firms. The failure of Lehman Brothers illustrated the need for such a better system to address the failure of large non-banking firms.Federal Housing Finance Agency Finally, to supervise the Federal Home Loan Banks and to oversee the emergence and future restructuring of Fannie Mae and Freddie Mac from conservatorship we propose that the Federal Housing Finance Agency remain in place, pending a thorough review of the role and structure of the housing GSEs in our economy.TARP Lending and Fair Value Accounting Before I close I would like to address two other issues of importance to policymakers and our financial services industry: lending by institutions that have received TARP funds, and the impact of fair value accounting in illiquid markets. Lending by institutions that have received TARP funds has become a concern, especially given the recessionary pressures facing the economy. I have attached to this statement a series of tables that the Roundtable has compiled on this issue. Those tables show the continued commitment of the nation's largest financial services firms to lending. Fair value accounting also is a major concern for the members of the Roundtable. We continue to believe that the pro-cyclical effects of existing policies are unnecessarily exacerbating this crisis. We urge this Committee to direct financial regulators to adjust current accounting standards to reduce the pro-cyclical effects of fair value accounting in illiquid markets. We also urge the U.S. and international financial regulators coordinate and harmonize regulatory policies to development accounting standards that achieve the goals of transparency, understandability, and comparability.Conclusion Thank you again for the opportunity to appear today to address the connection between consumer protection regulation and this on-going financial crisis. The Roundtable believes that the reforms to our financial regulatory system we have developed would substantially improve the protection of consumers by reducing existing gaps in regulation, enhancing coordination and cooperation among regulators, and identifying systemic risks. We also call on Congress to address the continuing pro-cyclical effects of fair value accounting. Broader regulatory reform is important not only to ensure that financial institutions continue to meet the needs of all consumers but to restart economic growth and much needed job creation. Financial reform and ending the recession soon are inextricably linked--we need both. We need a financial system that provides market stability and integrity, yet encourages innovation and competition to serve consumers and meet the needs of a vibrant and growing economy. We need better, more effective regulation and a modern financial regulatory system that is unrivaled anywhere in the world. We deserve no less. At the Roundtable, we are poised and ready to work with you on these initiatives. As John F. Kennedy once cited French Marshall Lyautey, who asked his gardener to plant a tree. The gardener objected that the tree was slow growing and would not reach maturity for 100 years. The Marshall replied, ``In that case, there is no time to lose; plant it this afternoon!'' The same is true with regard to the future of the United States in global financial services--there is no time to lose; let's all start this afternoon. ______ CHRG-111hhrg53021--82 Secretary Geithner," They would be allowed. There are some consumer practices that we believe should not be permitted. But we are proposing that the Congress establish the basic standards that would govern regulation in those areas. " CHRG-111hhrg53021Oth--82 Secretary Geithner," They would be allowed. There are some consumer practices that we believe should not be permitted. But we are proposing that the Congress establish the basic standards that would govern regulation in those areas. " FOMC20080430meeting--135 133,MR. FISHER.," For how long? This is a personal view, but it's not clear to me that things are that clear-cut on a sustainable basis. One of the things that seems to be undercutting confidence is the weakness in the dollar, even though in the past few days the dollar has rallied. I'm just wondering if it's clear-cut that we would necessarily have a sustained selloff. I can see an immediate reaction, particularly on the announcement. But it's conceivable, is it not, that if we had a dollar rally that we could have a positive effect on equity prices or on the credit markets? " CHRG-111hhrg53238--92 Mr. Bartlett," Congressman, you have hit the nail on the head. These agencies should regulate for safety and soundness and for consumer protection, but not to determine products. The products themselves, leave them in the competitive marketplace, but then protect the consumers by disclosure by anti-fraud protection, by unfair and deceptive acts, by coordinating the decentralized complaint systems and, otherwise, by sales practices, but don't set the products. As for the products, consumers are far better off with choice and with innovation. " CHRG-111hhrg52397--278 Mr. Garrett," Well, one of the proposals that's out there from CFTC Chairman Gensler was that he said in his proposal, ``We need to protect the public from improper marketing practices.'' And I guess the one question that follows from that is that endemic in the system right now, we are talking about sophisticated firms that are out there, is improper marketing practices--you mentioned energy but is that something that is widespread in the industry. And if you put in mandates and what have you, a second part, and anybody can answer this, if you put in mandates to beyond exchanges and clearinghouses, is there a potential, and maybe not, maybe I am just not seeing this, exposing the average investor then to a higher risk at the end of the day? " CHRG-111hhrg53238--163 Mr. Hensarling," Let me change subjects here, if I could. And this is a fairly long bill, I say, by congressional standards, weighing in at 200-some odd pages. Maybe it isn't all that long. I am not sure I found the language where it expressly says there will be product pre-approval. But as I read various sections of the underlying Act that was introduced by the chairman, subtitle C, section 131, it talks about the rulemaking authority of this new agency: ``The agency may prescribe regulations identifying as unlawful unfair acts, abusive acts or practices in connection with any transaction with a consumer financial product. Regulations prescribed under this section may include requirements for the purpose of preventing such acts and practices.'' So if we give the agency the ability to declare unlawful unfair practices--I assume each of your associations or organizations has legal counsel who has probably, hopefully, had a chance to review this. Have your organizations concluded whether a prepayment penalty in a 30-year fixed mortgage is fair under this statute? Mr. Yingling? " CHRG-111hhrg56767--44 Mr. Alvarez," Chairman Frank, Ranking Member Bachus, and members of the committee, thank you for the opportunity to discuss incentive compensation practices in the financial services industry. Compensation arrangements serve several important and worthy objectives. For example, they help firms attract and retain skilled staff, and promote better firm and employee performance. However, compensation arrangements can also provide employees with incentives to take excessive risks that are not consistent with the long-term health of the organization. This misalignment of incentives can occur at all levels of a firm, and is not limited to senior executives. Having experienced the consequences of misaligned incentives, many financial firms are re-examining their compensation structures to better align the interests of managers and other employees with the long-term health of the firm. For firms that have received assistance from TARP, that includes ensuring their compensation structures are consistent with the Special Master's rules designed to protect the financial interests of taxpayers. The Federal Reserve has also acted as a prudential supervisor. In October, we proposed supervisory guidance on incentive compensation practices that would apply to all banking organizations that the Federal Reserve supervises. The guidance, which we expect to finalize shortly, is based on three key principles. First, compensation arrangements should not provide employees incentives to take risks that the employer cannot effectively identify and manage. Financial firms should take a more balanced approach that adjusts incentive compensation, so that employees bear some of the risks, as well as the rewards associated with their activities over time. Second, firms should integrate their approaches to incentive compensation arrangements with their risk management and internal control frameworks. Risk managers should be involved in the design of incentive compensation arrangements, and should regularly evaluate whether compensation is adjusted in fact to account for increased risk. Third, boards of directors are expected to actively oversee compensation arrangements to ensure they strike the proper balance between risk and profit on an ongoing basis. Recently, the Federal Reserve also began two supervisory initiatives to spur the prompt implementation of improved practices. The first is a special horizontal review of incentive compensation practices at large, complex banking organizations. Large firms warrant special supervisory attention, because the adverse effects of flawed approaches at these firms are more likely to have consequences for the broader financial system. Although our review is ongoing, we have seen positive steps at many of these firms. However, substantial changes at many firms will be needed to fully conform incentive compensation practices with principles of safety and soundness. It will be some time before these changes are fully addressed. Nonetheless, we expect these firms to make significant progress in improving the risk sensitivity of their incentive compensation practices for the 2010 performance year. The second initiative is tailored to regional and smaller banking organizations. Experience suggests that incentive compensation arrangements at smaller banks are not nearly as complex or prevalent as at larger institutions. Accordingly, review of incentive compensation practices at these firms will occur as part of the normal supervisory process, a process that we expect to be effective, yet to involve minimal burden for the vast majority of community banks. Incentive compensation practices are likely to evolve significantly in the coming years. This committee's efforts in developing and passing H.R. 4173 will promote the uniform application of sound incentive compensation principles across large financial firms beyond those supervised by the Federal Reserve. In this way, H.R. 4173 would encourage financial firms, supervisors, shareholders, and others to develop incentive compensation practices that are more effectively balanced and reward and better align incentives. We appreciate the committee's efforts in this area, and thank you for the opportunity to testify on this important topic. I would be happy to answer any questions. [The prepared statement of Mr. Alvarez can be found on page 37 of the appendix.] " FOMC20070628meeting--80 78,MR. MOSKOW.," Also, on exhibit 8, the net worth chart in the top left-hand corner—I thought I heard you say that this was high by historical standards. So there are two things here—the stock market has been strong, and then housing prices have been very weak. I assume if you run this out into another year, the line is going to keep going down as well. I was just wondering if you could expand on this. Is this higher than you expected it to be at this particular time?" CHRG-111hhrg56241--161 The Chairman," The gentleman from New Jersey and the gentleman from Texas derided it as very ineffective and weak, and it failed in the Senate. I voted for the bill in the House and in the committee. When it got to the House Floor and the Republican leadership put in an amendment restricting affordable housing, unrelated to the structural organization of Fannie and Freddie, I then voted against that. But I voted for the bill until they put that amendment in. I thank the gentleman and he will get an additional minute for yielding. " CHRG-110hhrg46596--258 Mr. Kashkari," But if you have a bank that is weak or failing, and that bank is acquired by a healthy bank, that community is often better off, because now credit can still be extended, and branches will still stay open in that community, versus if that bank were allowed to fail and the bank would have to be shut down and dissolved, then that community would be worse off. So prudent mergers and acquisitions can be a healthy part of the financial system. We don't want to overdo it. " CHRG-111hhrg56778--23 Chairman Kanjorski," And you found that they were in fact without collateral to support their counterparty positions of $2.8 trillion; and, you were aware of that at the time? Ms. Gardineer. As we went through the targeted reviews, our examiners were able to find discrepancies in the corporate governance with regard to how information was flowing back and forth from the Financial Products silo up to the senior managers, and we made them aware of those weaknesses based on what we found in the Financial Products silo. " CHRG-109shrg26643--82 Chairman Bernanke," Well, actually we are looking for them to give us statistical indicators of their own loss experience in their past credits. And part of the process will be validation. That is, they have to show us that their numbers were derived from their actual experience over a period that encompasses both strong and weak credit conditions and that they are using those models for their own internal analysis of capital. So there will be a lot of checks and we will continue to work with the banks and with the Congress on this issue. " CHRG-111hhrg53248--121 Secretary Geithner," I probably can't do that justice today, but again, I am happy to spend some time working through those issues. Again, I think the basic principle--it is not enough to have standards, it is not enough to have rules, it is not enough to state protections. They have to be enforced. And fraud, violations of those protections, there has to be consequences. We need to make sure that the framework work in place today provides enough deterrents against those kind of practices reemerging. That is the objective we are working towards, lots of ways to do that. I am happy to spend time talking about how best to do that. " CHRG-111hhrg52261--128 Chairwoman Velazquez," Thank you. Mr. Roberts and Ms. Donovan, during times of financial duress, higher capital requirements can provide a cushion for lenders. But these increased levels can also restrict a bank or credit union's ability to make loans to small firms. Can you talk about how higher capital requirements might impact your small business lending practices? " CHRG-111shrg56376--101 Mr. Bowman," Yes, I would agree with that. I mean, in terms of people choosing a charter at the outset, the thrift charter is somewhat unique in terms of some of the limitations that are placed upon the kinds of business that an entity would want to engage in. Our thought is that people choose a charter based upon their business plan. In terms of others who are attempting to switch charters because of some perceived favorable difference between, say, a State charter and a Federal charter, within the State charters you have got 50 to choose from, or 52 to choose from. The Federal charter, you have two, the Federal thrift charter and the national bank charter. Anyone who is looking to avoid or evade some kind of supervisory action or enforcement action, I think as we have talked about here, we as a collective group, interagency basis, have tried to take steps to avoid that from happening or to slow it down, to make sure that it doesn't happen for the wrong reasons. Senator Warner. One common theme from all of you has been--and I think accurately--reflecting that a great deal of the source of the crisis has come from the nonbank financial sector. Another issue I am struggling with and would like to get all of your comments on is, assume whichever way, consolidating a single entity or maintaining the current structure, how do we get our arms around this nonbank financial arena? Clearly, one approach the Administration has talked about is on the consumer end, the consumer product end, looking at specific financial products coming from this array of institutions. Another is that if they kind of bump up to the level of becoming systemically risky, the Council, or in the Administration's proposal the Fed would have oversight. What I am not clear on is should these nonbank--this nonbank financial sector have some level of day-to-day prudential regulation, and I have not seen anybody propose where that--one, is it needed, and two, where that day-to-day prudential regulation in terms of safety and soundness would land. Comments? Ms. Bair. You have prudential supervision of banks because of deposit insurance and other vehicles as part of the safety net. With the nonbanks, you do not have that. They are not federally insured. Senator Warner. Should you have some? Ms. Bair. I don't think you need to. I don't think you need to go that far. I think the consumer abuses for the smaller entities were really more of a significant driver, the lax underwriting which then spilled over into the larger institutions because of the competitive situation it created. But no, I don't think you do. I think if you have the ability to impose prudential requirements on systemic institutions or systemic practices, then I don't think you need institutional---- Senator Warner. So the Council up here for systemic and the consumer down here, but no need for---- Ms. Bair. Yes. " fcic_final_report_full--538 This dissenting statement argues that the U.S. government’s housing policies were the major contributor to the financial crisis of 2008. These policies fostered the development of a massive housing bubble between 1997 and 2007 and the creation of 27 million subprime and Alt-A loans, many of which were ready to default as soon as the housing bubble began to deflate. The losses associated with these weak and high risk loans caused either the real or apparent weakness of the major financial institutions around the world that held these mortgages—or PMBS backed by these mortgages—as investments or as sources of liquidity. Deregulation, lack of regulation, predatory lending or the other factors that were cited in the report of the FCIC’s majority were not determinative factors. The policy implications of this conclusion are significant. If the crisis could have been prevented simply by eliminating or changing the government policies and programs that were primarily responsible for the financial crisis, then there was no need for the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, adopted by Congress in July 2010 and often cited as one of the important achievements of the Obama administration and the 111 th Congress. The stringent regulation that the Dodd-Frank Act imposes on the U.S. economy will almost certainly have a major adverse effect on economic growth and job creation in the United States during the balance of this decade. If this was the price that had to be paid for preventing another financial crisis then perhaps it’s one that will have to be borne. But if it was not necessary to prevent another crisis—and it would not have been necessary if the crisis was caused by actions of the government itself—then the Dodd-Frank Act seriously overreached. Finally, if the principal cause of the financial crisis was ultimately the government’s involvement in the housing finance system, housing finance policy in the future should be adjusted accordingly. 533 -----------------------------------------------------Page 562-----------------------------------------------------  CHRG-111hhrg55814--283 Mr. Manzullo," Thank you. I have a couple of questions. Mr. Dugan, on page 5 of your testimony you state, dealing with Federal Reserve separate authority and impose heightened prudential standards and safeguards concerning certain financial activities and practices, and then you say, ``Once the Council makes this identification, the Federal Reserve would have unilateral authority to establish a broad range of standards and safeguards for such activities and practices but without seeking public comment and without consulting with primary supervisors even where the primary supervisor has greater expertise and experience with respect to such activities.'' It is obvious you do not like that authority? " CHRG-111hhrg48674--189 Mr. Bernanke," They are not exempt from auditing. We have an outside auditor that does annual accounting. We have an Inspector General. And we have internal mechanisms, internal divisions, that look at the practices and management. " CHRG-110hhrg41184--63 Mrs. Maloney," Well, I congratulate you on your efforts in this area. It is very important. Would you agree that regulation of credit cards and credit card practices beyond disclosure, beyond Reg Z is necessary? " FinancialCrisisReport--536 Some Goldman clients also had questions about GSC’s involvement in Anderson. An Australian sales representative wanted “more color on asset selection process, especially with respect to GSC involvement.” 2338 This clarification was necessary, because although GSC’s role was mentioned in numerous internal Goldman documents, the official Anderson marketing materials did not mention GSC’s role in asset selection. 2339 In previous drafts of the marketing materials, for example, Goldman stated that “Goldman Sachs and GSC Group co-selected the assets”; “GSC pre-screens and evaluates assets for portfolio suitability”; the CDO was “co- sponsored by Goldman and GSC Eliot Bridge Fund”; and “Goldman Sachs and GSC ha[ve] aligned incentives with Anderson Funding by investing in a portion of equity.” 2340 But all of the references to GSC were removed from the final documents. 2341 Mr. Bieber told the Subcommittee that he did not recall specifically why the references to GSC were removed, but recalled GSC having an issue with disclosing its name in the offering documents. 2342 Edward Steffelin, a Senior Trader at GSC, also did not recall the specifics regarding why the references to GSC were removed, but told the Subcommittee that he felt GSC’s role in the Anderson CDO did not rise to the level of “co- selecting.” 2343 Mr. Steffelin said that although GSC had the ability to suggest assets and veto others, he felt that “co-selecting” implied a level of control over the portfolio that GSC didn’t have. 2344 2337 3/13/2007 email from Manisha Nanik to Loren Morris, “New Century EPDs,” at GS MBS-E-002146861, Hearing Exhibit 4/27-77. See also 2/2/2007 email from Matthew Nichols to Kevin Gasvoda and others, GS MBS-E- 005556331 ( “NC is running a 10% drop rate [due diligence drop] at ~6 points / drop and 4% EPD rate at close to 20 points.”); 2/8/2007 email from John Cassidy to Joseph Ozment, others, GS M BS-E-002045021 ( “Given the current state of the company I am no longer comfortable with the practice of taking loans with trailing docs . . . that we need in order to conduct compliance testing. ”). 2338 3/1/2007 email from Scott W isenbaker to Peter Ostrem and Matthew Bieber, GS M BS-E-000893661, Hearing Exhibit 4/27-172. 2339 2340 2/2007 Anderson Mezzanine Funding 2007-1, Ltd. Debt Marketing Book, GS MBS-E-000855351. 2/2007 Anderson Mezzanine Funding 2007-1, Ltd. Equity Marketing Book, GS MBS-E-000892557-598 at 560, 569. 2341 2/2007 Anderson Mezzanine Funding 2007-1, Ltd. Debt Marketing Book, GS MBS-E-000855351. Anderson Mezzanine Funding 2007-1, Ltd. Debt Marketing Book, GSC-CDO-FCIC-0031712 at 726. Around the time Goldman was deciding whether to underwrite Anderson, Fred Horton, head of CDOs at GSC, left the firm. While discussing whether to issue or underwrite the CDO with Matthew Bieber, Mr. Ostrem commented: “W ill need disclosure on Horton. This looks bad. ” 2/25/2007 email from Peter Ostrem to Matthew Bieber, GS MBS-E- 001996601, Hearing Exhibit 4/27-95. 2342 2343 Subcommittee interview of Matthew Bieber (10/21/2010). Subcommittee interview of Edward Steffelin (12/10/2010). The marketing materials also stated that the Anderson assets were “sourced from the Street.” Mr. Steffelin described this as a “weird phrase,” but felt it implied “it would be open, sourced from all over. ” See discussion of the phrase, “sourced from the Street,” in the prior section on Hudson 1. 2344 Id. Despite GSC ’s not being listed as having helped select the Anderson assets, some investors appeared to be aware of its involvement, perhaps from talking to Goldman personnel. See 3/28/2007 email from Matthew Bieber to Edward Steffelin, “ACA Meeting, ” GS MBS-E-014419176 ( “Questions on [Anderson] – but also want to do manager due diligence. They ’ve heard the GSC team shows well – so want to meet you in person.”). CHRG-111hhrg48674--330 Mr. Bernanke," Just to interject, the floor plans are eligible for the TALF under current rules. As far as securitization is concerned, even if the underlying credit isn't perfect, the AAA tranche, the more senior tranche, would still be eligible for financing through the TALF. We really couldn't--just procedurally and legally and operationally would have a great deal of difficulty financing individual loans. It is much more effective and efficient to have them in securitizations; and it is common practice to securitize those loans, as I understand. " fcic_final_report_full--326 On the next day, March , Treasury and White House officials received additional information about Fannie’s condition. The White House economist Jason Thomas sent Steel an email enclosing an alarming analysis: it claimed that in reporting its  financial results, Fannie was masking its insolvency through fraudulent ac- counting practices. The analysis, which resembled one offered in a March  Barron’s article, stated: Any realistic assessment of Fannie Mae’s capital position would show the company is currently insolvent. Accounting fraud has resulted in several asset categories (non-agency securities, deferred tax assets, low- income partnership investment) being overstated, while the guarantee obligation liability is understated. These accounting shenanigans add up to tens of billions of exaggerated net worth. Yet, the impact of a tsunami of mortgage defaults has yet to run through Fannie’s income statement and further annihilate its capital. Such grim results are a logical consequence of Fannie’s dual mandate to serve the housing market while maximizing shareholder returns. In try- ing to do both, Fannie has done neither well. With shareholder capital depleted, a government seizure of the company is inevitable.  Given the turmoil of the Bear Stearns crisis, Paulson said he wanted to increase confidence in the mortgage market by having Fannie and Freddie raise capital. Steel told him that Treasury, OFHEO, and the Fed were preparing plans to relax the GSEs’ capital surcharges in exchange for assurances that the companies would raise capital. On March , , Steel also reported to his Treasury colleagues that William Dudley, then executive vice president of the New York Fed, wanted to “harden” the implicit government guarantee of Freddie and Fannie. Steel wrote that Dudley “leaned on me hard” to make the guarantee explicit in conjunction with dialing back the surcharge and attempting to raise new capital, and Steel worried about how this might affect the federal government’s balance sheet: “I do not like that and it has not been part of my conversation with anyone else. I view that as a very significant move, way above my pay grade to double the size of the U.S. debt in one fell swoop.”  “THE IDEA STRIKES ME AS PERVERSE ” Regulators at OFHEO and the Treasury huddled with GSE executives to discuss low- ering capital requirements if the GSEs would raise more capital. “The entire mort- gage market was at risk,” Lockhart told the FCIC.  The pushing and tugging continued. Paulson told the FCIC that personal commitments from Mudd and Fred- die Mac CEO Richard Syron to raise capital cinched the deal.  Just days earlier, on March , Syron had announced in a quarterly call to investors that his company would not raise new capital. Fannie and Freddie executives prepared a draft press re- lease before a discussion with Lockhart and Steel. It announced a reduction in the capital surcharge from  to . Lockhart was not pleased; the draft lacked a com- mitment to raise additional capital, stating instead that the GSEs planned to raise it “over time as needed.”  It looked as if the GSEs were making the deal with their fin- gers crossed. In an email to Steel and the CEOs of both entities, Lockhart wrote: “The idea strikes me as perverse, and I assume it would seem perverse to the markets that a regulator would agree to allow a regulatee to increase its very high mortgage credit risk leverage (not to mention increasing interest rate risk) without any new capital.” The initial negotiations had the GSEs raising  of capital for each  of reduction in the surplus. Lockhart wrote in frustration, “We seem to have gone from  to  right through  to  to now  to .”  FOMC20060328meeting--283 281,MR. POOLE.," I like the format of the meeting for reasons already discussed. I would hate to lose the special topics that we have done twice a year. I think that’s what Jeff was referring to. I think they have been very valuable. I’d also point out that there’s a practical problem. Many of the boards of directors of Reserve Banks meet the second Thursday of the month, and a Tuesday–Wednesday schedule right ahead of that is not really practical. Richmond, in particular, has committee meetings at the end of the afternoon on Wednesday. Sometimes we do at the St. Louis Fed as well. So although I think a Tuesday–Wednesday is a better schedule than Monday–Tuesday, it really can’t be right up against the meetings of the boards of directors." CHRG-111hhrg67816--98 Mr. Leibowitz," I would want to come back--I would want to think about that. I would want to think about that. We certainly see experience--we certainly had experience with these advance fee scams including advance fee credit card scams that make us think that certainly the practice of a lot of companies should be prohibited. But as far as advance fees generally in the financial services area, I would want to think about that because there may be some value when legitimate companies are doing some things with advance fees. Ms. Matsui. So would you think then that the FTC should declare its view that it is an unfair practice to charge an advance fee for services that do nothing to save a home? " CHRG-110shrg50410--42 Secretary Paulson," Yes, let me say we have been--and I just would compliment--I just want to say something about both of these organizations. I agree with Senator Shelby that there are systemic risks, and no one today who has looked at this could argue that there isn't. But I would also say that when you look at the way they have run their operations, the reason we have these issues is they have got one line of business, there has been a housing correction. I would say that their standards and underwriting standards as we have gone through this period have been good relative to what we have seen many other places. And I would also say that they have worked with me, you know, not only over the weekend but leading up to the weekend, in a very constructive way. And so I would have every belief that, you know, the question you asked would play out that we would be in dialog, we would be in consultation. I think it will be very unusual if we suddenly say we think you need equity and no one else does, OK? I think this is something that we would work on together. But, again, to protect the Government, I cannot say that the only trigger is the GSEs come to us and ask for it and we give it to them. You would not want me to do that. Senator Bennett. I understand that. And your discretion means they come to you and ask for it, you may say no. That could also be---- " fcic_final_report_full--30 In Bakersfield, California, where home starts doubled and home values grew even faster between  and , the real estate appraiser Gary Crabtree initially felt pride that his birthplace,  miles north of Los Angeles, “had finally been dis- covered” by other Californians. The city, a farming and oil industry center in the San Joaquin Valley, was drawing national attention for the pace of its development. Wide-open farm fields were plowed under and divided into thousands of building lots. Home prices jumped  in Bakersfield in ,  in ,  in , and  more in . Crabtree, an appraiser for  years, started in  and  to think that things were not making sense. People were paying inflated prices for their homes, and they didn’t seem to have enough income to pay for what they had bought. Within a few years, when he passed some of these same houses, he saw that they were vacant. “For sale” signs appeared on the front lawns. And when he passed again, the yards were untended and the grass was turning brown. Next, the houses went into foreclosure, and that’s when he noticed that the empty houses were being vandalized, which pulled down values for the new suburban subdivisions. The Cleveland phenomenon had come to Bakersfield, a place far from the Rust Belt. Crabtree watched as foreclosures spread like an infectious disease through the community. Houses fell into disrepair and neighborhoods disintegrated. Crabtree began studying the market. In , he ended up identifying what he be- lieved were  fraudulent transactions in Bakersfield; some, for instance, were al- lowing insiders to siphon cash from each property transfer. The transactions involved many of the nation’s largest lenders. One house, for example, was listed for sale for ,, and was recorded as selling for , with  financing, though the real estate agent told Crabtree that it actually sold for ,. Crabtree realized that the gap between the sales price and loan amount allowed these insiders to pocket ,. The terms of the loan required the buyer to occupy the house, but it was never occupied. The house went into foreclosure and was sold in a distress sale for ,.  Crabtree began calling lenders to tell them what he had found; but to his shock, they did not seem to care. He finally reached one quality assurance officer at Fremont CHRG-110shrg50409--28 Mr. Bernanke," Well, as your point about the first quarter makes clear, even after the fact, it is sometimes hard to know exactly how much growth there was. Yes, our forecast calls for growth in the second half, but relatively weak. Part of what seems to have happened is that perhaps the fiscal stimulus or other factors--some of the growth that we anticipated--has been pulled forward into the second quarter, which looks to be doing somewhat better, frankly, than we anticipated. So our forecast---- Senator Bennett. You mean pulled forward into the first quarter? " CHRG-111hhrg48873--200 Mr. Dudley," In addition to that, we have worked on the governance of the compensation structure at AIG to basically firm it up so that they do a better job in terms of coordinating how compensation is done throughout the company. AIG is a company with a very weak core and lots of big business units spread all over the world. And so compensation was not done on a consistent basis across the company, and we are working to improve that with AIG. Ms. Velazquez. So if you imposed all those restrictions, how can you explain the types of bonuses that were provided by AIG? " CHRG-111shrg62643--15 Mr. Bernanke," Mr. Chairman, as you know, this is very controversial and there has been a lot of debate on both sides. On the one hand, and I will come back to a kind of recommendation, but on the one hand, you have folks who are focusing on the need for government support in the current economic environment. Obviously, in the United States and in many other countries, we have a great deal of excess capacity. Private spending is weak. And so the argument is that additional fiscal support might be helpful to the economy. " FOMC20070807meeting--46 44,MR. FISHER.," I noted Karen’s comments about the globalized interlinkages with financial markets, and I have a simple question for maybe Karen. In terms of the alternative scenario that was sketched for greater housing correction to spill over to confidence in financial markets, in that discussion and in that model or simulation, when you talk about equity prices, stresses in the debt markets, and further weakness in aggregate spending, are you talking about the United States only?" CHRG-111hhrg56776--55 Mr. Bernanke," Congressman, I have given a speech on this. I think the bottom line is, nobody really knows for sure, but that the evidence is really quite mixed. I would say even if they were too low for too long, the magnitude of the error was not big enough to account for the huge crisis we had. I think what caused the crisis were the failures of regulation. I would fault the Fed here, too, because some of those failures were ours in the sense that we did not do enough, and I have admitted this and acknowledged this many times, we did not do enough on mortgage regulation. I think it was the weakness of the regulatory system, not monetary policy, that was most important here. Dr. Paul. Of course, I do not agree with that, but if you assume for a minute that it was too low for too long, and you had perfect regulations, what is the harm done by interest rates being too low for too long? Do you see any damage by interest rates being artificially low for a long period of time? Let's sort that away from regulations for a second. " fcic_final_report_full--520 Finally, in a December 21, 2007, letter to Brian Montgomery, Assistant Secretary of Housing, Fannie CEO Daniel Mudd asked that, in light of the financial and economic conditions then prevailing in the country—particularly the absence of a PMBS market and the increasing number of mortgage delinquencies and defaults— HUD’s AH goals for 2007 be declared “infeasible.” He noted that HUD also has an obligation to “consider the financial condition of the enterprise when determining the feasibility of goals.” Then he continued: “Fannie Mae submits that the company took all reasonable actions to meet the subgoals that were both financially prudent and likely to contribute to the achievement of the subgoals…. In 2006, Fannie Mae relaxed certain underwriting standards and purchased some higher risk mortgage loan products in an effort to meet the housing goals. The company continued to purchase higher risk loans into 2007, and believes these efforts to acquire goals-rich loans are partially responsible for increasing credit losses.” 133 [emphasis supplied] This statement confirms two facts that are critical on the question of why Fannie (and Freddie) acquired so many high risk loans in 2006 and earlier years: first, the companies were trying to meet the AH goals established by HUD and not because these loans were profitable. It also shows that the efforts of HUD and others— including the Commission majority in its report—to blame the managements of Fannie and Freddie for purchasing the loans that ultimately dragged them to insolvency is misplaced. Finally, in a July 2009 report, the Federal Housing Finance Agency (FHFA, the GSEs’ new regulator, replacing OFHEO), noted that Fannie and Freddie both followed the practice of cross-subsidizing the subprime and Alt-A loans that they acquired: Although Fannie Mae and Freddie Mac consider model-derived estimates of cost in determining the single-family guarantee fees they charge, their pricing often subsidizes their guarantees on some mortgages using higher returns they expect to earn on guarantees of other loans. In both 2007 and 2008, cross-subsidization in single-family guarantee fees charged by the Enterprises was evident across product types, credit score categories, and LTV ratio categories. In each case, there were cross- subsidies from mortgages that posed lower credit risk on average to loans that posed higher credit risk. The greatest estimated subsidies generally went to the highest-risk mortgages. 134 The higher risk mortgages were the ones most needed by Fannie and Freddie to meet the AH goals. Needless to say, there is no need to cross-subsidize the G-fees of loans that are acquired because they are profitable. Accordingly, both market share and profitability must be excluded as reasons that Fannie (and Freddie) acquired subprime and Alt-A loans between 2004 and 131 132 133 134 Fannie Mae, “Housing Goals Forecast,” Alignment Meeting, June 22, 2007. Fannie Mae, Forecast Meeting, July 27, 2007 slide 4. Fannie Mae letter, Daniel Mudd to Asst. Secretary Brian Montgomery, December 21, 2007, p.6. FHFA, Fannie Mae and Freddie Mac Single Family Guarantee Fees in 2007 and 2008, p.33. 2007. The only remaining motive—and the valid one—was the effect of the AH goals imposed by HUD. CHRG-111hhrg74090--209 Mr. Dingell," Now, what would it lose? What would FTC lose? What consumer protection jurisdiction would it lose? Ms. Hillebrand. Yes. The FTC would lose the jurisdiction that has been important but difficult for it to use which is its authority to develop unfair and deceptive acts and practices rules in the financial services area. I am sure you are aware the last time that authority was used was in the credit practices rule, which came into effect in the mid-1980s. " Mr. Dingell," OK. Now, why should that be taken away from FTC? Ms. Hillebrand. If we were looking at just the FTC, there would be no reason to take it away, but the problem is, we need---- " CHRG-111hhrg53248--153 Mr. Scott," There is another growing practice that is happening in our financial sector and some banks, not all, but we have gotten reports where, in our rush to allow banks to do a multiplicity of services and products in which they have encouraged individuals to open up their savings account at this bank, open up their checking account at this bank and if they need a loan or home equity loan or any loan that they would take at the bank. What happens is that oftentimes and particularly now when there is pressure on consumers out there to--and they are on the margins, where these banks would go in and if they are a week or 2 late on their payment for a loan, they would go in and take that individual's savings without their knowledge and--or their checking and apply it to the loan. " CHRG-111shrg57321--170 Mr. McDaniel," Yes, we saw loosening underwriting standards---- Senator Kaufman. Right. Mr. McDaniel [continuing]. And we were certainly aware that home price appreciation was occurring through this period. Senator Kaufman. So, it is hard--Ms. Corbet, I will get back to it and maybe the two of you can work together. There is the chart. Oh, that bubble just came on. Look, I am not saying we are all victims of our own personal experience. In 2005, I sent my children a printout from Merrill Lynch of essentially that chart, and I sent with them what Merrill Lynch said. People say that this is because there are so many more people buying houses, but if that was true, they showed another chart and it showed then rental use would go up, too, and rental use was rock solid. So we have a housing bubble. That is what Merrill Lynch sent out to me as a Merrill Lynch investor and I sent it to my kids. The fact that we were coming onto a bubble, as you say, you didn't say it in 2003, but you are talking about it generally and you are still--do you see my point? These products are still rolling off the assembly lines with AAA on them. " CHRG-111shrg49488--66 Mr. Clark," Absolutely. We originate all the mortgages. We do not buy mortgages. We originate our own mortgages. And, therefore, we are very concerned about the underwriting standards because we are going to take the risks. I do believe that the system of holding the mortgages does a couple of things for you. One, it means you have the banking system trying to make sure you have conservative risk, not wild risk. But, second, it actually gives us an asset. The way I always describe our bank is we are not an income statement that generates a balance sheet. We are a balance sheet that generates an income statement. And that means we have a solidity of earnings that is there because we are not originating mortgages, then selling them off, and then saying, well, where am I getting next year's income if we originate more and sell them off. We are actually holding them. And so I think it produces tremendous stability in the system, but it does require a regulatory regime that does not penalize you for capital if, in fact, you hold a low-risk asset like that. Senator McCaskill. Do you think we should have regulations that require people who close mortgages to assume some of the risk? " FinancialCrisisReport--186 Attention that were noted in prior examinations but were not adequately addressed, including … an ERM function that was not fully effective.” 683 The ROE concluded: “The ERM function has been less than effective for some time. … ERM has not matured in a timely manner and other ERM functions have been generally ineffective.” 684 A separate OTS examination of WaMu’s compliance function observed that WaMu had hired nine different compliance officers in the past seven years, and that “[t]his amount of turnover is very unusual for an institution of this size and is a cause for concern.” 685 Despite these harsh assessments in 2007, OTS again refrained from taking any enforcement action against the bank such as developing a nonpublic Memorandum of Understanding or a public Cease and Desist Order with concrete plans for strengthening WaMu’s risk management efforts. 2008 Risk Management Deficiencies. In 2008, as WaMu continued to post billions of dollars in losses, OTS continued to express concerns about its risk management practices. In February 2008, OTS downgraded WaMu to a 3 CAMELS rating and required the bank to issue a Board Resolution committing to certain strategic initiatives including “a more disciplined framework for the identification and management of compliance risks.” 686 In June 2008, OTS issued a Findings Memorandum reacting to a WaMu internal review that found significant levels of loan fraud at a particular loan office, and expressed concern “as to whether similar conditions are systemic throughout the organization.” 687 The memorandum noted that “a formalized process did not exist to identify, monitor, resolve, and escalate third party complaints” about loan fraud, expressed concern about “an origination culture focused more heavily on production volume rather than quality”; noted that the WaMu review had found the “loan origination process did not mitigate misrepresentation/fraud”; and described the “need to implement incentive compensation programs to place greater emphasis on loan quality.” As referenced above, in July 2008, two months before the bank’s failure, OTS made a presentation to the WaMu Board which, among other problems, criticized its risk management efforts: “An adequate [Enterprise Risk Management] function still does not exist although this has been an MRBA [Matter Requiring Board Attention] for some time. Critical as a check and balance for profit oriented units[.] Necessary to ensure that critical risks are 683 Id. at OTSWMEF-0000046690. 684 Id. at OTSWMEF-0000046691. 685 5/31/2007 Draft OTS Findings Memorandum, “Compliance Management Program,” Franklin_Benjamin- 00020408_001, Hearing Exhibit 4/16-9. 686 3/11/2008 WaMu presentation, “Summary of Management’s Action to Address OTS Concerns,” JPM_WM01022322; 3/17/2008 letter from Kerry Killinger to Darrel Dochow with enclosed Board Resolution, OTSWMS08-015 0001216 (committing to initiatives outlined by management). 687 6/19/2008 OTS Asset Quality Memo 22, Bisset_John-00046124_002, Hearing Exhibit 4/16-12a. identified, measured, monitored and communicated[.] Even more critical given increased credit, market, and operational risk.” 688 CHRG-110hhrg41184--65 Mrs. Maloney," And as you said to Ms. Biggert, you believe substantive corrections of credit card practices can be done without restricting access to credit or restricting consumer spending? " CHRG-111hhrg53021--86 Secretary Geithner," Well, Congressman, if you are asking, again, whether we think it is appropriate in the consumer protection area--again, this is the marketing of financial products to individual consumers--there are some practices that I do think should be proscribed. " CHRG-111hhrg56847--77 Mr. Bernanke," We have done a series of papers. We have done one on monetary policy, which was made public. We have done a number of papers on supervision practice, and they have been guiding us to a revamping of our supervisory structure. So we have been doing a number of different---- " CHRG-111hhrg56847--52 Mr. Doggett," You believe we will see real genuine change in compensation practices from before this downturn to now, that people will be able to tell the difference? " CHRG-111hhrg54867--128 Secretary Geithner," I would be happy to do that. But as I said, I think the broad thrust of those proposals looks very encouraging and promising to us. And there is nothing in there at first glance that troubles me significantly in terms of its practical value. " CHRG-109shrg30354--82 Chairman Bernanke," I think as a practical matter being literally energy independent is not something that is feasible in the near-term. Senator Carper. It will not happen in my term and probably not yours either. " CHRG-111shrg57322--112 Mr. Sparks," Well, with respect to the origination practices, those would have been disclosed. Senator Kaufman. But they would not be disclosed to the people who were buying your securitized mortgages. I guarantee they were not disclosed. " CHRG-111hhrg53021Oth--86 Secretary Geithner," Well, Congressman, if you are asking, again, whether we think it is appropriate in the consumer protection area--again, this is the marketing of financial products to individual consumers--there are some practices that I do think should be proscribed. " CHRG-111hhrg54868--70 Mr. Dugan," But that rule was not in place. Mr. Miller of North Carolina. Okay. You have said on several occasions that there were a great many practices that you simply stopped banks from doing by dissuading them from doing it as part of your supervision. " CHRG-111shrg54789--161 Mr. Wallison," I think, Senator Shelby, you are focusing on exactly the problem here, which is trying to determine in advance what a person understands. The first person you are talking about--that consumer--may or may not have understood all of the elements of this loan, but it worked for him. It might not even have been the best loan he could have gotten, but it still worked for him. In the second case, it did not work for him. I am looking at it, again--and I must do this because we have to consider the way this works in practice--from the standpoint of the provider. The provider is going to be very much at risk if he offers a loan to the first or the second person--the same loan---- Senator Shelby. That is right. " FOMC20060629meeting--8 6,MR. KOS.," It’s reasonable that all of those factors would have had some influence. I suppose another factor would be the extent to which some market participants may have seen not only positioning but also future weakness from the global tightening that is occurring, especially in the industrial countries but also in China—that such tightening will at some point affect the demand for commodities and for resources. Some of those positions and adjustments may have been fundamentally based. If one had to explain the scale of the price moves, that would probably be a secondary factor." CHRG-111hhrg54867--51 Mr. Hensarling," Let's speak about balance for a second, Mr. Secretary. In your statement earlier today, you said that the Administration's proposal addresses core regulatory failures and weaknesses that directly contributed to the crisis and the dangers that could lead to the next one. As many of us look at your proposal for a CFPA, we see something that is very broad, very Draconian. As we read the legislative language, is it not true that ultimately Wal-Mart, Target, and Macy's could be subject to regulation by the CFPA? " FOMC20070509meeting--8 6,MR. DUDLEY.," I’m sure there is a disparity between the two. I do not know of any way to break that out clearly. One factor—the weakness of the dollar versus the euro—is definitely helping to boost corporate earnings. A disproportionate share of U.S. foreign activity is Europe- oriented, so it’s a bigger share than would be suggested by the European share of global GDP. That factor is definitely helping to support our earnings. I have never seen any data on that. We’ll look into it to see if there’s anything, but I’m not hopeful." CHRG-109shrg30354--52 Chairman Bernanke," Senator, on your first point about housing, we are watching housing market very carefully. I would point out that there have been some offsets in nonresidential construction, in exports, and in investment. So other parts of the economy are picking up to offset some of the weakness we see in the housing market. But we are watching that very carefully. Your point on owner-occupied equivalent rent is a good point and we are quite aware of it. Senator Sarbanes. Seventy percent of the housing in this country is owner occupied; correct? " CHRG-111shrg51395--119 Under high competition, lower ratings declined and investment grade rations soared. The authors conclude that increased competition may impair ``the reputational mechanism that underlies the provision of good quality ratings.'' \28\--------------------------------------------------------------------------- \28\ Id. at 21.--------------------------------------------------------------------------- The anecdotal evidence supports a similar conclusion: the major rating agencies responded to the competitive threat from Fitch by making their firms ``more client-friendly and focused on market share.'' \29\ Put simply, the evidence implies that the rapid change toward a more competitive environment made the competitors not more faithful to investors, but more dependent on their immediate clients, the issuers. From the standpoint of investors, agency costs increased.--------------------------------------------------------------------------- \29\ See ``Ratings Game--As Housing Boomed, Moody's Opened Up,'' The Wall Street Journal, April 11, 2008, at p. A-1.---------------------------------------------------------------------------The Responsibility of the SEC Each of the major investment banks that failed, merged, or converted into bank holding companies in 2008 had survived prior recessions, market panics, and repeated turmoil and had long histories extending back as far as the pre-Civil War era. Yet, each either failed or was gravely imperiled within the same basically 6 month period following the collapse of Bear Stearns in March 2008. \30\--------------------------------------------------------------------------- \30\ For a concise overview of these developments, see Jon Hilsenrath, Damian Palette, and Aaron Lucchetti, ``Goldman, Morgan Scrap Wall Street Model, Become Banks in Bid To Ride Out Crisis,'' The Wall Street Journal, September 22, 2008, at p. A-1 (concluding that independent investment banks could not survive under current market conditions and needed closer regulatory supervision to establish credibility).--------------------------------------------------------------------------- If their uniform collapse is not alone enough to suggest the likelihood of regulatory failure, one additional common fact unites them: each of these five firms voluntarily entered into the SEC's Consolidated Supervised Entity (``CSE'') Program, which was established by the SEC in 2004 for only the largest investment banks. \31\ Indeed, these five investment banks were the only investment banks permitted by the SEC to enter the CSE program. A key attraction of the CSE Program was that it permitted its members to escape the SEC's traditional net capital rule, which placed a maximum ceiling on their debt to equity ratios, and instead elect into a more relaxed ``alternative net capital rule'' that contained no similar limitation. \32\ The result was predictable: all five of these major investment banks increased their debt-to-equity leverage ratios significantly over the brief two year period following their entry into the CSE Program, as shown by Figure 1 below: \33\--------------------------------------------------------------------------- \31\ See Securities Exchange Act Release No. 34-49830 (June 21, 2004), 69 FR 34428 (``Alternative Net Capital Requirements for Broker-Dealers That Are Part of Consolidated Supervised Entities''). \32\ The SEC's ``net capital rule,'' which dates back to 1975, governs the capital adequacy and aggregate indebtedness permitted for most broker-dealers. See Rule 15c3-1 (``Net Capital Requirements for Brokers and Dealers''). 17 C.F.R. 240.15c3-1. Under subparagraph (a)(1)(i) of this rule, aggregate indebtedness is limited to fifteen times the broker-dealer's net capital; a broker-dealer may elect to be governed instead by subparagraph (a)(1)(ii) of this rule, which requires it maintain its net capital at not less than the greater of $250,000 or two percent of ``aggregate debit items'' as computed under a special formula that gives ``haircuts'' (i.e., reduces the valuation) to illiquid securities. Both variants place fixed limits on leverage. \33\ This chart comes from U.S. Securities and Exchange Commission, Office of the Inspector General, ``SEC's Oversight of Bear Stearns and Related Entities: The Consolidated Entity Program'' (`Report No. 446-A, September 25, 2008) (hereinafter ``SEC Inspector General Report'') at Appendix IX at p. 120. For example, at the time of its insolvency, Bear Stearns' gross leverage ratio had hit 33 to 1. \34\--------------------------------------------------------------------------- \34\ See SEC Inspector General Report at 19.--------------------------------------------------------------------------- The above chart likely understates the true increase in leverage because gross leverage (i.e., assets divided by equity) does not show the increase in off-balance sheet liabilities, as the result of conduits and liquidity puts. Thus, another measure may better show the sudden increase in risk. One commonly used metric for banks is the bank's value at risk (VaR) estimate, which banks report to the SEC in their annual report on Form 10-K. This measure is intended to show the risk inherent in their financial portfolios. The chart below shows ``Value at Risk'' for the major underwriters over the interval 2004 to 2007: \35\--------------------------------------------------------------------------- \35\ See Ferrell, Bethel, and Hu, supra note 15, at Table 8. Value at risk estimates have proven to be inaccurate predictors of the actual writedowns experienced by banks. They are cited here not because they are accurate estimates of risk, but because the percentage increases at the investment banks was generally extreme. Even Goldman Sachs, which survived the crisis in better shape than its rivals, saw its VaR estimate more than double over this period. Value at Risk, 2004-2007------------------------------------------------------------------------ 2004 2005 2006 2007 Firms ($mil) ($mil) ($mil) ($mil)------------------------------------------------------------------------Bank of America................. $44.1 $41.8 $41.3 -Bear Stearns.................... 14.8 21.4 28.8 $69.3Citigroup....................... 116.0 93.0 106.0 -Credit Suisse................... 55.1 66.2 73.0 -Deutsche Bank................... 89.8 82.7 101.5 -Goldman Sachs................... 67.0 83.0 119.0 134.0JPMorgan........................ 78.0 108.0 104.0 -Lehman Brothers................. 29.6 38.4 54.0 124.0Merrill Lynch................... 34.0 38.0 52.0 -Morgan Stanley.................. 94.0 61.0 89.0 83.0UBS............................. 103.4 124.7 132.8 -Wachovia........................ 21.0 18.0 30.0 -------------------------------------------------------------------------VaR statistics are reported in the 10K or 20F (in the case of foreign firms) of the respective firms. Note that the firms use different assumptions in computing their Value of Risk. Some annual reports are not yet avaialble for 2007. Between 2004 and 2007, both Bear Stearns and Lehman more than quadrupled their value at risk estimates, while Merrill Lynch's figure also increased significantly. Not altogether surprisingly, they were the banks that failed. These facts provide some corroboration for an obvious hypothesis: excessive deregulation by the SEC caused the liquidity crisis that swept the global markets in 2008. \36\ Still, the problem with this simple hypothesis is that it may be too simple. Deregulation did contribute to the 2008 financial crisis, but the SEC's adoption of the CSE Program in 2004 was not intended to be deregulatory. Rather, the program was intended to compensate for earlier deregulatory efforts by Congress that had left the SEC unable to monitor the overall financial position and risk management practices of the nation's largest investment banks. Still, even if the 2004 net capital rule changes were not intended to be deregulatory, they worked out that way in practice. The ironic bottom line is that the SEC unintentionally deregulated by introducing an alternative net capital rule that it could not effectively monitor.--------------------------------------------------------------------------- \36\ For the bluntest statement of this thesis, see Stephen Labaton, ``S.E.C. Concedes Oversight Plans Fueled Collapse,'' New York Times, September 27, 2008, at p. 1. Nonetheless, this analysis is oversimple. Although SEC Chairman Cox did indeed acknowledge that there were flaws in the ``Consolidated Supervised Entity'' Program, he did not concede that it ``fueled'' the collapse or that it represented deregulation. As discussed below, the SEC probably legitimately believed that it was gaining regulatory authority from the CSE Program (but it was wrong).--------------------------------------------------------------------------- The events leading up to the SEC's decision to relax its net capital rule for the largest investment banks began in 2002, when the European Union adopted its Financial Conglomerates Directive. \37\ The main thrust of the E.U.'s new directive was to require regulatory supervision at the parent company level of financial conglomerates that included a regulated financial institution (e.g., a broker-dealer, bank or insurance company). The E.U.'s entirely reasonable fear was that the parent company might take actions that could jeopardize the solvency of the regulated subsidiary. The E.U.'s directive potentially applied to the major U.S. investment and commercial banks because all did substantial business in London (and elsewhere in Europe). But the E.U.'s directive contained an exemption for foreign financial conglomerates that were regulated by their home countries in a way that was deemed ``equivalent'' to that envisioned by the directive. For the major U.S. commercial banks (several of which operated a major broker-dealer as a subsidiary), this afforded them an easy means of avoiding group-wide supervision by regulators in Europe, because they were subject to group-level supervision by U.S. banking regulators.--------------------------------------------------------------------------- \37\ See Council Directive 2002/87, Financial Conglomerates Directive, 2002 O.J. (L 35) of the European Parliament and of the Council of 16 December 2002 on the supplementary supervision of credit institutions, insurance undertakings and investment firms in a financial conglomerate and amending Council Directives. For an overview of this directive and its rationale, see Jorge E. Vinuales, The International Regulation of Financial Conglomerates: A Case Study of Equivalence as an Approach to Financial Integration, 37 Cal. W. Int'l L.J. 1, at 2 (2006).--------------------------------------------------------------------------- U.S. investment banks had no similar escape hatch, as the SEC had no similar oversight over their parent companies. Thus, fearful of hostile regulation by some European regulators, \38\ U.S. investment banks lobbied the SEC for a system of ``equivalent'' regulation that would be sufficient to satisfy the terms of the directive and give them immunity from European oversight. \39\ For the SEC, this offered a serendipitous opportunity to oversee the operations of investment bank holding companies, which authority the SEC had sought for some time. Following the repeal of the Glass-Steagall Act, the SEC had asked Congress to empower it to monitor investment bank holding companies, but it had been rebuffed. Thus, the voluntary entry of the holding companies into the Consolidated Supervised Entity program must have struck the SEC as a welcome development, and Commission unanimously approved the program without any partisan disagreement. \40\--------------------------------------------------------------------------- \38\ Different European regulators appear to have been feared by different entities. Some commercial banks saw French regulation as potentially hostile, while U.S. broker-dealers, all largely based in London, did not want their holding companies to be overseen by the U.K.'s Financial Services Agency (FSA). \39\ See Stephen Labaton, ``Agency's '04 Rule Let Banks Pile Up Debt and Risk,'' New York Times, October 3, 2008, at A-1 (describing major investment banks as having made an ``urgent plea'' to the SEC in April, 2004). \40\ See Securities Exchange Act Release No. 34-49830, supra note 31.--------------------------------------------------------------------------- But the CSE Program came with an added (and probably unnecessary) corollary: Firms that entered the CSE Program were permitted to adopt an alternative and more relaxed net capital rule governing their debt to net capital ratio. Under the traditional net capital rule, a broker-dealer was subject to fixed ceilings on its permissible leverage. Specifically, it either had to (a) maintain aggregate indebtedness at a level that could not exceed fifteen times net capital, \41\ or (b) maintain minimum net capital equal to not less than two percent of ``aggregate debit items.'' \42\ For most broker-dealers, this 15 to 1 debt to net capital ratio was the operative limit within which they needed to remain by a comfortable margin.--------------------------------------------------------------------------- \41\ See Rule 15c3-1(a)(1)(i)(``Alternative Indebtedness Standard''), 17 C.F.R. 240.15c3-1(a)(1). \42\ See Rule 15c3-1(a)(1)(ii)(``Alternative Standard''), 17 C.F.R. 240.15c3-1(a)(1)(ii). This alternative standard is framed in terms of the greater of $250,000 or 2 percent, but for any investment bank of any size, 2 percent will be the greater. Although this alternative standard may sound less restrictive, it was implemented by a system of ``haircuts'' that wrote down the value of investment assets to reflect their illiquidity.--------------------------------------------------------------------------- Why did the SEC allow the major investment banks to elect into an alternative regime that placed no outer limit on leverage? Most likely, the Commission was principally motivated by the belief that it was only emulating the more modern ``Basel II'' standards that the Federal Reserve Bank and European regulators were then negotiating. To be sure, the investment banks undoubtedly knew that adoption of Basel II standards would permit them to increase leverage (and they lobbied hard for such a change). But, from the SEC's perspective, the goal was to design the CSE Program to be broadly consistent with the Federal Reserve's oversight of bank holding companies, and the program even incorporated the same capital ratio that the Federal Reserve mandated for bank holding companies. \43\ Still, the Federal Reserve introduced its Basel II criteria more slowly and gradually, beginning more than a year later, while the SEC raced in 2004 to introduce a system under which each investment bank developed its own individualized credit risk model. Today, some believe that Basel II represents a flawed model even for commercial banks, while others believe that, whatever its overall merits, it was particularly ill-suited for investment banks. \44\--------------------------------------------------------------------------- \43\ See SEC Inspector General Report at 10-11. Under these standards, a ``well-capitalized'' bank was expected to maintain a 10 percent capital ratio. Id. at 11. Nonetheless, others have argued that Basel II ``was not designed to be used by investment banks'' and that the SEC ``ought to have been more careful in moving banks on to the new rules.'' See ``Mewling and Puking: Bank Regulation,'' The Economist, October 25, 2008 (U.S. Edition). \44\ For the view that Basel II excessively deferred to commercial banks to design their own credit risk models and their increase leverage, see Daniel K. Tarullo, BANKING ON BASEL: The Future of International Financial Regulation (2008). Mr. Tarullo has recently been nominated by President Obama to the Board of Governors of the Federal Reserve Board. For the alternative view, that Basel II was uniquely unsuited for investment banks, see ``Mewling and Puking,'' supra note 43.--------------------------------------------------------------------------- Yet, what the evidence demonstrates most clearly is that the SEC simply could not implement this model in a fashion that placed any real restraint on its subject CSE firms. The SEC's Inspector General examined the failure of Bear Stearns and the SEC's responsibility therefor and reported that Bear Stearns had remained in compliance with the CSE Program's rules at all relevant times. \45\ Thus, if Bear Stearns had not cheated, this implied (as the Inspector General found) that the CSE Program, itself, had failed. The key question is then what caused the CSE Program to fail. Here, three largely complementary hypotheses are plausible. First, the Basel II Accords may be flawed, either because they rely too heavily on the banks' own self-interested models of risk or on the highly conflicted ratings of the major credit rating agencies. \46\ Second, even if Basel II made sense for commercial banks, it may have been ill-suited for investment banks. \47\ Third, whatever the merits of Basel II in theory, the SEC may have simply been incapable of implementing it.--------------------------------------------------------------------------- \45\ SEC Inspector General Report, 10. \46\ The most prominent proponent of this view is Professor Daniel Tarullo. See supra note 44. \47\ See ``Mewling and Puking,'' supra note 43.--------------------------------------------------------------------------- Clearly, however, the SEC moved faster and farther to defer to self-regulation by means of Basel II than did the Federal Reserve. \48\ Clearly also, the SEC's staff was unable to monitor the participating investment banks closely or to demand specific actions by them. Basel II's approach to the regulation of capital adequacy at financial institutions contemplated close monitoring and supervision. Thus, the Federal Reserve assigns members of its staff to maintain an office within a regulated bank holding company in order to provide constant oversight. In the case of the SEC, a team of only three SEC staffers were assigned to each CSE firm \49\ (and a total of only thirteen individuals comprised the SEC's Office of Prudential Supervision and Risk Analysis that oversaw and conducted this monitoring effort). \50\ From the start, it was a mismatch: three SEC staffers to oversee an investment bank the size of Merrill Lynch, which could easily afford to hire scores of highly quantitative economists and financial analysts, implied that the SEC was simply outgunned. \51\--------------------------------------------------------------------------- \48\ The SEC adopted its CSE program in 2004. The Federal Reserve only agreed in principle to Basel II in late 2005. See Stavros Gadinis, The Politics of Competition in International Financial Regulation, 49 Harv. Int'l L. J. 447, 507 n. 192 (2008). \49\ SEC Inspector General Report at 2. \50\ Id. Similarly, the Office of CSE Inspectors had only seven staff. Id. \51\ Moreover, the process effectively ceased to function well before the 2008 crisis hit. After SEC Chairman Cox re-organized the CSE review process in the Spring of 2007, the staff did not thereafter complete ``a single inspection.'' See Labaton, supra note 39.--------------------------------------------------------------------------- This mismatch was compounded by the inherently individualized criteria upon which Basel II relies. Instead of applying a uniform standard (such as a specific debt to equity ratio) to all financial institutions, Basel II contemplated that each regulated financial institution would develop a computer model that would generate risk estimates for the specific assets held by that institution and that these estimates would determine the level of capital necessary to protect that institution from insolvency. Thus, using the Basel II methodology, the investment bank generates a mathematical model that crunches historical data to evaluate how risky its portfolio assets were and how much capital it needed to maintain to protect them. Necessarily, each model was ad hoc, specifically fitted to that specific financial institution. But no team of three SEC staffers was in a position to contest these individualized models or the historical data used by them. Effectively, the impact of the Basel II methodology was to shift the balance of power in favor of the management of the investment bank and to diminish the negotiating position of the SEC's staff. Whether or not Basel II's criteria were inherently flawed, it was a sophisticated tool that was beyond the capacity of the SEC's largely legal staff to administer effectively. The SEC's Inspector General's Report bears out this critique by describing a variety of instances surrounding the collapse of Bear Stearns in which the SEC's staff did not respond to red flags that the Inspector General, exercising 20/20 hindsight, considered to be obvious. The Report finds that although the SEC's staff was aware that Bear Stearns had a heavy and increasing concentration in mortgage securities, it ``did not make any efforts to limit Bear Stearns mortgage securities concentration.'' \52\ In its recommendations, the Report proposed both that the staff become ``more skeptical of CSE firms' risk models'' and that it ``develop additional stress scenarios that have not already been contemplated as part of the prudential regulation process.'' \53\--------------------------------------------------------------------------- \52\ SEC Inspector General Report at ix. \53\ SEC Inspector General Report at ix.--------------------------------------------------------------------------- Unfortunately, the SEC Inspector General Report does not seem realistic on this score. The SEC's staff cannot really hope to regulate through gentle persuasion. Unlike a prophylactic rule (such as the SEC's traditional net capital rule that placed a uniform ceiling on leverage for all broker-dealers), the identification of ``additional stress scenarios'' by the SEC's staff does not necessarily lead to specific actions by the CSE firms; rather, such attempts at persuasion are more likely to produce an extended dialogue, with the SEC's staff being confronted with counter-models and interpretations by the financial institution's managers. The unfortunate truth is that in an area where financial institutions have intense interests (such as over the question of their maximum permissible leverage), a government agency in the U.S. is unlikely to be able to obtain voluntary compliance. This conclusion is confirmed by a similar assessment from the individual with perhaps the most recent experience in this area. Testifying in September, 2008 testimony before the Senate Banking Committee, SEC Chairman Christopher Cox emphasized the infeasibility of voluntary compliance , expressing his frustration with attempts to negotiate issues such as leverage and risk management practices with the CSE firms. In a remarkable statement for a long-time proponent of deregulation, he testified: Beyond highlighting the inadequacy of the . . . CSE program's capital and liquidity requirements, the last six months--during which the SEC and the Federal Reserve worked collaboratively with each of the CSE firms . . . --have made abundantly clear that voluntary regulation doesn't work. \54\--------------------------------------------------------------------------- \54\ See Testimony of SEC Chairman Christopher Cox before the Committee on Banking, Housing, and Urban Affairs, United States Senate, September 23, 2008 (``Testimony Concerning Turmoil in U.S. Credit Markets: Recent Actions Regarding Government Sponsored Entities, Investment Banks and Other Financial Institutions''), at p. 4 (available at www.sec.gov) (emphasis added). Chairman Cox has repeated this theme in a subsequent Op/Ed column in the Washington Post, in which he argued that ``Reform legislation should steer clear of voluntary regulation and grant explicit authority where it is needed.'' See Christopher Cox, ``Reinventing A Market Watchdog,'' the Washington Post, November 4, 2008, at A-17. His point was that the SEC had no inherent authority to order a CSE firm to reduce its debt to equity ratio or to keep it in the CSE Program. \55\ If it objected, a potentially endless regulatory negotiation might only begin.--------------------------------------------------------------------------- \55\ Chairman Cox added in the next sentence of his Senate testimony: ``There is simply no provision in the law authorizes the CSE Program, or requires investment bank holding companies to compute capital measures or to maintain liquidity on a consolidated basis, or to submit to SEC requirements regarding leverage.'' Id. This is true, but if a CSE firm left the CSE program, it would presumably become subject to European regulation; thus, the system was not entirely voluntary and the SEC might have used the threat to expel a non-compliant CSE firm. The SEC's statements about the degree of control they had over participants in the CSE Program appear to have been inconsistent over time and possibly defensively self-serving. But clearly, the SEC did not achieve voluntary compliance.--------------------------------------------------------------------------- Ultimately, even if one absolves the SEC of ``selling out'' to the industry in adopting the CSE Program in 2004, it is still clear at a minimum that the SEC lacked both the power and the expertise to restrict leverage by the major investment banks, at least once the regulatory process began with each bank generating its own risk model. Motivated by stock market pressure and the incentives of a short-term oriented executive compensation system, senior management at these institutions affectively converted the process into self-regulation. One last factor also drove the rush to increased leverage and may best explain the apparent willingness of investment banks to relax their due diligence standards: competitive pressure and the need to establish a strong market share in a new and expanding market drove the investment banks to expand recklessly. For the major players in the asset-backed securitization market, the long-term risk was that they might be cut off from their source of supply, if loan originators were acquired by or entered into long-term relationships with their competitors, particularly the commercial banks. Needing an assured source of supply, some investment banks (most notably Lehman and Merrill, Lynch) invested heavily in acquiring loan originators and related real estate companies, thus in effect vertically integrating. \56\ In so doing, they assumed even greater risk by increasing their concentration in real estate and thus their undiversified exposure to a downturn in that market. This need to stay at least even with one's competitors best explains the now famous line uttered by Charles Prince, the then CEO of Citigroup in July, 2007, just as the debt market was beginning to collapse. Asked by the Financial Times if he saw a liquidity crisis looming, he answered:--------------------------------------------------------------------------- \56\ See Terry Pristin, ``Risky Real Estate Deals Helped Doom Lehman,'' N.Y. Times, September 17, 2008, at C-6 (discussing Lehman's expensive, multi-billion dollar acquisition of Archstone-Smith); Gretchen Morgenson, ``How the Thundering Herd Faltered and Fell,'' N.Y. Times, November 9, 2008, at B4-1 (analyzing Merrill Lynch's failure and emphasizing its acquisitions of loan originators). When the music stops, in terms of liquidity, things will get complicated. But as long as the music is playing, you've got to get up and dance. We're still dancing. \57\--------------------------------------------------------------------------- \57\ See Michiyo Nakamoto & David Wighton, ``Citigroup Chief Stays Bullish on Buy-Outs,'' Financial Times, July 9, 2007, available at http://www.ft.com/cms/s/0/80e2987a-2e50-11dc-821c-0000779fd2ac.html In short, competition among the major investment banks can periodically produce a mad momentum that sometimes leads to a lemmings-like race over the cliff. \58\ This in essence had happened in the period just prior to the 2000 dot.com bubble, and again during the accounting scandals of 2001-2002, and this process repeated itself during the subprime mortgage debacle. Once the market becomes hot, the threat of civil liability--either to the SEC or to private plaintiffs in securities class actions--seems only weakly to constrain this momentum. Rationalizations are always available: ``real estate prices never fall;'' ``the credit rating agencies gave this deal a `Triple A' rating,'' etc. Explosive growth and a decline in professional standards often go hand in hand. Here, after 2000, due diligence standards appear to have been relaxed, even as the threat of civil liability in private securities litigation was growing. \59\--------------------------------------------------------------------------- \58\ Although a commercial bank, Citigroup was no exception this race, impelled by the high fee income it involved. From 2003 to 2005, ``Citigroup more than tripled its issuing of C.D.O.s to more than $30 billion from $6.28 billion.'' See Eric Dash and Julie Creswell, ``Citigroup Pays for a Rush to Risk'' New York Times, November 22, 2008, at 1, 34. In 2005 alone, the New York Times estimates that Citigroup received over $500 million in fee income from these C.D.O. transactions. From being the sixth largest issuer of C.D.O.s in 2003, it rose to being the largest C.D.O. issuer worldwide by 2007, issuing in that year some $49.3 billion out of a worldwide total of $442.3 billion (or slightly over 11 percent of the world volume). Id. at 35. What motivated this extreme risk-taking? Certain of the managers running Citigroup's securitization business received compensation as high as $34 million per year (even though they were not among the most senior officers of the bank). Id. at 34. This is consistent with the earlier diagnosis that equity compensation inclines management to accept higher and arguably excessive risk. At the highest level of Citigroup's management, the New York Times reports that the primary concern was ``that Citigroup was falling behind rivals like Morgan Stanley and Goldman.'' Id. at 34 (discussing Robert Rubin and Charles Prince's concerns). Competitive pressure is, of course, enforced by the stock market and Wall Street's short-term system of bonus compensation. The irony then is that a rational strategy of deleveraging cannot be pursued by making boards and managements more sensitive to shareholder desires. \59\ From 1996 to 1999, the settlements in securities class actions totaled only $1.7 billion; thereafter, aggregate settlements rose exponentially, hitting a peak of $17.1 billion in 2006 alone. See Laura Simmons & Ellen Ryan, ``Securities Class Action Settlements: 2006, Review and Analysis'' (Cornerstone Research 2006) at 1. This decline of due diligence practices as liability correspondingly increased seems paradoxical, but may suggest that at least private civil liability does not effectively deter issuers or underwriters.--------------------------------------------------------------------------- As an explanation for an erosion in professional standards, competitive pressure applies with particular force to those investment banks that saw asset-back securitizations as the core of their future business model. In 2002, a critical milestone was reached, as in that year the total amount of debt securities issued in asset-backed securitizations equaled (and then exceeded in subsequent years) the total amount of debt securities issued by public corporations. \60\ Debt securitizations were not only becoming the leading business of Wall Street, as a global market of debt purchasers was ready to rely on investment grade ratings from the major credit rating agencies, but they were particularly important for the independent investment banks in the CSE Program.--------------------------------------------------------------------------- \60\ For a chart showing the growth of asset-backed securities in relation to conventional corporate debt issuances over recent years, see J. Coffee, J. Seligman, and H. Sale, SECURITIES REGULATION: Case and Materials (10th ed. 2006) at p. 10.--------------------------------------------------------------------------- Although all underwriters anticipated high rates of return from securitizations, the independent underwriters had gradually been squeezed out of their traditional line of business--underwriting corporate securities--in the wake of the step-by-step repeal of the Glass-Steagall Act. Beginning well before the formal repeal of that Act in 1999, the major commercial banks had been permitted to underwrite corporate debt securities and had increasingly exploited their larger scale and synergistic ability to offer both bank loans and underwriting services to gain an increasing share of this underwriting market. Especially for the smaller investment banks (e.g., Bear Stearns and Lehman), the future lay in new lines of business, where, as nimble and adaptive competitors, they could steal a march on the larger and slower commercial banks. To a degree, both did, and Merrill eagerly sought to follow in their wake. \61\ To stake out a dominant position, the CEOs of these firms adopted a ``Damn-the-torpedoes-full-speed-ahead'' approach that led them to make extremely risky acquisitions. Their common goal was to assure themselves a continuing source of supply of subprime mortgages to securitize, but in pursuit of this goal, both Merrill Lynch and Lehman made risky acquisitions, in effect vertically integrating into the mortgage loan origination field. These decisions, plus their willingness to acquire mortgage portfolios well in advance of the expected securitization transaction, left them undiversified and exposed to large writedowns when the real estate market soured.--------------------------------------------------------------------------- \61\ For a detailed description of Merrill, Lynch's late entry into the asset-backed securitization field and its sometimes frenzied attempt to catch up with Lehman by acquiring originators of mortgage loans, see Gretchen Morgenson, ``How the Thundering Herd Faltered and Fell,'' New York Times, November 9, 2008, at BU-1. Merrill eventually acquired an inventory of $71 billion in risky mortgages, in part through acquisitions of loan originators. By mid-2008, an initial writedown of $7.9 billion forced the resignation of its CEO. As discussed in this New York Times article, loan originators dealing with Merrill believed it did not accurately understand the risks of their field. For Lehman's similar approach to acquisitions of loan originators, see text and note, supra, at note 56.---------------------------------------------------------------------------Regulatory Modernization: What Should Be Done?An Overview of Recent Developments Financial regulation in the major capital markets today follows one of three basic organizational models: The Functional/Institutional Model: In 2008, before the financial crisis truly broke, the Treasury Department released a major study of financial regulation in the United States. \62\ This document (known as the ``Blueprint'') correctly characterized the United States as having a ``current system of functional regulation, which maintains separate regulatory agencies across segregated functional lines of financial services, such as banking, insurance, securities, and futures.'' \63\ Unfortunately, even this critical assessment may understate the dimensions of this problem of fragmented authority. In fact, the U.S. falls considerably short of even a ``functional'' regulatory model. By design, ``functional'' regulation seeks to subject similar activities to regulation by the same regulator. Its premise is that no one regulator can have, or easily develop, expertise in regulating all aspects of financial services. Thus, the securities regulator understands securities, while the insurance regulator has expertise with respect to the very different world of insurance. In the Gramm-Leach-Bliley Act of 1999 (``GLBA''), which essentially repealed the Glass-Steagall Act, Congress endorsed such a system of functional regulation. \64\--------------------------------------------------------------------------- \62\ The Department of the Treasury, Blueprint for Modernized Financial Regulatory Structure (2008) (hereinafter, ``Blueprint''). \63\ Id. at 4 and 27. \64\ The Conference Report to the Gramm-Leach-Bliley Act clearly states this: Both the House and Senate bills generally adhere to the principle of functional regulation, which holds that similar activities should be regulated by the same regulator. Different regulators have expertise at supervising different activities. It is inefficient and impractical to expect a regulator to have or develop expertise in regulating all aspects of financial services. H.R. Rep. No. 106-434, at 157 (1999), reprinted in 1999 U.S.C.C.A.N. 1252.--------------------------------------------------------------------------- Nonetheless, the reality is that the United States actually has a hybrid system of functional and institutional regulation. \65\ The latter approach looks not to functional activity, but to institutional type. Institutional regulation is seldom the product of deliberate design, but rather of historical contingency, piecemeal reform, and gradual evolution.--------------------------------------------------------------------------- \65\ For this same assessment, see Heidi Mandanis Schooner & Michael Taylor, United Kingdom and United States Responses to the Regulatory Challenges of Modern Financial Markets, 38 Tex. Int'l L. J. 317, 328 (2003).--------------------------------------------------------------------------- To illustrate this difference between functional and institutional regulation, let us hypothesize that, under a truly functional system, the securities regulator would have jurisdiction over all sales of securities, regardless of the type of institution selling the security. Conversely, let us assume that under an institutional system, jurisdiction over sales would be allocated according to the type of institution doing the selling. Against that backdrop, what do we observe today about the allocation of jurisdiction? Revealingly, under a key compromise in GLBA, the SEC did not receive general authority to oversee or enforce the securities laws with respect to the sale of government securities by a bank. \66\ Instead, banking regulators retained that authority. Similarly, the drafters of the GLBA carefully crafted the definitions of ``broker'' and ``dealer'' in the Securities Exchange Act of 1934 to leave significant bank securities activities under the oversight of bank regulators and not the SEC. \67\ Predictably, even in the relatively brief time since the passage of GLBA in 1999, the SEC and bank regulators have engaged in a continuing turf war over the scope of the exemptions accorded to banks from the definition of ``broker'' and ``dealer.'' \68\--------------------------------------------------------------------------- \66\ See 15 U.S.C. 78o-5(a)(1)(B), 15 U.S.C. 78(c)(a)(34)(G), and 15 U.S.C. 78o-5(g)(2). \67\ See 15 U.S.C. 78(c)(a)(4),(5). \68\ See Kathleen Day, Regulators Battle Over Banks: 3 Agencies Say SEC Rules Overstep Securities-Trading Law, Wash. Post, July 3, 2001, at E3. Eventually, the SEC backed down in this particular skirmish and modified its original position. See Securities Exch. Act Release No. 34-44570 (July 18, 2001) and Securities Exchange Age Release No. 34-44291, 66 Fed. Reg. 27760 (2001).--------------------------------------------------------------------------- None of this should be surprising. The status quo is hard to change, and regulatory bodies do not surrender jurisdiction easily. As a result, the regulatory body historically established to regulate banks will predictably succeed in retaining much of its authority over banks, even when banks are engaged in securities activities that from a functional perspective should belong to the securities regulator. ``True'' functional regulation would also assign similar activities to one regulator, rather than divide them between regulators based on only nominal differences in the description of the product or the legal status of the institution. Yet, in the case of banking regulation, three different federal regulators oversee banks: the Office of the Controller of the Currency (``OCC'') supervises national banks; the Federal Reserve Board (``FRB'') oversees state-chartered banks that are members of the Federal Reserve System and the Federal Deposit Insurance Corporation (``FDIC'') supervises state-chartered banks that are not members of the Federal Reserve System but are federally insured. \69\ Balkanization does not stop there. The line between ``banks,'' with their three different regulators at the federal level, and ``thrifts,'' which the Office of Thrift Supervision (``OTS'') regulates, is again more formalistic than functional and reflects a political compromise more than a difference in activities.--------------------------------------------------------------------------- \69\ This is all well described in the Blueprint. See Blueprint, supra note 62, at 31-41.--------------------------------------------------------------------------- Turning to securities regulation, one encounters an even stranger anomaly: the United States has one agency (the SEC) to regulate securities and another (the Commodities Future Trading Commission (CFTC)) to regulate futures. The world of derivatives is thereby divided between the two, with the SEC having jurisdiction over options, while the CFTC has jurisdiction over most other derivatives. No other nation assigns futures and securities regulation to different regulators. For a time, the SEC and CFTC both asserted jurisdiction over a third category of derivatives--swaps--but in 2000 Congress resolved this dispute by placing their regulation largely beyond the reach of both agencies. Finally, some major financial sectors (for example, insurance and hedge funds) simply have no federal regulator. By any standard, the United States thus falls well short of a true system of functional regulation, because deregulation has placed much financial activity beyond the reach of any federal regulator. Sensibly, the Blueprint proposes to rationalize this patchwork-quilt structure of fragmented authority through the merger and consolidation of agencies. Specifically, it proposes both a merger of the SEC and CFTC and a merger of the OCC and the OTS. Alas, such mergers are rarely politically feasible, and to date, no commentator (to our knowledge) has predicted that these proposed mergers will actually occur. Thus, although the Blueprint proposes that we move beyond functional regulation, the reality is that we have not yet approached even a system of functional regulation, as our existing financial regulatory structure is organized at least as much by institutional category as by functional activity. Disdaining a merely ``functional'' reorganization under which banking, insurance, and securities would each be governed by their own federal regulator, the Blueprint instead envisions a far more comprehensive consolidation of all these specialized regulators. Why? In its view, the problems with functional regulation are considerable: A functional approach to regulation exhibits several inadequacies, the most significant being the fact that no single regulator possesses all the information and authority necessary to monitor systemic risk, or the potential that events associated with financial institutions may trigger broad dislocation or a series of defaults that affect the financial system so significantly that the real economy is adversely affected. \70\--------------------------------------------------------------------------- \70\ Blueprint, supra note 62, at 4.--------------------------------------------------------------------------- But beyond these concerns about systemic risk, the architects of the Blueprint were motivated by a deeper anxiety: regulatory reform is necessary to maintain the capital market competitiveness of the United States. \71\ In short, the Blueprint is designed around two objectives: (1) the need to better address systemic risk and the possibility of a cascading series of defaults, and (2) the need to enhance capital market competitiveness. As discussed later, the first concern is legitimate, but the second involves a more dubious logic.--------------------------------------------------------------------------- \71\ In particular, the Blueprint hypothesizes that the U.K. has enhanced its own competitiveness by regulatory reforms, adopted in 2000, that are principles-based and rely on self regulation for their implementation. Id. at 3.--------------------------------------------------------------------------- The Consolidated Financial Services Regulator: A clear trend is today evident towards the unification of supervisory responsibilities for the regulation of banks, securities markets and insurance. \72\ Beginning in Scandinavia in the late 1980s, \73\ this trend has recently led the United Kingdom, Japan, Korea, Germany and much of Eastern Europe to move to a single regulator model. \74\ Although there are now a number of precedents, the U.K. experience stands out as the most influential. It was the first major international market center to move to a unified regulator model, \75\ and the Financial Services and Markets Act, adopted in 2000, went significantly beyond earlier precedents towards a ``nearly universal regulator.'' \76\ The Blueprint focuses on the U.K.'s experience because it believes that the U.K.'s adoption of a consolidated regulatory structure ``enhanced the competitiveness of the U.K. economy.'' \77\--------------------------------------------------------------------------- \72\ For recent overviews, see Ellis Ferran, Symposium: Do Financial Supermarkets Need Super-Regulators? Examining the United Kingdom's Experience in Adopting the Single Financial Regulator Model, 28 Brook. J. Int'l L. 257, 257-59 (2003); Jerry W. Markham, A Comparative Analysis of Consolidated and Functional Regulation: Super Regulator: A Comparative Analysis of Securities and Derivative Regulation in the United States, the United Kingdom, and Japan, 28 Brook. J. Int'l L. 319, 319-20 (2003); Giorgio Di Giorgio & Carmine D. Noia, Financial Market Regulation and Supervision: How Many Peaks for the Euro Area?, 28 Brook. J. Int'l L. 463, 469-78 (2003). \73\ Norway moved to an integrated regulatory agency in 1986, followed by Denmark in 1988, and Sweden in 1991. See D. Giorgio & D. Noia, supra note 72, at 469-478. \74\ See Bryan D. Stirewalt & Gary A. Gegenheimer, Consolidated Supervision of Banking Groups in the Former Soviet Republics: A Comparative Examination of the Emerging Trend in Emerging Markets, 23 Ann. Rev. Banking & Fin. L. 533, 548-49 (2004). As discussed later, in some countries (most notably Japan), the change seems more one of form than of substance, with little in fact changing. See Markham, supra note 72, at 383-393, 396. \75\ See Ferran, supra note 72, at 258. \76\ See Schooner & Taylor, supra note 65, at 329. Schooner and Taylor also observe that the precursors to the U.K.'s centralized regulator, which were mainly in Scandinavia, had a ``predominantly prudential focus.'' Id. at 331. That is, the unified new regulator was more a guardian of ``safety and soundness'' and less oriented toward consumer protection. \77\ Blueprint, supra note 62 at 3.--------------------------------------------------------------------------- Yet it is unclear whether the U.K.'s recent reforms provide a legitimate prototype for the Blueprint's proposals. Here, the Blueprint may have doctored its history. By most accounts, the U.K.'s adoption of a single regulator model was ``driven by country-specific factors,'' \78\ including the dismal failure of a prior regulatory system that relied heavily on self-regulatory bodies but became a political liability because of its inability to cope with a succession of serious scandals. Ironically, the financial history of the U.K. in the 1990s parallels that of the United States over the last decade. On the banking side, the U.K. experienced two major banking failures--the Bank of Credit and Commerce International (``BCCI'') in 1991 and Barings in 1995. Each prompted an official inquiry that found lax supervision was at least a partial cause. \79\--------------------------------------------------------------------------- \78\ Ferran, supra note 72, at 259. \79\ Id. at 261-262.--------------------------------------------------------------------------- Securities regulation in the U.K. came under even sharper criticism during the 1990s because of a series of financial scandals that were generally attributed to an ``excessively fragmented regulatory infrastructure.'' \80\ Under the then applicable law (the Financial Services Act of 1986), most regulatory powers were delegated to the Securities and Investments Board (SIB), which was a private body financed through a levy on market participants. However, the SIB did not itself directly regulate. Rather, it ``set the overall framework of regulation,'' but delegated actual authority to second tier regulators, which consisted primarily of self-regulatory organizations (SROs). \81\ Persistent criticism focused on the inability or unwillingness of these SROs to protect consumers from fraud and misconduct. \82\ Ultimately, the then chairman of the SIB, the most important of the SROs, acknowledged that self-regulation had failed in the U.K. and seemed unable to restore investor confidence. \83\ This acknowledgement set the stage for reform, and when a new Labour Government came into power at the end of the decade, one of its first major legislative acts (as it had promised in its election campaign) was to dismantle the former structure of SROs and replace it with a new and more powerful body, the Financial Services Authority (FSA).--------------------------------------------------------------------------- \80\ Id. at 265. \81\ Id. at 266. The most important of these were the Securities and Futures Authority (SFA), the Investment Managers' Regulatory Organization (IMRO), and the Personal Investment Authority (PIA). \82\ Two scandals in particular stood out: the Robert Maxwell affair in which a prominent financier effectively embezzled the pension funds of his companies and a ``pension mis-selling'' controversy in which highly risky financial products were inappropriately sold to pension funds without adequate supervision or disclosure. Id. at 267-268. \83\ Id. at 268.--------------------------------------------------------------------------- Despite the Blueprint's enthusiasm for the U.K.'s model, the structure that the Blueprint proposes for the U.S. more closely resembles the former U.K. system than the current one. Under the Blueprint's proposals, the securities regulator would be restricted to adopting general ``principles-based'' policies, which would be implemented and enforced by SROs. \84\ Ironically, the Blueprint relies on the U.K. experience to endorse essentially the model that the U.K. concluded had failed.--------------------------------------------------------------------------- \84\ See infra notes--and accompanying text.--------------------------------------------------------------------------- The ``Twin Peaks'' Model: As the Blueprint recognizes, not all recent reforms have followed the U.K. model of a universal regulator. Some nations--most notably Australia and the Netherlands--instead have followed a ``twin peaks'' model that places responsibility for the ``prudential regulation of relevant financial institutions'' in one agency and supervision of ``business conduct and consumer protection'' in another. \85\ The term ``twin peaks'' derives from the work of Michael Taylor, a British academic and former Bank of England official. In 1995, just before regulatory reform became a hot political issue in the U.K., he argued that financial regulation had two separate basic aims (or ``twin peaks''): (1) ``to ensure the soundness of the financial system,'' and (2) ``to protect consumers from unscrupulous operators.'' \86\ Taylor's work was original less in its proposal to separate ``prudential'' regulation from ``business conduct'' regulation than in its insistence upon the need to consolidate ``responsibility for the financial soundness of all major financial institutions in a single agency.'' \87\ Taylor apparently feared that if the Bank of England remained responsible for the prudential supervision of banks, its independence in setting interest rates might be compromised by its fear that raising interest rates would cause bank failures for which it would be blamed. In part for this reason, the eventual legislation shifted responsibility for bank supervision from the Bank of England to the FSA.--------------------------------------------------------------------------- \85\ Blueprint, supra note 62, at 3. For a recent discussion of the Australian reorganization, which began in 1996 (and thus preceded the U.K.), see Schooner & Taylor, supra note65, at 340-341. The Australian Securities and Investments Commission (ASIC) is the ``consumer protection'' agency under this ``twin peaks'' approach, and the Australian Prudential Regulatory Authority (APRA) supervises bank ``safety and soundness.'' Still, the ``twin peaks'' model was not fully accepted in Australia as ASIC, the securities regulator, does retain supervisory jurisdiction over the ``financial soundness'' of investment banks. Thus, some element of functional regulation remains. \86\ Michael Taylor, Twin Peaks: A Regulatory Structure for the New Century i (Centre for the Study of Financial Institutions 1995). For a brief review of Taylor's work, see Cynthia Crawford Lichtenstein, The Fed's New Model of Supervision for ``Large Complex Banking Organizations'': Coordinated Risk-Based Supervision of Financial Multinationals for International Financial Stability, 18 Transnat'l Law. 283, 295-296 (2005). \87\ Lichtenstein, supra note 86, at 295; Taylor, supra note 86, at 4.--------------------------------------------------------------------------- The Blueprint, itself, preferred a ``twin peaks'' model, and that model is far more compatible with the U.S.'s current institutional structure for financial regulation. But beyond these obvious points, the best argument for a ``twin peaks'' model involves conflict of interests and the differing culture of banks and securities regulators. It approaches the self-evident to note that a conflict exists between the consumer protection role of a universal regulator and its role as a ``prudential'' regulator intent on protecting the safety and soundness of the financial institution. The goal of consumer protection is most obviously advanced through deterrence and financial sanctions, but these can deplete assets and ultimately threaten bank solvency. When only modest financial penalties are used, this conflict may sound more theoretical than real. But, the U.S. is distinctive in the severity of the penalties it imposes on financial institutions. In recent years, the SEC has imposed restitution and penalties exceeding $3 billion annually, and private plaintiffs received a record $17 billion in securities class action settlements in 2006. \88\ Over a recent ten year period, some 2,400 securities class actions were filed and resulted in settlements of over $27 billion, with much of this cost (as in the Enron and WorldCom cases) being borne by investment banks. \89\ If one agency were seeking both to protect consumers and guard the solvency of major financial institutions, it would face a difficult balancing act to achieve deterrence without threatening bank solvency, and it would risk a skeptical public concluding that it had been ``captured'' by its regulated firms.--------------------------------------------------------------------------- \88\ See Coffee, Law and the Market: The Impact of Enforcement, 156 U. of Pa. L. Rev. 299 (2007) (discussing average annual SEC penalties and class action settlements). \89\ See Richard Booth, The End of the Securities Fraud Class Action as We Know It, 4 Berkeley Bus. L. J. 1, at 3 (2007).--------------------------------------------------------------------------- Even in jurisdictions adopting the universal regulator model, the need to contemporaneously strengthen enforcement has been part of the reform package. Although the 2000 legislation in the U.K. did not adopt the ``twin peaks'' format, it did significantly strengthen the consumer protection role of its centralized regulator. The U.K.'s Financial Services and Markets Act, enacted in 2000, sets out four statutory objectives, with the final objective being the ``reduction of financial crime.'' \90\ According to Heidi Schooner and Michael Taylor, this represented ``a major extension of the FSA's powers compared to the agencies it replaced,'' \91\ and it reflected a political response to the experience of weak enforcement by self-regulatory bodies, which had led to the creation of the FSA. \92\ With probably unintended irony, Schooner and Taylor described this new statutory objective of reducing ``financial crime'' as the ``one aspect of U.K. regulatory reform in which its proponents seem to have drawn direct inspiration from U.S. law and practice.'' \93\ Conspicuously, the Blueprint ignores that ``modernizing'' financial regulation in other countries has generally meant strengthening enforcement.--------------------------------------------------------------------------- \90\ See Financial Services and Markets Act, 2000, c. 8, pt. 1, 6, http://www.opsi.gov.uk/ACTS/acts2000/pdf/ukpga_20000008_en.pdf \91\ See Schooner & Taylor, supra note 65, at 335. \92\ Id. \93\ Id. at 335-36.--------------------------------------------------------------------------- A Preliminary Evaluation: Three preliminary conclusions merit emphasis: First, whether the existing financial regulatory structure in the United States is considered ``institutional'' or ``functional'' in design, its leading deficiency seems evident: it invites regulatory arbitrage. Financial institutions position themselves to fall within the jurisdiction of the most accommodating regulator, and investment banks design new financial products so as to encounter the least regulatory oversight. Such arbitrage can be defended as desirable if one believes that regulators inherently overregulate, but not if one believes increased systemic risk is a valid concern (as the Blueprint appears to believe). Second, the Blueprint's history of recent regulatory reform involves an element of historical fiction. The 2000 legislation in the U.K., which created the FSA as a nearly universal regulator, was not an attempt to introduce self-regulation by SROs, as the Blueprint seems to assume, but a sharp reaction by a Labour Government to the failures of self-regulation. Similarly, Japan's slow, back-and-forth movement in the direction of a single regulator seems to have been motivated by an unending series of scandals and a desire to give its regulator at least the appearance of being less industry dominated. \94\--------------------------------------------------------------------------- \94\ Japan has a history and a regulatory culture of economic management of its financial institutions through regulatory bodies that is entirely distinct from that of Europe or the United States. Although it has recently created a Financial Services Agency, observers contend that it remains committed to its traditional system of bureaucratic regulation that supports its large banks and discourages foreign competition. See Markham, supra note 72, at 383-92, 396. Nonetheless, scandals have been the primary force driving institutional change there too, and Japan's FSA was created at least in part because Japan's Ministry of Finance (MOF) had become embarrassed by recurrent scandals.--------------------------------------------------------------------------- Third, the debate between the ``universal'' regulator and the ``twin peaks'' alternative should not obscure the fact that both are ``superregulators'' that have moved beyond ``functional'' regulation on the premise that, as the lines between banks, securities dealers, and insurers blur, so regulators should similarly converge. That idea will and should remain at the heart of the U.S. debate, even after many of the Blueprint's proposals are forgotten.Defining the Roles of the ``Twin Peaks'' (Systemic Risk Regulator and Consumer Protector)--Who Should Do What? The foregoing discussion has suggested why the SEC would not be an effective risk regulator. It has neither the specialized competence nor the organizational culture for the role. Its comparative advantage is enforcement, and thus its focus should be on transparency and consumer protection. Some also argue that ``single purpose'' agencies, such as the SEC, are more subject to regulatory capture than are broader or ``general purpose'' agencies. \95\ To the extent that the Federal Reserve would have responsibility for all large financial institutions and would be expected to treat monitoring their capital adequacy and risk management practices as among its primary responsibilities, it does seem less subject to capture, because any failure would have high visibility and it would bear the blame. Still, this issue is largely academic because the SEC no longer has responsibility over any investment banks of substantial size.--------------------------------------------------------------------------- \95\ See Jonathan Macey, Organizational Design and Political Control of Administrative Agencies, 8 J. Law, Economics, and Organization 93 (1992). It can, of course, be argued which agency is more ``single purpose'' (the SEC or the Federal Reserve), but the latter does deal with a broader class of institutions in terms of their capital adequacy.--------------------------------------------------------------------------- The real issue then is defining the relationships between the two peaks so that neither overwhelms the other. The Systemic Risk Regulator (SRR): Systemic risk is most easily defined as the risk of an inter-connected financial breakdown in the financial system--much like the proverbial chain of falling dominoes. The closely linked insolvencies of Lehman, AIG, Fannie Mae and Freddie Mac in the Fall of 2008 present a paradigm case. Were they not bailed out, other financial institutions were likely to have also failed. The key idea here is not that one financial institution is too big to fail, but rather that some institutions are too interconnected to permit any of them to fail, because they will drag the others down. What should a system risk regulator be authorized to do? Among the obvious powers that it should have are the following: a. Authority To Limit the Leverage of Financial Institutions and Prescribe Mandatory Capital Adequacy Standards. This authority would empower the SRR to prescribe minimum levels of capital and ceilings on leverage for all categories of financial institutions, including banks, insurance companies, hedge funds, money market funds, pension plans, and quasi-financial institutions (such as, for example, G.E. Capital). The standards would not need to be identical for all institutions and should be risk adjusted. The SRS should be authorized to require reductions in debt to equity ratios below existing levels, to consider off-balance sheet liabilities (including those of partially owned subsidiaries and also contractual agreements to repurchase or guarantee) in computing these tests and ratios (even if generally accepted accounting principles would not require their inclusion). The SRR would focus its monitoring on the largest institutions in each financial class, leaving small institutions to be regulated and monitored by their primary regulator. For example, the SEC might require all hedge funds to register with it under the Investment Advisers Act of 1940, but hedge funds with a defined level of assets (say, $25 billion in assets) would be subject to the additional and overriding authority of the SSR. b. Authority To Approve, Restrict and Regulate Trading in New Financial Products. By now, it has escaped no one's attention that one particular class of over-the-counter derivative (the credit default swap) grew exponentially over the last decade and was outside the jurisdiction of any regulatory agency. This was not accidental, as the Commodities Futures Modernization Act of 2000 deliberately placed over-the-counter derivatives beyond the general jurisdiction of both the SEC and the CFTC. The SRR would be responsible for monitoring the growth of new financial products and would be authorized to regulate such practices as the collateral or margin that counter-parties were required to post. Arguably, the SRR should be authorized to limit those eligible to trade such instruments and could bar or restrict the purchase of ``naked'' credit default swaps (although the possession of this authority would not mean that the SRR would have to exercise it, unless it saw an emergency developing). c. Authority To Mandate Clearing Houses. Securities and options exchanges uniformly employ clearing houses to eliminate or mitigate credit risk. In contrast, when an investor trades in an over-the-counter derivative, it must accept both market risk (the risk that the investment will sour or price levels will change adversely) and credit risk (the risk that the counterparty will be unable to perform). Credit risk is the factor that necessitated the bailout of AIG, as its failure could have potentially led to a cascade of failures by other financial institutions if it defaulted on its swaps. Use of the clearing house should eliminate the need to bail out a future AIG because its responsibilities would fall on the clearing house to assume and the clearing house would monitor and limit the risk that its members assumed. At present, several clearinghouses are in the process of development in the United States and Europe. The SRR would be the obvious body to oversee such clearing houses (and indeed the Federal Reserve was already instrumental in their formation). Otherwise, some clearing houses are likely to be formed under the SEC's supervision and some under the CFTC's, thus again permitting regulatory arbitrage to develop. A final and complex question is whether competing clearing houses are desirable or whether they should be combined into a single centralized clearing house. This issue could also be given to the SRR. d. Authority To Mandate Writedowns for Risky Assets. A real estate bubble was the starting point for the 2008 crisis. When any class of assets appreciates meteorically, the danger arises that on the eventual collapse in that overvalued market, the equity of the financial institution will be wiped out (or at the least so eroded as to create a crisis in investor confidence that denies that institution necessary financing). This tendency was palpably evident in the failure of Bear Stearns, Lehman, Fannie Mae and Freddie Mac. If the SRR regulator relies only on debt/equity ratios to protect capital adequacy, they will do little good and possibly provide only illusory protections. Any financial institution that is forced to writedown its investment in overpriced mortgage and real estate assets by 50 percent will necessarily breach mandated debt to equity ratios. The best answer to this problem is to authorize the SRR to take a proactive and countercyclical stance by requiring writedowns in risky asset classes (at least for regulatory purposes) prior to the typically much later point at which accountants will require such a writedown. Candidly, it is an open question whether the SRS, the Federal Reserve, or any banking regulator would have the courage and political will to order such a writedown (or impose similar restraints on further acquisitions of such assets) while the bubble was still expanding. But Congress should at least arm its regulators with sufficient power and direct them to use it with vigor. e. Authority To Intervene To Prevent and Avert Liquidity Crises. Financial institutions often face a mismatch between their assets and liabilities. They may invest in illiquid assets or make long-term loans, but their liabilities consist of short-term debt (such as commercial paper). Thus, regulating leverage ratios is not alone adequate to avoid a financial crisis, because the institution may suddenly experience a ``run'' (as its depositors flee) or be unable to roll over its commercial paper or other short-term debt. This problem is not unique to banks and can be encountered by hedge funds and private equity funds (as the Long Term Capital Management crisis showed). The SRR thus needs the authority to monitor liquidity problems at large financial institutions and direct institutions in specific cases to address such imbalances (either by selling assets, raising capital, or not relying on short-term debt). From the foregoing description, it should be obvious that the only existing agency in a position to take on this assignment and act as an SRR is the Federal Reserve Board. But it is less politically accountable than most other federal agencies, and this could give rise to some problems discussed below. The Consumer Protection and Transparency Agency: The creation of an SSR would change little at the major Federal agencies having responsibilities for investor protection. Although it might be desirable to merge the SEC and the CFTC, this is not essential. Because no momentum has yet developed for such a merger, I will not discuss it further at this time. Currently, there are over 5,000 broker-dealers registered with the SEC. They would remain so registered, and the SRR would concern itself only with those few whose potential insolvency could destabilize the markets. The focus of the SEC's surveillance of broker-dealers is on consumer protection and market efficiency, and this would not be within the expertise of the Federal Reserve or any other potential SRR. The SEC is also an experienced enforcement agency, while the Federal Reserve has little, if any, experience in this area. Further, the SEC understands disclosure issues and is a champion of transparency, whereas banking regulators start from the unstated premise that disclosures of risks or problems at a financial institution is undesirable because it might provoke a ``run'' on the bank. The SEC and the Controller of the Currency have long disagreed about what banks should disclose in the Management Discussion and Analysis that banks file with the SEC. Necessarily, this tension will continue. Resolving the Conflicts: The SEC and the PCAOB have continued to favor ``mark to market'' accounting, while major banks have sought relief from the write-downs that it necessitates. Suppose then that in the future a SRR decided that ``mark to market'' accounting increased systemic risk. Could it determine that financial institutions should be spared from such an accounting regime on the ground that it was pro-cyclical? This is an issue that Congress should address in any legislation authorizing a SRR or enhancing the powers of the Federal Reserve. I would recommend that Congress maintain authority in the SEC to determine appropriate accounting policies, because, put simply, transparency has been the core value underlying our system of securities regulation. But there are other areas where a SRR might well be entitled to overrule the SEC. Take, for example, the problem of short selling the stocks of financial institutions during a period of market stress. Although the SEC did ban short selling in financial stocks briefly in 2008, one can still imagine an occasion on which the SRR and the SEC might disagree. Here, transparency would not be an issue. Short selling is pro-cyclical, and a SRR could determine that it had the potential to destabilize and increase systemic risk. If it did so, its judgment should control. These examples are given only by way of illustration, and the inevitability of conflicts between the two agencies is not assumed. The President's Working Group on Financial Markets has generally been able to work out disagreements through consultation and negotiation. Still, in any legislation, it would be desirable to identify those core policies (such as transparency and full disclosure) that the SRR could not override. The Failure of Quantitative Models: If one lesson should have been learned from the 2008 crisis, it is that quantitative models, based on historical data, eventually and inevitably fail. Rates of defaults on mortgages can change (and swiftly), and housing markets do not invariably rise. In the popular vernacular, ``black swans'' both can occur and even become predominant. This does not mean that quantitative models should not be used, but that they need to be subjected to qualitative and judgmental overrides. The weakness in quantitative models is particularly shown by the extraordinary disparity between the value at risk estimates (VaRs) reported by underwriters to the SEC and their eventual writedowns for mortgage-backed securities. Ferrell, Bethel and Hu report that for a selected group of major financial institutions the average ratio of asset writedowns as of August 20, 2008, to VaRs reported for 2006 was 291 to 1. \96\ If financial institutions cannot accurately estimate their exposure for derivatives and risky assets, this undermines many of the critical assumptions underlying the Basel II Accords, and suggests that regulators cannot defer to the institutions' own risk models. Instead, they must reach their own judgments, and Congress should so instruct them.--------------------------------------------------------------------------- \96\ See Farrell, Bethel, and Hu, supra note 15, at 47.---------------------------------------------------------------------------The Lessons of Madoff: Implications for the SEC, FINRA, and SIPC No time need be wasted pointing out that the SEC missed red flags and overlooked credible evidence in the Madoff scandal. Unfortunately, most Ponzi schemes do not get detected until it is too late. This implies that an ounce of prevention may be worth several pounds of penalties. More must be done to discourage and deter such schemes ex ante, and the focus cannot be only on catching them ex post. From this perspective focused on prevention, rather than detection, the most obvious lesson is that the SEC's recent strong tilt towards deregulation contributed to, and enabled, the Madoff fraud in two important respects. First, Bernard L. Madoff Investment Securities LLC (BMIS) was audited by a fly-by-night auditing firm with only one active accountant who had neither registered with the Public Company Accounting Oversight Board (``PCAOB'') nor even participated in New York State's peer review program for auditors. Yet, the Sarbanes-Oxley Act required broker-dealers to use a PCAOB-registered auditor. \97\ Nonetheless, until the Madoff scandal exploded, the SEC repeatedly exempted privately held broker-dealers from the obligation to use such a PCAOB-registered auditor and permitted any accountant to suffice. \98\ Others also exploited this exemption. For example, in the Bayou Hedge Fund fraud, which was the last major Ponzi scheme before Madoff, the promoters simply invented a fictitious auditing firm and forged certifications in its name. Had auditors been required to have been registered with PCAOB, this would not have been feasible because careful investors would have been able to detect that the fictitious firm was not registered.--------------------------------------------------------------------------- \97\ See Section 17(e)(1) of the Securities Exchange Act of 1934, 15 U.S.C. 78(q)(e)(1). \98\ See, e.g., Securities Exch. Act Rel. No. 34-54920 (Dec. 12, 2006).--------------------------------------------------------------------------- Presumably, the SEC's rationale for this overbroad exemption was that privately held broker-dealers did not have public shareholders who needed protection. True, but they did have customers who have now been repeatedly victimized. At the end of 2008, the SEC quietly closed the barn door by failing to renew this exemption--but only after $50 billion worth of horses had been stolen. A second and even more culpable SEC mistake continues to date. Under the Investment Advisers Act, investment advisers are required to maintain client funds or securities with a ``qualified custodian.'' \99\ In principle, this requirement should protect investors from Ponzi schemes, because an independent custodian would not permit the investment adviser to have access to the investors' funds. Indeed, for exactly this reason, mutual funds appear not to have experienced Ponzi-style frauds, which have occurred only in the case of hedge funds and investment advisers. Under Section 17(f) of the Investment Company Act, mutual funds must use a separate custodian. But in the case of investment advisors, the SEC permits the investment adviser to use an affiliated broker-dealer or bank as its qualified custodian. Thus, Madoff could and did use BMIS, his broker dealer firm, to serve as custodian for his investment adviser activities. The net result is that only a very tame watchdog monitors the investment adviser. Had an independent and honest custodian held the investors' funds, Madoff could not have recycled new investors' contributions to earlier investors, and the custodian would have noticed that Madoff was not actually trading. Other recent Ponzi schemes seem to have similarly sidestepped the need for an independent custodian. At Senate Banking Committee hearings on the Madoff debacle this January, the director of the SEC's Office of Compliance, Inspection and Examinations estimated that, out of the 11,300 investment advisers currently registered with the SEC, some 1,000 to 1,500 might similarly use an affiliated broker-dealer as their custodian. For investors, the SEC's tolerance for self-custodians makes the ``qualified custodian'' rule an illusory protection.--------------------------------------------------------------------------- \99\ See Rule 206(4)-2 (``Custody of Funds or Securities of Clients By Investment Advisers''), 17 CFR 275.206(4)-2.--------------------------------------------------------------------------- At present, the Madoff scandal has so shaken investor confidence in investment advisors that even the industry trade group for investment advisers (the Investment Advisers Association) has urged the SEC to adopt a rule requiring investment advisers to use an independent custodian. Unfortunately, one cannot therefore assume that the SEC will quickly produce such a rule. The SEC's staff knows that smaller investment advisers will oppose any rule that requires them to incur additional costs. Even if a reform rule is proposed, the staff may still overwhelm such a rule with exceptions (such as by permitting an independent custodian to use sub-custodians who are affiliated with the investment adviser). Congress should therefore direct it to require an independent custodian, across the board for mutual funds, hedge funds, and investment advisers. The Madoff scandal exposes shortcomings not only at the SEC but elsewhere in related agencies. Over the last 5 years, the number of investment advisers has grown from roughly 7,500 to 11,300--more than one third. Given this growth, it is becoming increasingly anomalous that there is no self-regulatory body (SRO) for investment advisers. Although FINRA may have overstated in its claim that it had no authority to investigate Madoff's investment adviser operations (because it could and should have examined BMIS's performance as the ``qualified custodian'' for Madoff's investment advisory activities), it still lacks authority to examine investment advisers. Some SRO (either FINRA or a new body) should have direct authority to oversee the investment adviser activities of an integrated broker-dealer firm. Similarly, the Securities Investor Protection Corporation (SIPC) continues to charge all broker-dealer firms the same nominal fee for insurance without any risk-adjustment. Were it to behave like a private insurer and charge more to riskier firms for insurance, these firms would have a greater incentive to adopt better internal controls against fraud. A broker-dealer that acted as a self-custodian for a related investment adviser would, for example, pay a higher insurance commission. Also, if higher fees were charged, more insurance (which is currently capped at $500,000 per account) could be provided to investors. When all broker-dealers are charged the same insurance premium, this subsidizes the riskier firms--i.e., the future Madoffs of the industry. Finally, one of the most perplexing problems in the Madoff story is why, when the SEC finally forced Madoff to register as an investment adviser in 2006, it did not conduct an early examination of BMIS's books and records. Red flags were flying, as Madoff (1) used an unknown accountant, (2) served as his own self-custodian, (3) had apparently billions of dollars in customer accounts, (4) had long resisted registration, and (5) was the subject of plausible allegations of fraud from credible whistle-blowers. Cost constrained as the SEC may have been, the only conclusion that can be reached here is that the SEC has poor criteria for evaluating the relative risk of investment advisers. At a minimum, Congress should require a report by the SEC as to the criteria used to determine the priority of examinations and how the SEC proposes to change those criteria in light of the Madoff scandal. Some have proposed eliminating the SEC's Office of Compliance, Inspection and Examinations and combining its activities with the Division of Investment Management. I do not see this as a panacea. Rather, it simply reshuffles the cards. The real problem is the criteria used to determine who should be examined. Credible allegations of fraud need to be directed to the compliance inspectors.Asset-Backed Securitizations: What Failed? Asset-backed securitizations represent a financial technology that failed. As outlined earlier, this failure seems principally attributable to a ``moral hazard'' problem that arose under which both loan originators and underwriters relaxed their lending standards and packaged non-creditworthy loans into portfolios, because both found that they could sell these portfolios at a high profit and on a global basis--at least so long as the debt securities carried an investment grade credit rating from an NRSRO credit rating agency. Broad deregulatory rules contributed to this problem, and the two most important such SEC rules are Rules 3a-7 under the Investment Company Act \100\ and Regulation AB. \101\ Asset-backed securities (including CDOs) are typically issued by a special purpose vehicle (SPV) controlled by the promoter (which often may be an investment or commercial bank). This SPV would under ordinary circumstances be deemed an ``investment company'' and thus subjected to the demanding requirements of the Investment Company Act--but for Rule 3a-7. That rule exempts fixed-income securities issued by an SPV if, at the time of sale, the securities are rated in one of the four highest categories of investment quality by a ``nationally recognized statistical rating organization'' (NRSRO). In essence, the SEC has delegated to the NRSROs (essentially, at the time at least, Moody's, S&P and Fitch) the ability exempt SPVs from the Investment Company Act. Similarly, Regulation AB governs the disclosure requirements for ``asset-backed securities'' (as such term is defined in Section 1101(c) of Regulation AB) in public offerings. Some have criticized Regulation AB for being more permissive than the federal housing agencies with respect to the need to document and verify the loans in a portfolio. \102\ Because Regulation AB requires that the issuer not be an investment company (see Item 101(c)(2)(i) of Regulation AB), its availability (and thus expedited registration) also depends on an NRSRO investment grade rating.--------------------------------------------------------------------------- \100\ 17 CFR 270.3a-7 (``Issuers of Asset-Backed Securities''). This exemption dates back to 1992. \101\ 17 CFR 229.1100 et seq. (``Asset-Backed Securities''). Regulation AB was adopted in 2005, but reflects an earlier pattern of exemptions in no-action letters. \102\ See Mendales, supra note 18.--------------------------------------------------------------------------- No suggestion is here intended that SPVs should be classified as ``investment companies,'' but the need for the exemption given by Rule 3a-7 shows that the SEC has considerable leverage and could condition this exemption on alternative or additional factors beyond an NRSRO investment grade rating. The key point is that exemptions like Rule 3a-7 give the SEC a tool that they could use even without Congressional legislation--if the SEC was willing to take action. What actions should be taken to respond to the deficiencies in asset-backed securitizations? I would suggest two basic steps: (1) curtail the ``originate-and-distribute'' model of lending that gave rise to the moral hazard problem, and (2) re-introduce due diligence into the securities offering process (both for public and Rule 144A offerings). Restricting the ``Originate-and-Distribute'' Model of Lending. In a bubble, everyone expects that they can pass the assets on to the next buyer in the chain--``before the music stops.'' Thus, all tend to economize on due diligence and ignore signs that the assets are not creditworthy. This is because none expect to bear the costs of holding the financial assets to maturity. Things were not always this way. When asset-backed securitizations began, the promoter usually issued various tranches of debt to finance its purchase of the mortgage assets, and these tranches differed in terms of seniority and maturity. The promoter would sell the senior most tranche in public offerings to risk averse public investors and retain some or all of the subordinated tranche, itself, as a signal of its confidence in the creditworthiness of the underlying assets. Over time, this practice of retaining the subordinated tranche withered away. In part, this was because hedge funds would take the risk of buying this riskier debt; in part, it was because the subordinated tranche could be included in more complex CDOs (where overcollateralization was the investor's principal protection), and finally it was because in a bubbly market, investors no longer looked for commitments or signals from the promoter. Given this definition of the problem, the answer seems obvious: require the promoter to retain some portion of the subordinated tranche. This would incentivize it to buy only creditworthy financial assets and end the ``moral hazard'' problem. To make this proposal truly effective, however, more must be done. The promoter would have to be denied the ability to hedge the risk on the subordinated tranche that it retained. Otherwise it might hedge that risk by buying a credit default swap on its own offering through an intermediary. But this is feasible. Even in the absence of legislation, the SEC could revise Rule 3a-7 to require, as a price of its exemption, that the promoter (either through the SPV or an affiliate) retain a specified percentage of the bottom, subordinated tranche (or, if there were no subordinated tranche, of the offering as a whole). Still, the cleaner, simpler way would be a direct legislative requirement of a minimum retention. 2. Mandating Due Diligence. One of the less noticed but more important developments associated with asset-backed securitization is the rapid decline in due diligence after 2000. Once investment banks did considerable due diligence on asset-backed securitizations, but they outsourced the work to specialized ``due diligence'' firms. These firms (of which Clayton Holdings, Inc. was the best known) would send squads of ten to fifteen loan reviewers to sample the loans in a securitized portfolio, checking credit scores and documentation. But the intensity of this due diligence review declined over recent years. The Los Angeles Times quotes the CEO of Clayton Holdings to the effect that: Early in the decade, a securities firm might have asked Clayton to review 25 percent to 40 percent of the sub-prime loans in a pool, compared with typically 10 percent in 2006 \103\ \103\ See E. Scott Reckard, ``Sub-Prime mortgage watchdogs kept on leash; loan checkers say their warnings of risk were met with indifference,'' Los Angeles Times, March 17, 2008, at C-1.--------------------------------------------------------------------------- The President of a leading rival due diligence firm, the Bohan Group, made an even more revealing comparison: By contrast, loan buyers who kept the mortgages as an investment instead of packaging them into securities would have 50 percent to 100 percent of the loans examined, Bohan President Mark Hughes said. \104\--------------------------------------------------------------------------- \104\ Id. In short, lenders who retained the loans checked the borrowers carefully, but the investment banks decreased their investment in due diligence, making only a cursory effort by 2006. Again, this seems the natural consequence of an originate-and-distribute model. The actual loan reviewers employed by these firms also told the above-quoted Los Angeles Times reporter that supervisors in these firms would often change documentation in order to avoid ``red-flagging mortgages.'' These employees also report regularly encountering inflated documentation and ``liar's loans,'' but, even when they rejected loans, ``loan buyers often bought the rejected mortgages anyway.'' \105\--------------------------------------------------------------------------- \105\ Id.--------------------------------------------------------------------------- In short, even when the watchdog barked, no one at the investment banks truly listened. Over the last several years, due diligence practices long followed in the industry seemed to have been relaxed, ignored, or treated as a largely optional formality. That was also the conclusion of the President's Working Group on Financial Markets, which in early 2008 identified ``a significant erosion of market discipline by those involved in the securitization process, including originators, underwriters, credit rating agencies, and global investors.'' \106\--------------------------------------------------------------------------- \106\ See President's Working Group on Financial Markets, Policy Statement on Financial Market Developments at 1 (March, 2008). (emphasis added). This report expressly notes that underwriters had the incentive to perform due diligence, but did not do so adequately.--------------------------------------------------------------------------- Still, in the case of the investments bank, this erosion in due diligence may seem surprising. At least over the long-term, it seems contrary to their own self-interest. Four factors may explain their indifference: (1) an industry-wide decline in due diligence as the result of deregulatory reforms that have induced many underwriters to treat legal liability as simply a cost of doing business; (2) heightened conflicts of interest attributable to the underwriters' position as more a principal than an agent in structured finance offerings; (3) executive compensation formulas that reward short-term performance (coupled with increased lateral mobility in investment banking so that actors have less reason to consider the long-term); and (4) competitive pressure. Each is briefly examined below, and then I suggest some proposed reforms to address these problems. i. The Decline of Due Diligence: A Short History: The Securities Act of 1933 adopted a ``gatekeeper'' theory of protection, in the belief that by imposing high potential liability on underwriters (and others), this would activate them to search for fraud and thereby protect investors. As the SEC wrote in 1998: Congress recognized that underwriters occupied a unique position that enabled them to discover and compel disclosure of essential facts about the offering. Congress believed that subjecting underwriters to the liability provisions would provide the necessary incentive to ensure their careful investigations of the offering.'' \107\--------------------------------------------------------------------------- \107\ See SEC Release No. 7606A (``The Regulation of Securities Offerings''), 63 Fed. Reg. 67174, 67230 (Dec. 4 1998). Specifically, Section 11 of the Securities Act of 1933 holds the underwriters (and certain other persons) liable for any material misrepresentation or omission in the registration statement, without requiring proof of scienter on the part of the underwriter or reliance by the plaintiff. This is a cause of action uniquely tilted in favor of the plaintiff, but then Section 11(b) creates a powerful incentive by establishing an affirmative defense under which any defendant (other ---------------------------------------------------------------------------than the issuer) will not be held liable if: he had, after a reasonable investigation, reasonable ground to believe and did believe, at the time such registration statement became effective, that the statements made therein were true and that there was an omission to state a material fact required to be stated therein or necessary to make the statements therein not misleading. 15 U.S.C. 77k (b)(3)(A). (emphasis added) Interpreting this provision, the case law has long held that an underwriter must ``exercise a high degree of care in investigation and independent verification of the company's representations.'' Feit v. Leasco Data Processing Equip. Corp., 332 F. Supp. 554, 582 (E.D.N.Y. 1971). Overall, the Second Circuit has observed that ``no greater reliance in our self-regulatory system is placed on any single participant in the issuance of securities than upon the underwriter.'' Chris-Craft Indus., Inc. v. Piper Aircraft Corp., 480 F. 2d 341, 370 (2d Cir. 1973). Each underwriter need not personally perform this investigation. It can be delegated to the managing underwriters and to counsel, and, more recently, the task has been outsourced to specialized experts, such as the ``due diligence firms.'' The use of these firms was in fact strong evidence of the powerful economic incentive that Section 11(b) of the Securities Act created to exercise ``due diligence.'' But what then changed? Two different answers make sense and are complementary: First, many and probably most CDO debt offerings are sold pursuant to Rule 144A, and Section 11 does not apply to these exempt and unregistered offerings. Second, the SEC expedited the processing of registration statements to the point that due diligence has become infeasible. The latter development goes back nearly thirty years to the advent of ``shelf registration'' in the early 1980s. In order to expedite the ability of issuers to access the market and capitalize on advantageous market conditions, the SEC permitted issuers to register securities ``for the shelf''--i.e., to permit the securities to be sold from time to time in the future, originally over a two year period (but today extended to a three year period). \108\ Under this system, ``takedowns''--i.e., actual sales under a shelf registration statement--can occur at any time without any need to return to the SEC for any further regulatory permission. Effectively, this telescoped a period that was often three or four months in the case of the traditional equity underwriting (i.e., the period between the filing of the registration statement and its ``effectiveness,'' while the SEC reviewed the registration statement) to a period that might be a day or two, but could be only a matter of hours.--------------------------------------------------------------------------- \108\ See Rule 415 (17 C.F.R. 230.415)(2007).--------------------------------------------------------------------------- Today, because there is no longer any delay for SEC review in the case of an issuer eligible for shelf registration, an eligible issuer could determine to make an offering of debt or equity securities and in fact do so within a day's time. The original premise of this new approach was that eligible issuers would be ``reporting entities'' that filed continuous periodic disclosures (known as Form 10-Ks and Form 10-Qs) under the Securities Exchange Act of 1934. Underwriters, the SEC hoped, could do ``continuing due diligence'' on these issuers at the time they filed their periodic quarterly reports in preparation for a later, eventual public offering. This hope was probably never fully realized, but, more importantly, this premise never truly applied to debt offerings by issuers of asset-backed securities. For bankruptcy and related reasons, the issuers of asset-backed issuers (such as CDOs backed by a pool of residential mortgages) are almost always ``special purpose vehicles'' (SPVs), created for the single offering; they thus have no prior operating history and are not ``reporting companies'' under the Securities Exchange Act of 1934. To enable issuers of asset-backed securities to use shelf-registration and thus obtain immediate access to the capital markets, the SEC had to develop an alternative rationale. And it did! To use Form S-3 (which is a precondition for eligibility for shelf-regulation), an issuer of asset-backed securities must receive an ``investment grade'' rating from an ``NRSRO'' credit-rating agency. \109\ Unfortunately, this requirement intensified the pressure that underwriters brought to bear on credit-ratings agencies, because unless the offering received an investment grade rating from at least one rating agency, the offering could not qualify for Form S-3 (and so might be delayed for an indefinite period of several months while its registration statement received full-scale SEC review). An obvious alternative to the use of an NRSRO investment grade rating as a condition for Form S-3 eligibility would be certification by ``gatekeepers'' to the SEC (i.e., attorneys and due diligence firms) of the work they performed. Form S-3 could still require an ``investment grade'' rating, but that it come from an NRSRO rating agency should not be mandatory.--------------------------------------------------------------------------- \109\ See Form S-3, General Instructions, IB5 (``Transaction Requirements--Offerings of Investment Grade Asset-Backed Securities'').--------------------------------------------------------------------------- After 2000, developments in litigation largely convinced underwriters that it was infeasible to expect to establish their due diligence defense. The key event was the WorldCom decision in 2004. \110\ In WorldCom, the court effectively required the same degree of investigation for shelf-registered offerings as for traditional offerings, despite the compressed time frame and lack of underwriter involvement in the drafting of the registration statement. The Court asserted that its reading of the rule should not be onerous for underwriters because they could still perform due diligence prior to the offering by means of ``continuous due diligence'' (i.e., through participation by the underwriter in the drafting of the various Form 10-Ks and Form 10-Qs that are incorporated by reference into the shelf-registration).--------------------------------------------------------------------------- \110\ In re WorldCom Inc. Securities Litigation, 346 F. Supp. 2d 628 (S.D.N.Y. 2004). The WorldCom decision denied the underwriters' motion for summary judgment based on their asserted due diligence defense, but never decided whether the defense could be successfully asserted at trial. The case settled before trial for approximately $6.2 billion.--------------------------------------------------------------------------- For underwriters, the WorldCom decision was largely seen as a disaster. Their hopes--probably illusory in retrospect--were dashed that courts would soften Securities Act 11's requirements in light of the near impossibility of complying with due diligence responsibilities during the shortened time frames imposed by shelf registration. Some commentators had long (and properly) observed that the industry had essentially played ``ostrich,'' hoping unrealistically that Rule 176 would protect them. \111\ In WorldCom's wake, the SEC did propose some amendments to strengthen Rule 176 that would make it something closer to a safe harbor. But the SEC ultimately withdrew and did not adopt this proposal.--------------------------------------------------------------------------- \111\ See Donald Langevoort, Deconstructing Section 11: Public Offering Liability in a Continuous Disclosure Environment, 63 Law and Contemporary Problems, U.S. 62-63 (2000).--------------------------------------------------------------------------- As the industry now found (as of late 2004) that token or formalistic efforts to satisfy Section 11 would not work, it faced a bleak choice. It could accept the risk of liability on shelf offerings or it could seek to slow them down to engage in full scale due diligence. Of course, different law firms and different investment banks could respond differently, but I am aware of no firms attempting truly substantial due diligence on asset-backed securitizations. Particularly in the case of structured finance, the business risk of Section 11 liability seemed acceptable. After all, investment grade bonds did not typically default or result in class action litigation, and Section 11 has a short statute of limitations (one year from the date that the plaintiffs are placed on ``inquiry notice''). Hence, investment banks could rationally decide to proceed with structured finance offerings knowing that they would be legally exposed if the debt defaulted, in part because the period of their exposure would be brief. In the wake of the WorldCom decision, the dichotomy widened between the still extensive due diligence conducted in IPOs, and the minimal due diligence in shelf offerings. As discussed below, important business risks may have also motivated investment banks to decide not to slow down structured finance offerings for extended due diligence. The bottom line here then is that, at least in the case of asset-backed shelf offerings, investment banks ceased to perform the due diligence intended by Congress, but instead accepted the risk of liability as a cost of doing business in this context. But that is only the beginning of the story. Conflicts of Interest: Traditionally, the investment bank in a public offering played a gatekeeping role, vetting the company and serving as an agent both for the prospective investors (who are also its clients) and the corporate issuer. Because it had clients on both sides of the offering, the underwriter's relationship with the issuer was somewhat adversarial, as its counsel scrutinized and tested the issuer's draft registration statement. But structured finance is different. In these offerings, there is no corporate issuer, but only a ``special purpose vehicle'' (SPV) typically established by the investment bank. The product--residential home mortgages--is purchased by the investment bank from loan originators and may be held in inventory by the investment bank for some period until the offering can be effected. In part for this reason, the investment bank will logically want to expedite the offering in order to minimize the period that it must hold the purchased mortgages in its own inventory and at its own risk. Whereas in an IPO the underwriter (at least in theory) is acting as a watchdog testing the quality of the issuer's disclosures, the situation is obviously different in an assets-backed securities offering that the underwriter is structuring itself. It can hardly be its own watchdog. Thus, the quality of disclosure may suffer. Reports have circulated that some due diligence firms advised their underwriters that the majority of mortgages loans in some securitized portfolio were ``exception'' loans--i.e., loans outside the bank's normal guidelines. \112\ But the registration statement disclosed only that the portfolio included a ``significant'' or ``substantial'' number of such loans, not that it was predominantly composed of such loans. This is inferior and materially deficient disclosure, and it seems attributable to the built-in conflicts in this process.--------------------------------------------------------------------------- \112\ See, e.g., Vikas Bajaj and Jenny Anderson, ``Inquiry Focuses on Withholding of Data on Loans,'' New York Times, January 12, 2008, at A-1.--------------------------------------------------------------------------- Executive Compensation: Investment bankers are typically paid year-end bonuses that are a multiple of their salaries. These bonuses are based on successful completion of fee-generating deals during the year. But a deal that generates significant income in Year One could eventually generate significant liability in Year Two or Three. In this light, the year-end bonus system may result in a short-term focus that ignores or overly discounts longer-term risks. Moreover, high lateral mobility characterizes investment banking firms, meaning that the individual investment banker may not identify with the firm's longer-term interests. In short, investment banks may face serious agency costs problems, which may partly explain their willingness to acquire risky mortgage portfolios without adequate investigation of the collateral. Competitive Pressure: Citigroup CEO Charles Prince's now famous observation that ``when the music is playing, you've got to get up and dance'' is principally a recognition of the impact of competitive pressure. If investors are clamoring for ``investment grade'' CDOs (as they were in 2004-2006), an investment bank understands that if it does not offer a steady supply of transactions, its investors will go elsewhere--and possibly not return. Thus, to hold onto a profitable franchise, investment banks sought to maintain a steady pipeline of transactions; this in turn lead them to seek to lock in sources of supply. Accordingly, they made clear to loan originators their willingness to buy all the ``product'' that the latter could supply. Some investment banks even sought billion dollar promises from loan originators of a minimum amount of product. Loan originators quickly realized that due diligence was now a charade (even if it had not been in the past) because the ``securitizing'' investment banks were competing fiercely for supply. In a market where the demand seemed inexhaustible, the real issue was obtaining supply, and investment banks spent little time worrying about due diligence or rejecting a supply that was already too scarce for their anticipated needs. Providing Time for Due Diligence: The business model for structured finance is today broken. Underwriters and credit rating agencies have lost much of their credibility. Until structured finance can regain credibility, housing finance in the United States will remain in scarce supply. The first lesson to be learned is that underwriters cannot be trusted to perform serious due diligence when they are in effect selling their own inventory and are under severe time pressure. The second lesson is that because expedited shelf registration is inconsistent with meaningful due diligence, the process of underwriting structured finance offerings needs to be slowed down to permit more serious due diligence. Shelf registration and abbreviated time schedules may be appropriate for seasoned corporate issuers whose periodic filings are incorporated by reference into the registration statement, but it makes less sense in the case of a ``special purpose vehicle'' that has been created by the underwriter solely as a vehicle by which to sell asset-backed securities. Offerings by seasoned issuers and by special purpose entities are very different and need not march to the same drummer (or the same timetable). An offering process for structured finance that was credible would look very different than the process we have recently observed. First, a key role would be played by the due diligence firms, but their reports would not go only to the underwriter (who appears to have at time ignored them). Instead, without editing or filtering, their reports would also go directly to the credit-rating agency. Indeed, the rating agency would specify what it would want to see covered by the due diligence firm's report. Some dialogue between the rating agency and the due diligence firm would be built into the process, and ideally their exchange would be outside the presence of the underwriter (who would still pay for the due diligence firm's services). At a minimum, the NRSRO rating agencies should require full access to such due diligence reports as a condition of providing a rating (this is a principle with which these firms agree, but may find it difficult to enforce in the absence of a binding rule). To enable serious due diligence to take place, one approach would be to provide that structured finance offerings should not qualify for Form S-3 (or for any similar form of expedited SEC review). If the process can occur in a day, the pressures on all the participants to meet an impossible schedule will ensure that little serious investigation of the collateral's quality will occur. An alternative (or complementary approach) would be to direct the SEC to revise Regulation AB to incorporate greater verification by the underwriter (and thus its agents) of the quality of the underlying financial assets. Does this sound unrealistic? Interestingly, the key element in this proposal--that that due diligence firm's report go to the credit rating agency--is an important element in the settlement negotiated in 2008 by New York State Attorney General Cuomo and the credit rating agencies. \113\--------------------------------------------------------------------------- \113\ See Aaron Lucchetti, ``Big Credit-Rating Firms Agree to Reforms,'' The Wall Street Journal, June 6, 2008 at p. C-3.--------------------------------------------------------------------------- The second element of this proposal--i.e., that the process be slowed to permit some dialogue and questioning of the due diligence firm's findings--will be more controversial. It will be argued that delay will place American underwriters at a competitive disadvantage to European rivals and that offerings will migrate to Europe. But today, structured finance is moribund on both sides of the Atlantic. To revive it, credibility must be restored to the due diligence process. Instantaneous due diligence is in the last analysis simply a contradiction in terms. Time and effort are necessary if the quality of the collateral is to be verified--and if investors are to perceive that a serious effort to protect their interests is occurring.Rehabilitating the Gatekeepers Credit rating agencies remain the critical gatekeeper whose performance must be improved if structured finance through private offerings (i.e., without government guarantees) is to become viable again. As already noted, credit rating agencies face a concentrated market in which they are vulnerable to pressure from underwriters and active competition for the rating business. At present, credit rating agencies face little liability and perform little verification. Rather, they state explicitly that they are assuming the accuracy of the issuer's representations. The only force that can feasibly induce them to conduct or obtain verification is the threat of securities law liability. Although that threat has been historically non-existent, it can be legislatively augmented. The credit rating agency does make a statement (i.e., its rating) on which the purchasers of debt securities do typically rely. Thus, potential liability does exist under Rule 10b-5 to the extent that it makes a statement in connection with a purchase or sale of a security. The difficult problem is that a defendant is only liable under Rule 10b-5 if it makes a material misrepresentation or omission with scienter. In my judgment, there are few cases, if any, in which the rating agencies actually know of the fraud. But, under Rule 10b-5, a rating agency can be held liable if it acted ``recklessly.'' Accordingly, I would proposed that Congress expressly define the standard of ``recklessness'' that creates liability under Rule 10b-5 for a credit rating agency to be the issuance of a rating when the rating agency knowingly or recklessly is aware of facts indicating that reasonable efforts have not been conducted to verify the essential facts relied upon by its ratings methodology. A safe harbor could be created for circumstances in which the ratings agency receives written certification from a ``due diligence'' firm, independent of the promoter, indicating that it has conducted sampling procedures that lead it to believe in the accuracy of the facts or estimates asserted by the promoter. The goal of this strategy is not to impose massive liabilities on rating agencies, but to make it unavoidable that someone (either the rating agency or the due diligence firm) conduct reasonable verification. To be sure, this proposal would involve increased costs to conduct such due diligence (which either the issuer or the underwriter would be compelled to assume). But these costs are several orders of magnitude below the costs that the collapse of the structured finance market has imposed on the American taxpayer.Conclusions 1. The current financial crisis--including the collapse of the U.S. real estate market, the insolvency of the major U.S. investment banks, and the record decline in the stock market--was not the product of investor mania or the classic demand-driven bubble, but rather was the product of the excesses of an ``originate-and-distribute'' business model that both loan originators and investment banks followed to the brink of disaster--and beyond. Under this business model, financial institutions abandoned discipline and knowingly made non-creditworthy loans because they did not expect to hold the resulting financial assets for long enough to matter. 2. The ``moral hazard'' problem that resulted was compounded by deregulatory policies at the SEC (and elsewhere) that permitted investment banks to increase their leverage rapidly between 2004 and 2006, while also reducing their level of diversification. Under the Consolidated Supervised Entity (CSE) Program, the SEC essentially deferred to self-regulation by the five largest investment banks, who woefully underestimated their exposure to risk. 3. This episode shows (if there ever was doubt) that in an environment of intense competition and under the pressure of equity-based executive compensation systems that are extraordinarily short-term oriented, self-regulation does not work. 4. As a result, all financial institutions that are ``too big to fail'' need to be subjected to prudential financial supervision and a common (although risk-adjusted) standard. This can only be done by the Federal Reserve Board, which should be given authority to regulate the capital adequacy, safety and soundness, and risk management practices of all large financial institutions. 5. Incident to making the Federal Reserve the systemic risk regulator for the U.S. economy, it should receive legislative authority to: (1) establish ceilings on debt/equity ratios and otherwise restrict leverage at all major financial institutions (including banks, hedge funds, money market funds, insurance companies, and pension plans, as well as financial subsidiaries of industrial corporations); (2) supervise and restrict the design, and trading of new financial products (particularly including over-the-counter derivatives); (3) mandate the use of clearinghouses, to supervise them, and in its discretion to require their consolidation; (4) require the writedown of risky assets by financial institutions, regardless of whether required by accounting rule; and (5) to prevent liquidate crises by restricting the issuance of short-term debt. 6. Under the ``twin peaks'' model, the systemic risk regulatory agency would have broad powers, but not the power to override the consumer protection and transparency policies of the SEC. Too often bank regulators and banks have engaged in a conspiracy of silence to hide problems, lest they alarm investors. For that reason, some SEC responsibilities should not be subordinated to the authority of the Federal Reserve. 7. As a financial technology, asset-backed securitizations have decisively failed. To restore credibility to this marketplace, sponsors must abandon their ``originate-and-distribute'' business model and instead commit to retain a significant portion of the most subordinated tranche. Only if the promoter, itself, holds a share of the weakest class of debt that it is issuing (and on an unhedged basis) will there be a sufficient signal of commitment to restore credibility. 8. Credit rating agencies must be compelled either to conduct reasonable verification of the key facts that they are assuming in their ratings methodology or to obtain such verification from professionals independent of the issuer. For this obligation to be meaningful, it must be backstopped by a standard of liability specifically designed to apply to credit-rating agencies. ______ FinancialCrisisReport--40 If a regulator became concerned about the safety or soundness of a financial institution, it had a wide range of informal and formal enforcement actions that could be used to require operational changes. Informal actions included requiring the financial institution to issue a safety and soundness plan, memorandum of understanding, Board resolution, or commitment letter pledging to take specific corrective actions by a certain date, or issuing a supervisory letter to the financial institution listing specific “matters requiring attention.” These informal enforcement actions are generally not made public and are not enforceable in court. Formal enforcement actions included a regulator issuing a public memorandum of understanding, consent order, or cease and desist order requiring the financial institution to stop an unsafe practice or take an affirmative action to correct identified problems; imposing a civil monetary penalty; suspending or removing personnel from the financial institution; or referring misconduct for criminal prosecution. A wide range of large and small banks and thrifts were active in the mortgage market. Banks like Bank of America, Citigroup, JPMorgan Chase, and Wells Fargo originated, purchased, and securitized billions of dollars in home loans each year. Thrifts, whose charters typically required them to hold 65% of their assets in mortgage related assets, also originated, purchased, sold, and securitized billions of dollars in home loans, including such major lenders as Countrywide Financial Corporation, IndyMac Bank, and Washington Mutual Bank. Some of these banks and thrifts also had affiliates, such as Long Beach Mortgage Corporation, which specialized in issuing subprime mortgages. Still more lenders operated outside of the regulated banking system, including New Century Financial Corporation and Fremont Loan & Investment, which used such corporate vehicles as industrial loan companies, real estate investment trusts, or publicly traded corporations to carry out their businesses. In addition, the mortgage market was populated with tens of thousands of mortgage brokers that were paid fees for their loans or for bringing qualified borrowers to a lender to execute a home loan. 76 Oversight of Securities Firms. Another group of financial institutions active in the mortgage market were securities firms, including investment banks, broker-dealers, and investment advisors. These security firms did not originate home loans, but typically helped design, underwrite, market, or trade securities linked to residential mortgages, including the RMBS and CDO securities that were at the heart of the financial crisis. Key firms included Bear Stearns, Goldman Sachs, Lehman Brothers, Merrill Lynch, Morgan Stanley, and the asset management arms of large banks, including Citigroup, Deutsche Bank, and JPMorgan Chase. Some of these firms also had affiliates which specialized in securitizing subprime mortgages. Securities firms were overseen on the federal level by the Securities and Exchange Commission (SEC) whose mission is to “protect investors, maintain fair, orderly, and efficient 76 1/2009 “Financial Regulation: A Framework for Crafting and Assessing Proposals to Modernize the Outdated U.S. Financial Regulatory System,” prepared by the Government Accountability Office, Report No. GAO-09-216, at 26-27. markets, and facilitate capital formation.” 77 The SEC oversees the “key participants in the securities world, including securities exchanges, securities brokers and dealers, investment advisors, and mutual funds,” primarily for the purpose of “promoting the disclosure of important market related information, maintaining fair dealing, and protecting against fraud.” 78 CHRG-111hhrg51592--8 Mr. Bachus," I thank the chairman. It's not normally my tendency to be overly critical, but I'm going to make an exception in this case. I think surely everyone now recognizes that the credit rating agencies have failed, and failed spectacularly and broadly. Inaccurate rating agency risk assessments are one of the fundamental factors, in my opinion, in the global financial crisis, and effective correction action must address these shortcomings. As Mr. Ackerman alluded to, the rating agencies say that these assessments or ratings are opinions, predictive opinions, and I think from a legal standpoint, that's true. But in the real world, that's not reality. The SEC special examination report of the three major credit rating agencies uncovered significant weaknesses in their rating practices for mortgage-backed securities, and also called into question the impartiality of their ratings. As the SEC report detailed, the rating agencies failed to accurately rate the creditworthiness of many structured financial products. Investors and the government both over-relied on these inaccurate ratings, which undoubtedly contributed to the dramatic collapse of the United States and its financial market, or near-collapse. In order to avoid future meltdowns, we must return to a time where the rating agencies are not deemed a valid substitute for thorough investor due diligence. My own view is that while the SEC report did not address municipal securities, the rating agency practices were also significant factors in the problems that plagued municipal issuers. The Federal Government must also share the blame for fostering over-reliance on rating agencies. The Federal Reserve's recent designation of certain rating agencies as major nationally recognized statistical rating organizations implies a government stamp of approval that does not exist. What we have is what I would call, and others have called, a government-sanctioned duopoly. I think that's a mistake. As we move forward with regulatory reform proposals, the committee should consider removing from Federal laws, regulations, and programs all references that require reliance on ratings. The SEC also should take action to remove similar references in its own rules as quickly as possible. At a minimum, the committee should consider changing NRSROs from nationally recognized to nationally registered statistical rating organizations, to further reduce the appearance of government support or approval. As Mr. Garrett said, I think credit swap derivatives have been an accurate predictor of credit risk, and more so than credit ratings, and the credit ratings have become almost--well, I won't go into all that, but what I would say, this should give us caution in discouraging the use of credit default swaps, and it's critical that this committee doesn't restrict these CDS contracts in the marketplace as we consider broader regulatory reform. Let me close by saying, to say what has occurred in the marketplace since 2006 has been volatile and frightening is an understatement. Correcting inadequacies of the credit rating process is absolutely essential to restoring investor confidence. There must be further changes in the current rating system to respond to very serious concerns expressed by investors, market participants, and policymakers alike. I look forward to hearing from the witnesses concerning these matters. Thank you, Mr. Chairman. " FinancialCrisisReport--35 If an investment bank agreed to act as an “underwriter” for the issuance of a new security to the public, it typically bore the risk of those securities on its books until the securities were sold. By law, securities sold to the public generally must be registered with the SEC. 57 Registration statements explain the purpose of a proposed public offering, an issuer’s operations and management, key financial data, and other important facts to potential investors. Any offering document or prospectus provided to the investing public must also be filed with the SEC. If an issuer decides not to offer a new security to the general public, it can still offer it to investors through a “private placement.” 58 Investment banks often act as the “placement agent” in these private offerings, helping to design, market, and sell the security to selected investors. Solicitation documents in connection with private placements are not required to be filed with the SEC. Under the federal securities laws, however, investment banks that act as an underwriter or placement agent may be liable for any material misrepresentations or omissions of material facts made in connection with a solicitation or sale of a security to an investor. 59 In the years leading up to the financial crisis, RMBS securities were generally registered with the SEC and sold in public offerings, while CDO securities were generally sold to investors through private placements. Investment banks frequently served as the underwriter or placement agent in those transactions, and typically sold both types of securities to large institutional investors. In addition to arranging for a public or private offering, some investment banks take on the role of a “market maker,” standing willing and able to buy or sell financial products to their clients or other market participants. To facilitate client orders to buy or sell those products, the investment bank may acquire an inventory of them and make them available for client transactions. 60 By filling both buy and sell orders, market makers help create a liquid market for the financial products and make it easier and more attractive for clients to buy and sell them. Market makers typically rely on fees in the form of markups in the price of the financial products for their profits. At the same time, investment banks may decide to buy and sell the financial products for their own account, which is called “proprietary trading.” Investment banks often use the same inventory of financial products to carry out both their market making and proprietary trading activities. Investment banks that trade for their own account typically rely on changes in the values of the financial products to turn a profit. Inventories that are used for market making and short term proprietary trading purposes are typically designated as a portfolio of assets “held for sale.” Investment banks also typically maintain an inventory or portfolio of assets that they intend to keep as long term investments. 57 Securities Act of 1933, 15 U.S.C. § 77a (1933). 58 See, e.g., Securities Act of 1933 §§ 3(b) and 4(2); 17 CFR § 230.501 et seq. (Regulation D). 59 Securities Act of 1933, § 11, 15 U.S.C. § 77k; and Securities Exchange Act of 1934, § 10(b), 15 U.S.C. § 78j(b), and Rule 10b-5 thereunder. 60 For a detailed discussion of market making, see “Study & Recommendations on Prohibitions on Proprietary Trading & Certain Relationships with Hedge Funds & Private Equity Funds,” prepared by the Financial Stability Oversight Council, at 28-29 (Jan. 18, 2011) (citing SEC Exchange Act Rel. No. 34-58775 (Oct. 14, 2008)). FOMC20060328meeting--16 14,MR. KOHN.," My second question has to do with New Zealand and Iceland. I guess I thought you ascribed this entirely to an unwinding of the carry trade. But I thought there were other things going on. I thought that there were some very weak data for New Zealand, so that despite the decline in the New Zealand dollar, interest rates actually fell there, and that there was a report from some Scandinavian bank about problems in the Icelandic banking systems. I hesitate to ascribe this situation entirely to the carry trade." CHRG-111shrg56376--211 Mr. Carnell," Senator, be wary of anyone who puts a lot of stress on the notion that we need a new resolution mechanism. By and large, we had the resolution mechanisms that we needed. I could be a little more specific about that, but just to put it in the perspective. There certainly are some things that could be helpful here, but basically, we had the mechanisms. There were two problems. First, the system had been allowed to go in the direction of internal weakness to such a degree that problems piled up and happened quickly. But mainly---- Senator Corker. And how did that happen, by the way? " CHRG-111shrg52966--22 Mr. Cole," I would indeed, and thank you for the opportunity, Senator. First of all, I would say that my understanding is that the report that the GAO has done is really based on review of one institution. Senator Bunning. That is incorrect, but that is fine. " Mr. Cole," OK, and that we received this report with reference to perspectives on risk just in the last couple days. So we would like an opportunity to go over these findings with the GAO, as we typically do in GAO reviews. We have not had that opportunity. But I will say this, that I think that what Ms. Williams quoted from is in the report, but unfortunately, there are other parts that were not quoted, and one in particular is, quote: The effects of a long period of easy liquidity and benign credit conditions have continued to weaken underwriting standards across all major credit portfolios. Finally, we note that investor demands appear to be encouraging large financial institutions to originate more assets and even greater volumes of low-quality assets, and in order to distribute them through the capital markets.In response to that, we took very firm actions, and that---- Senator Bunning. When? " CHRG-111shrg53085--99 Mr. Whalen," Well, I think it is a horrible risk, and what I have said to people in the administration and to my clients and the readers of our public newsletters is that I do not think we can fund it. Does anybody really believe that we can go to market looking for $200 or $250 billion at a shot in new money and roll the existing paper that is coming due in that period? I do not think we can fund it. We have to go look for ways to limit the cash cost of subsidies for our financial institutions so that we can focus on the economy. And the way you do that is by resolving these companies in the traditional fashion. Otherwise, these zombies will keep eating cash as long as we leave them alive. That is the issue. If you want to stop giving money to AIG, push it into bankruptcy. Let the State of New York Insurance Commissioner deal with the underwriters, and then the rest of it gets resolved by the U.S. Trustee. And I will say it again: That man should be sitting here. I would spend a whole week with him. Senator Johanns. Mr. Chairman, thank you. " CHRG-111hhrg53238--133 Mr. Bartlett," Mr. Chairman, I can understand how you could reach that conclusion. Let me say it forcefully. We are not advocating the status quo. Consumer protections are not adequately provided in current Federal law for the safety and soundness regulators. That is the primary reason why they didn't get the job done. The unfair, deceptive trade practices does not apply to the OCC, just as one example. TILA and RESPA are with two different agencies that are mandated to cooperate, but they are not cooperating, and they have not done their job. So in issue after issue, these consumer protection practices are not in the hands of the safety and soundness regulators, and they should be. I think you heard unanimously that it would be an unmitigated disaster to separate safety and soundness from consumer protection because-- " CHRG-110hhrg44901--125 Mrs. Biggert," Thank you. When you were doing the disclosure rules, there was a real focus on the consumer testing. Was there similar consumer testing done as you put out the proposal on unfair and deceptive card practices? " CHRG-111hhrg56847--53 Mr. Bernanke," The structure of the compensation practices needs to change so that there is not an incentive to take excessive risks. Packages where the trader gets all the upside and none of the downside, that is the kind of thing we are trying to get rid of. " CHRG-111shrg57320--142 Mr. Reich," I think that is the fairly common practice in---- Senator Levin. It may be common, but that is OTS' determination not to take any kind of formal action at all, and the 2 is your decision. " fcic_final_report_full--491 There were subprime loans and subprime lenders, but in the early 1990s subprime lenders were generally niche players that made loans to people who could not get traditional mortgage loans; the number of loans they generated was relatively small and bore higher than normal interest rates to compensate for the risks of default. In addition, mortgage bankers and others relied on FHA insurance for loans with low downpayments, impaired credit and high debt ratios. Until the 1990s, these NTMs were never more than a fraction of the total number of mortgages outstanding. The reason that low underwriting standards were not generally used is simple. Low standards would result in large losses when these mortgages defaulted, and very few lenders wanted to hold such mortgages. In addition, Fannie and Freddie were the buyers for most middle class mortgages in the United States, and they were conservative in their approach. Unless an originator made a traditional mortgage it was unlikely that Fannie or Freddie or another secondary market buyer could be found for it. This is common sense. If you produce an inferior product—whether it’s a household cleaner, an automobile, or a loan—people soon recognize the lack of quality and you are out of business. This was not the experience with mortgages, which became weaker and riskier as the 1990s and 2000s progressed. Why did this happen? In its report, the Commission majority seemed to assume that originators of mortgages controlled the quality of mortgages. Much is made in the majority’s report of the so-called “originate to distribute” idea, where an originator is not supposed to care about the quality of the mortgages because they would eventually be sold off. The originator, it is said, has no “skin in the game.” The motivation for making poor quality mortgages in this telling is to earn fees, not only on the origination but in each of the subsequent steps in the securitization process. This theory turns the mortgage market upside down. Mortgage originators could make all the low quality mortgages they wanted, but they wouldn’t earn a dime unless there was a buyer . The real question, then, is why there were buyers for inferior mortgages and this, as it turns out, is the same as asking why mortgage underwriting standards, beginning in the early 1990s, deteriorated so badly. As Professor Raghuram Rajan notes in Fault Lines , “[A]s brokers came to know that someone out there was willing to buy subprime mortgage-backed securities without asking too many questions, they rushed to originate loans without checking the borrowers’ creditworthiness, and credit quality deteriorated. But for a while, the problems were hidden by growing house prices and low defaults—easy credit masked the problems caused by easy credit—until house prices stopped rising and the flood of defaults burst forth.” 60 Who were these buyers? Table 1, reporting the number of NTMs outstanding on June 30, 2008, identified government agencies and private organizations required by the government to acquire, hold or securitize NTMs as responsible for two-thirds 60 Raghuram G. Rajan, Fault Lines , p.44. 487 of these mortgages, about 19 million. The table also identifies the private sector as the securitizer of the remaining one-third, about 7.8 million loans. In other words, if we are looking for the buyer of the NTMs that were being created by originators at the local level, the government’s policies would seem to be the most likely culprit. The private sector certainly played a role, but it was a subordinate one. Moreover, what the private sector did was respond to demand—that’s what the private sector does—but the government’s role involved deliberate policy, an entirely different matter. Of its own volition, it created a demand that would not otherwise have been there. FOMC20080625meeting--62 60,MR. STOCKTON.," Again, we want to step back a bit from taking this regime-switching too seriously as implying that there are just two states of the world or maybe three states of the world. There are lots of different states of the world. What we are trying to do is look at the residuals in our spending equations and ask how they behave in various kinds of periods. In periods with substantial increases in the unemployment rate, weak payroll employment, and big declines in consumer sentiment, there also are substantial negative residuals in our spending equations, particularly on the consumer spending side. That is still built into this forecast. So we have not interpreted the last six weeks of data as suggesting that recession concerns are all behind us, that we were just completely wrong, and that we are now on a much stronger growth path than we previously thought. If, in fact, you're worried that the incoming data might be signaling a stronger growth path, then I would take a look at the ""upside risk"" scenario that we show in the Greenbook. There we take out all of our spending residuals--those that are incorporated because we thought we might be in this low-growth or recessionary-like state and the ones that are associated with financial turmoil--and you get growth in that case that is a little above potential growth and a path for the fed funds rate that is even steeper than the current market expectations. Now, although we kept these negative residuals in our forecast, we did have to acknowledge the fact that underlying aggregate demand appeared stronger than we thought it was going to be at the time of the last FOMC meeting. There is an underlying strengthening of aggregate demand in this forecast that shows up as an increase in the equilibrium funds rate of roughly � percentage point. So we're trying to acknowledge the strength of the incoming data, but we want to be clear that this forecast still embeds some significant negative add-factors on spending going forward. That could be wrong. Maybe the incoming data are signaling that we are just fundamentally wrong about that aspect of the forecast. As Larry showed, given the stunning decline in consumer sentiment, the continued weak business sentiment, and the fact that the unemployment rate has risen as much as it has and has done this in the past only in periods of recession, we felt comfortable still presenting you with a forecast that anticipates that aggregate demand is going to be very weak over the next several quarters. " CHRG-111shrg54789--82 Mr. Barr," I think, again, in the credit card context, this Committee has discussed problems with unfair practices in credit cards, problems we have seen with respect to bank overdraft fees, which are not disclosed as credit problems, problems in the payday lending sector, where there have been significant failings, problems in the auto loan sector, where disclosures have been inadequate and abuses have occurred. I think if you look really across the consumer financial services marketplace, at credit products, at payment products, and the like, bank products, there have been a series of failures of our existing regime to take account of the needs of consumers. And I am sure you hear the complaints from your constituents on these matters. Senator Bayh. Certainly in the credit card area we did, and that is one of the reasons the Committee and the Congress acted in that area. So it is your judgment, Mr. Barr--and I agree with your assessment of many of the practices you have outlined there--it is your judgment that the problem can't be addressed by simply proscribing some of those things or tightening existing enforcement and regulation to prevent a recurrence or to require greater disclosure in the future? " fcic_final_report_full--214 CDS protection on subprime mortgage–backed securities. In an email to Cassano on February , Park wrote: Joe, Below summarizes the message we plan on delivering to dealers later this week with regard to our approach to the CDO of ABS super senior business going forward. We feel that the CDO of ABS market has in- creasingly become less diverse over the last year or so and is currently at a state where deals are almost totally reliant on subprime/non prime residential mortgage collateral. Given current trends in the housing market, our perception of deteriorating underwriting standards, and the potential for higher rates we are no longer as comfortable taking such concentrated exposure to certain parts of the non prime mortgage securitizations. On the deals that we participate on we would like to see significant change in the composition of these deals going forward—i.e. more diversification into the non-correlated asset classes. As a result of our ongoing due diligence we are not as comfortable with the mezzanine layers (namely BBB and single A tranches) of this asset class. . . . We realize that this is likely to take us out of the CDO of ABS market for the time being given the arbitrage in subprime collat- eral. However, we remain committed to working with underwriters and managers in developing the CDO of ABS market to hopefully become more diversified from a collateral perspective. With that in mind, we will be open to including new asset classes to these structures or in- creasing allocations to others such as [collateralized loan obligations] and [emerging market] CDOs .  AIG’s counterparties responded with indifference. “The day that you [AIG] drop out, we’re going to have  other people who are going to replace you,” Park says he was told by an investment banker at another firm.  In any event, counterparties had some time to find new takers, because AIG Financial Products continued to write the credit default swaps. While the bearish executives were researching the issue from the summer of  onward, the team continued to work on deals that were in the pipeline, even after February . Overall, they completed  deals between Sep- tember  and July —one of them on a CDO backed by  subprime assets.  By June , AIG had written swaps on  billion in multisector CDOs, five times the  billion held at the end of .  Park asserted that neither he nor most others at AIG knew at the time that the swaps entailed collateral calls on AIG if the market value of the referenced securities declined.  Park said their concern was sim- ply that AIG would be on the hook if subprime and Alt-A borrowers defaulted in large numbers. Cassano, however, told the FCIC that he did know about the possible calls,  but AIG’s SEC filings to investors for  mentioned the risk of collateral calls only if AIG were downgraded. fcic_final_report_full--121 Early in the decade, banks and thrifts such as Countrywide and Washington Mutual increased their origination of option ARM loans, changing the product in ways that made payment shocks more likely. At Golden West, after  years, or if the principal balance grew to  of its original size, the Pick-a-Pay mortgage would recast into a new fixed-rate mortgage. At Countrywide and Washington Mutual, the new loans would recast in as little as five years, or when the balance hit just  of the original size. They also offered lower teaser rates—as low as —and loan-to- value ratios as high as . All of these features raised the chances that the bor- rower’s required payment could rise more sharply, more quickly, and with less cushion. In , Washington Mutual was the second-largest mortgage originator, just ahead of Countrywide. It had offered the option ARM since , and in , as cited by the Senate Permanent Subcommittee on Investigations, the originator con- ducted a study “to explore what Washington Mutual could do to increase sales of Op- tion ARMs, our most profitable mortgage loan.”  A focus group made clear that few customers were requesting option ARMs and that “this is not a product that sells it- self.”  The study found “the best selling point for the Option Arm” was to show con- sumers “how much lower their monthly payment would be by choosing the Option Arm versus a fixed-rate loan.”  The study also revealed that many WaMu brokers “felt these loans were ‘bad’ for customers.”  One member of the focus group re- marked, “A lot of (Loan) Consultants don’t believe in it . . . and don’t think [it’s] good for the customer. You’re going to have to change the mindset.”  Despite these challenges, option ARM originations soared at Washington Mutual from  billion in  to  billion in , when they were more than half of WaMu’s originations and had become the thrift’s signature adjustable-rate home loan product.  The average FICO score was around , well into the range considered “prime,” and about two-thirds were jumbo loans—mortgage loans exceeding the maximum Fannie Mae and Freddie Mac were allowed to purchase or guarantee.  More than half were in California.  Countrywide’s option ARM business peaked at . billion in originations in the second quarter of , about  of all its loans originated that quarter.  But it had to relax underwriting standards to get there. In July , Countrywide decided it would lend up to  of a home’s appraised value, up from , and reduced the minimum credit score to as low as .  In early , Countrywide eased standards again, increasing the allowable combined loan-to-value ratio (including second liens) to .  CHRG-110shrg50418--16 STATEMENT OF SENATOR ELIZABETH DOLE Senator Dole. Thank you, Mr. Chairman. As I have indicated before, I have very serious concerns about the $700 billion rescue package that this legislation unfairly holds taxpayers responsible for the costly and reckless decisions of investment bankers on Wall Street and policymakers in Washington. Like so many North Carolinians I have heard from, I continue to be very skeptical that this newly enacted law is turning out to be the blank check that so many of us feared. Incredibly, only last week Treasury Secretary Paulson said that the Troubled Asset Relief Program would now not include the purchase of illiquid mortgage securities. This proposal was principally sold to Congress as the way to return our financial institutions to health. In fact, this Committee and its staff spent countless hours quizzing Treasury and Federal Reserve officials about how this proposal would work in practice. I know I was hardly the only Member who found their responses either inconclusive or unsubstantiated. Well, as someone who opposed this legislation from the beginning, I am pleased that Secretary Paulson now recognizes this type of mortgage purchase mechanism looks destined to failure. I can only imagine the number of Members of Congress who have had to come to grips with the fact that the TARP plan was an ill-advised, hurried attempt to stymie fundamental underlying problems in our housing and credit markets. And now we are talking about extending this same legislation to the automotive companies? This would ignore the original intent of the law, which was to clear out the credit markets so banks would lend money to one another and to businesses, thereby spurring economic activity. Additionally, this would distract from what I believe to be the root cause of our economic problem: the collapse of our housing market. So much of what is now happening with regard to the credit crisis, the housing slump, and the bankruptcy and dissolving of major financial institutions can be linked to the mismanagement of Fannie Mae and Freddie Mac, which was made possible by weak oversight and very little accountability. If anything, this Committee should now be spending its precious time asking regulators: What is going to happen with those GSEs in a post-Government-conservatorship world? After the conservatorship, what next? As I have previously stated, we need to end the existing structure of an implied Government guarantee. We need to end the practice of private rewards at public risk. Another topic that would be more pertinent for this Committee's attention right now, it seems to me, would be the results of this past weekend's G-20 summit. One bright note from those discussions was the recognition among the participants for the need for stronger regulation of derivatives, including credit default swaps. I have called for more transparency in this area of the credit markets--called for it for some months--which have grown exponentially from $1 trillion in 2000 to $55 trillion today in market exposure. Finally, without fundamental changes in the automotive industry, we would just be throwing taxpayers' dollars at firms that will inevitably go under. For instance, the enormous costs in union-required benefits is unsustainable. Renegotiating these contracts would be essential if there were to be hope of keeping these companies afloat. Thank you, Mr. Chairman. " CHRG-111hhrg50289--28 Mr. Graves," Thanks, Madam Chair. My first question is to Ms. Huels. Has the economy changed as far as your investment practices go? With the downturn in the economy, have you changed your policies or practices or backed off or anything like that? Ms. Huels. We have not. We invest primarily in midwest based industrial manufacturing companies, and while many may think manufacturing has declined in this country, we find there are significant opportunities to invest in growing middle market, lower middle market manufacturing companies. We have not changed our profile. If there is a profile that has changed, it is really the availability of senior lending available to us. So what we have done is we have had to write a little bit bigger check and provide more of the capital because the senior lenders are typically providing less. " CHRG-111hhrg48874--142 Mr. Long," We run into this a lot with commercial real estate. It is normal practice in some sectors of commercial real estate lending for the bank to fund an interest carry. And that's simply to bridge the timing differences between the cash outflows and the cash inflows. So, what we run into in a lot in community banks right now in some parts of the country are these busted residential development loans. And technically, they're current because the bank's paying themselves interest and they're going to be current right up until the day they default and that loan has to be foreclosed. " CHRG-111hhrg53234--53 Mr. Sherman," I am not asking you what new law should be passed. I am not asking you what your practice has been in the past. I am asking you what are the legal authorities you have under present law right now? " CHRG-111hhrg48868--689 Mr. Liddy," I have not, sir. I would not condone it. I have seen absolutely none. We have had a number of investigative authorities looking at our practices and our books and records, and nothing has come to light that I am aware of. Could I go back to one other point? " CHRG-111shrg57320--130 Mr. Reich," We are at a point of hindsight today, and I regret it. Senator Levin. What kind of efforts did you make to change these practices? Did you issue a temporary new guidance and let people comment on it? " CHRG-110hhrg46594--317 Mr. Perlmutter," Thanks, Mr. Chairman. And, gentlemen, thank you for your time today. We have had a lot of questions and you have heard a lot of comments. And we appreciate your perseverance. First, there are a couple of places where I differ with the chairman. One, just as full disclosure, I am a Chapter 11 lawyer. So I don't see that as the absolute end of the world, that there are plenty of ways through an 11, through prepackaged, as you said, Mr. Nardelli, kinds of approaches to deal with this. The second thing is I do see a difference between manufacturing and underwriting or supporting the manufacturing industry as opposed to trying to keep the banking industry in some kind of shape that would facilitate our economy. So I do look at this a little bit differently. These are my questions. But I did want to say and I do want to applaud all three companies for really having moved into this century with your Volts and your Escapes and all your different cars that are much more fuel efficient, and I know you put a lot of money into that R&D and that development. So thank you. The first question. And this goes to you, Mr. Wagoner. What was--in the third quarter of last year, did you make money or lose money, 2007, and what was it? " FinancialCrisisReport--336 At Deutsche Bank, five different parts of the Securitized Product Group played key roles in its CDO business. They were the CDO Group (North America); the CDO sales force, formally called Securitized Products; the CDO Syndication Desk which helped promote and track CDO sales; the mortgage department; and the CDO Trading Desk, formally called ABS (Asset Backed Security) Trading, CDO Trading, and ABS Correlation Trading. The CDO Group had two co-heads, Michael Lamont and Michael Herzig, and approximately 20 employees. The heads of the group reported to Richard D’Albert, Global Head of Deutsche Bank’s Securitized Product Group. The CDO Group designed and structured the bank’s CDOs, analyzed the assets that went into the CDOs, monitored the purchasing and warehousing of those assets, obtained CDO credit ratings, prepared CDO legal documentation, acted as the CDO underwriter or placement agent on behalf of Deutsche Bank, and oversaw the issuance of the CDO securities. 1269 The CDO sales force sold the resulting CDO securities for Deutsche Bank. It received assistance from the CDO Syndication, sometimes called the “syndicate,” which helped promote the deals with investors and tracked CDO sales. The CDO sales force was headed by Sean Whelan and Michael Jones. They reported to Munir D’auhajre, overall head of sales, who reported, in turn, to Fred Brettschneider, the head of the Institutional Client Group of Deutsche Bank Americas. The CDO sales force had approximately 20 employees. In the United States, the CDO Syndication had about seven employees, and was headed by Anthony Pawlowski, who reported to Mr. Lamont and Mr. Herzig, who headed the CDO Group. The Deutsche Bank mortgage department was responsible for purchasing residential mortgages from a variety of sources, warehousing those mortgages, and securitizing the mortgages into RMBS securities for which Deutsche Bank acted as the underwriter or placement agent. Some of those RMBS securities were later included or referenced in CDOs issued by the bank. The CDO Trading Desk was headed by Greg Lippmann, who served as global head of Deutsche Bank’s CDO, ABS, and ABS Correlation Trading Desks. 1270 Those desks were responsible for trading a variety of RMBS, CDO, and other asset backed securities on the secondary market. Mr. Lippmann had a staff of approximately 30 employees, 20 in the United States and 10 in London. Like the head of the CDO Group, Mr. Lippmann reported to Mr. D’Albert, the head of the bank’s Securitized Product Group. Mr. Lippmann was also the head of risk management for all new issue CDOs and described himself as “involved in underwriting, structuring, marketing and hedging our warehouse risk for new issue cdos.” 1271 http://online.wsj.com/article/SB10001424052748704594804575649170454587534.html?KEYWORDS=Banks+in+ Talks+to+End+Bond+Probe . See also 10/2006, “CDO Primary Update Progress Report,” prepared by Deutsche Bank, DBSI_PSI_EMAIL03970167-72, at 68 (ranking Deutsche Bank as third in CDO issuances as of October 2006). 1269 Subcommittee interview of Michael Lamont (9/29/2010). 1270 Organizational Chart for Deutsche Bank Global CDO Group, DB_PSI_C00000001. 1271 7/14/2006 email from Greg Lippmann to Melissa Goldsmith at Deutsche Bank, DBSI_PSI_EMAIL01400135- 37. CHRG-111hhrg72887--57 STATEMENT OF KATHLEEN KEEST Ms. Keest. Thank you, Mr. Chairman, and thank you very much for inviting me to testify. In my remarks today, I am only going to focus, I think, on a couple of points, primarily the Magnuson-Moss rulemaking, and I may add a couple of remarks about the Attorney General's enforcement authority, as I used to be in the Attorney General's office myself. And I would refer the committee to my written testimony for the specifics. While we are not talking so much about mortgages today, I think since we are talking about consumer credit, we have an object lesson that we can learn from in what happened there. And the FTC's jurisdiction over consumer credit covers a lot of the same subject matter area that the Federal banking agencies did. And what we know is that from a regulatory perspective, that there are three tools that are needed to make sure that there are clear rules to the game, and that there is a referee on site to enforce those rules. We know, now, that the banking agencies, much to our dismay, didn't use any of them. The FTC, by contrast, really, it functionally only had one of those tools, and that was the tool that allows the referee to call a foul after it has already happened, and it is an important tool, but it is not sufficient. What are those three tools? One of them is to set the rules of the game that everybody has to play. And I am a strong believer in the fact that that is as important for ethical and honest business competition as it is for consumers. I do not believe it is a zero-sum game, and I think that has been part of the problem of thinking of it in that way. The second is the right to sort of keep an ongoing monitoring system where you can do prevention through monitoring. That is a tool that the banking industries have that the FTC doesn't, which leaves just the law enforcement, and that was the only tool the FTC had in practice. In theory, it had the rulemaking authority, but Magnuson-Moss, I understand--I am sorry Congressman Gingrey isn't here--I understand the purpose of it originally, but I can tell you that I have got gray hair now. The first year, my first year in practice, was when the last time the Magnuson-Moss rule was used by the FTC. The credit practices rule was started in 1975 when I was a brand new lawyer. That process took 10 years. I testified at one of the hearings; I was part of that two-book record that it took to get that rule in place. It was 10 years later when that rule finally went into effect. The amount of credit out there went from something like $190 billion to almost $500 billion in that time, and the market had already started to change. Now, that rule was very important, and it did a lot of things, but we were so far behind the eight ball by the time it happened--and in an agency that has got the breadth of jurisdiction this one does, devoting time and resources to a process that could take 10 years is a march down into a long, dark tunnel that they simply could not afford, and neither could consumers, because too much damage happens along that way. By contrast, the Federal banking agencies, once they got on the dime, they proposed their credit card rules. The OTS, the Federal Reserve Board and the NCUA proposed their credit card rules. It was proposed, there was input, there was a lot of discussion, and it was promulgated within less than a year; and now there is a year-and-a-half lead time for the issuers who are affected by that rule to gear up and do it, but they know what those rules are going to be, and they have got that time to do it. So I think the APA rulemaking is a critical, critical part of this. And I would just like to make a pitch for--Congressman, you mentioned sort of perhaps wanting to consider paydays along the way. In our testimony that we had suggested--that is, this credit practices rule, the last one that the FTC used, this Magnuson-Moss provision that had a delivery period that would make an elephant weep, it was a really good rule that took care of some of the most egregious abuses that were in the consumer credit market that day. It took care of the wage assignments that basically had people's paychecks going first to a creditor before it went to the groceries. It took care of the confession of judgment clauses that prevented people from raising a defense, which I can tell you as an old legal aid lawyer where a lot of people had them, and it took care of the in terrorem use of some of the tactics. My first client--the reason I spent 35 years doing this, it was my very first client who in my very first case, a loan company wanted to come in and clean out her house, the furniture in a 72-year-old widow's house, everything down to the two gray washtubs. And the credit practices rule got rid of that. And we have some segments of the market today that use practices which are a modern-day electronic equivalent of that, holding checks or the key to somebody's bank account. And they can do everything that credit practices rule took care of by the abuses with that check hold. And so we have suggested that now that we are approaching the silver anniversary of that credit practices rule, that the FTC review that to see if, perhaps, we can update that and take care of some of those abuses again. And if I still have a couple of minutes left. " FOMC20070918meeting--170 168,MR. ALVAREZ.," I was delighted to hear this morning that employment of lawyers is now a factor in assessing the robustness of the economy. I recommend that in the Committee’s drive for transparency, however, the FOMC not disclose this new factor because undoubtedly there will be those among my colleagues in the legal profession who will sue for a more prominent and permanent place in the Committee’s forecasting models. Today, I’ve been asked to address an element of the Committee’s governance. Over time, a consensus appears to have developed that the Committee would prefer to change its current practice of approving only the assessment of risk portion of the policy announcement issued after each Committee meeting and instead approve the entire statement. If that is the Committee’s desire, there are several methods for achieving that result. Each method has advantages and disadvantages. A key concern in choosing an alternative involves the amount of flexibility that the Committee wishes to retain to allow other methods for announcing its decisions, especially in emergency, intermeeting, and special circumstances. A second key concern is how much attention the Committee wants to draw to its change in practice. The first and simplest alternative would be for the Committee just to begin voting on the entire statement along with the policy action. This approach maintains the maximum flexibility for the Committee to alter its practice in different situations and to adjust the content of the statement. This approach also maintains the flexibility of the Chairman to issue a statement in times of emergency or special need. If the Committee chooses this alternative, the Committee also controls the amount of prominence that it calls to this change in the minutes. If the Committee believes this change is significant, it may include a robust discussion in the minutes. If it views the change as not significant, it may have no or only a brief notice in the minutes. A second and slightly more formal alternative would be to adopt a nonbinding resolution outlining the Committee’s desired new practice. A nonbinding resolution provides a more formal vehicle than the first alternative for explaining the change in voting practice in the minutes. At the same time, because the resolution would be nonbinding, it retains the flexibility of simply voting on the matter. The remaining two alternatives are the most formal and involve adopting a binding resolution or changing the Committee’s rules to require Committee approval of statements issued at each regularly scheduled meeting. These alternatives are more binding because they require further deliberate Committee action to change the practice in the future. A rule change would also be very visible because, in addition to an explanation in the Committee’s minutes, a rule change entails publication in the code of federal regulations. This would attract attention in part because the Committee’s rules currently do not address voting practices beyond the requirements of a quorum. A formal resolution or a rule change may hold an advantage for a member who wants to delineate publicly the exact content of the statement. On the other hand, were the Committee to desire to retain flexibility to alter the content of the statement, a rule or resolution would have to be carefully crafted to ensure that flexibility. A binding resolution or a rule change could also limit the flexibility of the Committee and of the Chairman to speak about the FOMC’s actions. To date, the Chairman has retained the flexibility to speak for the Committee in emergency and other situations. Indeed, the statement was originally a statement of the Chairman, not of the Committee. If the Committee desires to retain this flexibility and yet adopt a binding resolution or rule, the resolution or rule could be drafted to maintain that flexibility. That concludes my presentation. I would be happy to entertain any questions." fcic_final_report_full--74 DOTCOM CRASH: “LAY ON MORE RISK ” The late s was a good time for investment banking. Annual public underwrit- ings and private placements of corporate securities in U.S. markets almost quadru- pled, from  billion in  to . trillion in . Annual initial public offerings of stocks (IPOs) soared from  billion in  to  billion in  as banks and securities firms sponsored IPOs for new Internet and telecommunications compa- nies—the dot-coms and telecoms.  A stock market boom ensued comparable to the great bull market of the s. The value of publicly traded stocks rose from . tril- lion in December  to . trillion in March .  The boom was particularly striking in recent dot-com and telecom issues on the NASDAQ exchange. Over this period, the NASDAQ skyrocketed from  to ,. In the spring of , the tech bubble burst. The “new economy” dot-coms and telecoms had failed to match the lofty expectations of investors, who had relied on bullish—and, as it turned out, sometimes deceptive—research reports issued by the same banks and securities firms that had underwritten the tech companies’ initial public offerings. Between March  and March , the NASDAQ fell by almost two-thirds. This slump accelerated after the terrorist attacks on September  as the nation slipped into recession. Investors were further shaken by revelations of ac- counting frauds and other scandals at prominent firms such as Enron and World- com. Some leading commercial and investment banks settled with regulators over improper practices in the allocation of IPO shares during the bubble—for spinning (doling out shares in “hot” IPOs in return for reciprocal business) and laddering (doling out shares to investors who agreed to buy more later at higher prices).  The regulators also found that public research reports prepared by investment banks’ ana- lysts were tainted by conflicts of interest. The SEC, New York’s attorney general, the National Association of Securities Dealers (now FINRA), and state regulators settled enforcement actions against  firms for  million, forbade certain practices, and instituted reforms.  The sudden collapses of Enron and WorldCom were shocking; with assets of  billion and  billion, respectively, they were the largest corporate bankruptcies before the default of Lehman Brothers in . Following legal proceedings and investigations, Citigroup, JP Morgan, Merrill Lynch, and other Wall Street banks paid billions of dollars—although admitted no wrongdoing—for helping Enron hide its debt until just before its collapse. Enron and its bankers had created entities to do complex transactions generating fictitious earnings, disguised debt as sales and derivative transactions, and understated the firm’s leverage. Executives at the banks had pressured their analysts to write glowing evaluations of Enron. The scandal cost Citigroup, JP Morgan, CIBC, Merrill Lynch, and other financial institutions more than  million in settlements with the SEC; Citigroup, JP Morgan, CIBC, Lehman Brothers, and Bank of America paid another . billion to investors to settle class action lawsuits.  In response, the Sarbanes- Oxley Act of  required the personal certification of financial reports by CEOs and CFOs; independent audit committees; longer jail sentences and larger fines for executives who misstate financial results; and protections for whistleblowers. Some firms that lent to companies that failed during the stock market bust were successfully hedged, having earlier purchased credit default swaps on these firms. Regulators seemed to draw comfort from the fact that major banks had succeeded in transferring losses from those relationships to investors through these and other hedging transactions. In November , Fed Chairman Greenspan said credit de- rivatives “appear to have effectively spread losses” from defaults by Enron and other large corporations. Although he conceded the market was “still too new to have been tested” thoroughly, he observed that “to date, it appears to have functioned well.”  The following year, Fed Vice Chairman Roger Ferguson noted that “the most re- markable fact regarding the banking industry during this period is its resilience and retention of fundamental strength.”  CHRG-111hhrg67816--41 Mr. Green," Mr. Chairman, thank you for your friendship over the last 17 years. I thank you for holding this hearing on the consumer credit and debt protection and to look at the role that the FTC should play. I would like to welcome our new FTC chairman, Jon Leibowitz, and congratulate him on the new position as the chair of the Commission. I look forward to working with you. The FTC is important all the time but in this day and time it is even more so. As the primary federal agency that enforces consumer credit laws at entities other than banks, the thrifts and federal credit unions, the FTC has broad responsibility regarding consumer financial issues in the mortgage market including those involving mortgage lenders, brokers, and services. The FTC enforces a number of federal laws governing mortgage lending, Truth in Lending Act, the Home Ownership and Equity Protection Act, and the Equal Credit Opportunity Act. The Commission also enforces Section 5 of the Federal Trade Commission Act which more generally prohibits unfair and deceptive acts or practices in the marketplace. That is probably one of the most important that we can deal with. In addition, the Commission enforces a number of other consumer protection statutes that govern financial services including Consumer Leasing Act, Fair Debt Collection Practice Act, the Fair Credit Reporting Act, the Credit Repair Organization Act, and the privacy provisions of the Gramm-Leach-Bliley Act. I also have a particular concern about non-traditional loans such as pay-day loans and car title loans, which can carry enormous interest rates and fees. In 2006, Congress enacted to cap the pay-day loans made to military personnel to a 36 percent annual percentage rate after pay-day loans grew 34 percent to reach a total of 500 million the previous 2 years. That figures has doubled since 2002. In an economic climate such as the one we are in today where credit availability is shrinking consumers may be more inclined to turn to these options which are much less regulated and therefore the potential for predatory practice is much greater. In recent months, the FTC has taken significant steps to protect consumers and crack down on scam artists by going after Internet pay-day lenders, alleged mortgage foreclosure rescue companies, and companies claiming they remove negative information from the consumers' credit reports. I look forward to hearing what other actions the FTC is making to protect consumers, what tools it may need from Congress, and what the rest of our witnesses believe could be done better to protect consumers in today's volatile economic environment. All told, this gives the FTC broad authority to go after those predatory practices. The Congress may need to act particularly to give FTC authority to issue rules under the Administrative Procedures Act. Again, Mr. Chairman, thank you for calling the hearing, and I appreciate the opportunity. " CHRG-111shrg50815--84 Mr. Levitin," And I think it is also--I just want to try and link up two pieces of this, because I think often interchange and the consumer side are seen as separate issues. These are very intimately linked. This is a complete cycle. So interchange funds rewards programs. Rewards programs and teaser rates, those are the honey that lure in the consumer flies into this venus fly trap of sticky interest rates, of hidden fees, and so forth. So if you are concerned about an unsafe and unsound underwriting model, it is not enough just to go out to try and focus on solicitations. You have to look at the entire business model with this. Senator Tester. I appreciate that. I want to talk a little bit, and I know that the House Financial Services Committee yesterday had an extensively reported hearing on what is going on with the TARP money. I just want to ask, and I think if there is anybody else that this question applies to, answer, and I don't mean to direct them all to you, Mr. Clayton, but have any of your members raised rates on credit cards that received TARP funds? " FOMC20080130meeting--338 336,MR. GIBSON.," As noted in the top left panel of exhibit 5, we would like to stress two key points on the rating agency and investor issues. First, credit rating agencies are one of the weak links that helped a relatively small shock in the subprime mortgage market spread so widely, though certainly not the only one. This is not just our staff working group's view--most market participants have also expressed the opinion that rating agencies deserve some of the blame. Second, the way that some investors use ratings for their own risk management has not kept up with financial innovations, such as the growth of structured finance. These financial innovations have made a credit rating less reliable as a sufficient statistic for risk. The top right panel provides a roadmap to our presentation. To start, I'll expand on some of the points that Pat made on the role of rating agencies in the financial crisis. My aim is to show why credit rating agencies were a weak link, which will lead naturally to our recommendations on rating agency practices. As we go, I'll point out several places where the rating agency issues link up with the investor practices issues that you'll hear about next from Bev. We feel strongly that the ratings and investor issues are really just two angles on the same underlying issue. The crisis began in the subprime market, the subject of the next panel. The subprime mess happened--and keeps getting worse--in part because of the issues associated with rating agencies (though as I said earlier, there is plenty of blame to go around). Our staff working group was asked whether the rating agencies got it wrong when they rated subprime RMBS. The answer is ""yes""--they got it wrong. Rating agencies badly underestimated the risk of subprime RMBS. Last year, Moody's downgraded 35 percent of the first-lien subprime RMBS issued in 2006. The average size of these subprime RMBS downgrades was two broad rating categories--for example, a downgrade from A to BB--compared with the historical average downgrade of 1 broad rating categories. As indicated in the exhibit, the rating methodologies for subprime were flawed because the rating agencies relied too much on historical data at several points in their analysis. First, the rating agencies underestimated how severe a housing downturn could become. Second, rating agencies underestimated how poorly subprime loans would perform when house prices fell because they relied on historical data that did not contain any periods of falling house prices. Third, the subprime market had changed over time, making the originator matter more for the performance of subprime loans, but rating agencies did not factor the identity of the originator into their ratings. Fourth, the rating agencies did not consider the risk that refinancing opportunities would probably dry up in whatever stress event seriously threatened the subprime market. Of course, the rating agencies were not alone in this. Many others misjudged these risks as well. Some have suggested that conflicts of interest were a factor in the poor performance of rating agencies. While conflicts of interest at rating agencies certainly do exist, because the rating is paid for by the issuer, we didn't see evidence that conflicts affected ratings. That said, we also cannot say that conflicts were not a factor. The SEC currently has examinations under way at the rating agencies to gather the detailed information that is needed to check whether conflicts had a significant effect. In the next panel, I turn to the ABS CDOs that had invested heavily in subprime. Rating agencies got it wrong for ABS CDOs. The downgrade rate of ABS CDOs in 2007 was worse than the previous historical worst case, just as it was for subprime. AAA tranches of ABS CDOs turned out to be remarkably vulnerable: Last year, twenty-seven AAA tranches were downgraded all the way from AAA to below investment grade. As indicated in the exhibit, the main reason that rating agencies got it wrong for ABS CDOs was that their rating models were very crude. Rating agencies used corporate CDO models to rate ABS CDOs. They had no data to estimate the correlation of defaults across asset-backed securities. Despite the many flaws of credit ratings as a sufficient statistic for credit risk, the rating agencies used ratings as the main measure of the quality of the subprime RMBS that the ABS CDOs invested in. And the rating agencies did only limited, ad hoc analysis of how the timing of cash flows affects the risk of ABS CDO tranches. As a result, the ratings of ABS CDOs should have been viewed as highly uncertain. As one risk manager put it, ABS CDOs were ""model risk squared."" A final point on ABS CDOs is that the market's reaction to the poor performance of ABS CDOs makes it clear that some investors did not understand the differences between corporate and structured-finance ratings. Because structured-finance securities are built on diversified portfolios, they have more systematic risk and less idiosyncratic risk than corporate securities. They will naturally be more sensitive to macroeconomic risk factors like house prices, and by design, downgrades of structured-finance securities will be more correlated and larger than downgrades of corporate bonds. Turning to the bottom panel, as Pat noted, in August of last year the subprime shock hit the ABCP markets, especially markets for ABCP issued by SIVs. Rating agencies also got it wrong for the SIVs. More than two-thirds of the SIVs' commercial paper has been downgraded or has defaulted. The problem with the ratings was that the rating agencies' models for SIVs relied on a rapid liquidation of the SIVs' assets to shield the SIVs' senior debt from losses. While this might have worked if a single SIV got into trouble, the market would not have been able to absorb a rapid liquidation by all SIVs at the same time. Once investors began to understand the rating model for SIVs, even SIVs with no subprime exposure could not roll over their commercial paper. Investors who thought they were taking on credit risk became uncomfortable with the market risk and liquidity risk that are inherent in a SIV's business model. The next exhibit presents the staff subgroup's recommendations for addressing the weaknesses in credit ratings for structured-credit products. A common theme of our recommendations is drawing sharper distinctions between corporate ratings and structured-finance ratings. First, we recommend that rating agencies should differentiate structured-finance ratings from corporate ratings by providing additional measures of the risk or leverage of structured-finance securities to the market along with the rating. We don't make a specific recommendation on exactly what measures of risk or leverage because we believe rating agencies and investors should work out the details together (on this and the recommendations to follow). Second, rating agencies should convey a rating's uncertainty in an understandable way. The ratings of ABS CDOs were highly uncertain because the models were so crude. This is what I call the Barry Bonds solution--put an asterisk on the rating if you have doubts about the quality. [Laughter] Third, we recommend more transparency from rating agencies for structured-finance ratings. What we need is not just a tweak to the existing transparency, but a whole new paradigm that actually helps investors get the information they want and need. For example, why can't the rating agency pass on to investors, along with its rating, all the information it got from the issuer that it used to assign the rating? Fourth, we recommend that rating agencies be conservative when they rate new or evolving asset classes. Fifth, the rating agencies should enhance their rating frameworks for structured products. For example, when they rate RMBS, they should consider the originator as well as the servicer as an important risk factor. Our last recommendation is addressed to regulators, including the Federal Reserve. When we reference a rating, we should differentiate better between corporate and structured-finance ratings. Sometimes we do that already, but we could provide some leadership to the market by doing more. Now Bev will discuss the work on investor practices. " CHRG-111shrg50564--19 Mr. Volcker," Quite deliberately. But there is--obviously, this administrative question you raise is relevant. We were dealing with what we think of as safety and soundness of the system. We were not dealing with protection of consumers, protection of investors, business practices--which are related but a different function. And one of the questions--which we did not deal with, but I think the Congress has to deal with it and the administration has to deal with it--do you adopt a separate agency and a separate administrative structure for what I will call ``business practices,'' including consumer protection, separate from the prudential regulator--which is a development which is true in some countries now, and it is along the lines that Secretary Paulson proposed in his thinking about the long run. I think that is a serious issue. I do not want to express an opinion now, but I have certain sympathy for exploring it, at least, personally. " FinancialCrisisReport--633 The Dodd-Frank Act contains two conflict of interest prohibitions to restore the ethical bar against investment banks and other financial institutions profiting at the expense of their clients. The first is a broad prohibition that applies in any circumstances in which a firm trades for its own account, as explained above. 2845 The second, in Section 621, imposes a specific, explicit prohibition on any firm that underwrites, sponsors, or acts as a placement agent for an asset backed security, including a synthetic asset backed security, from engaging in a transaction “that would involve or result in any material conflict of interest” with an investor in that security. 2846 Together, these two prohibitions, if well implemented, will protect market participants from the self-dealing that contributed to the financial crisis. Study of Banking Activities. Section 620 of the Dodd-Frank Act directs banking regulators to review what types of banking activities are currently allowed under federal and state law, submit a report to Congress and the Financial Stability Oversight Council on those activities, and offer recommendations to restrict activities that are inappropriate or may have a negative effect on the safety and soundness of a banking entity or the U.S. financial system. This study could evaluate, for example, the use of complex structured finance products that are difficult to understand, have little or no track record on performance, and encourage investors to bet on the failure rather than the success of financial instruments. Structured Finance Guidance. In connection with provisions in the Dodd-Frank Act related to approval of new products and standards of business conduct, 2847 the banking agencies, SEC, and CFTC may update and strengthen existing guidance on new structured finance products. In 2004, after the collapse of the Enron Corporation, the banking regulators and SEC proposed joint guidance to prevent abusive structured finance transactions. 2848 This guidance, which was not finalized until January 2007, was issued in a much weaker form. 2849 The final guidance eliminated, for example, warnings against structured finance products that facilitate deceptive accounting, circumvention of regulatory or financial reporting requirements, or tax evasion, as well as detailed guidance on the roles that should be played by a financial institution's board of directors, senior management, and legal counsel in approving new products and on the documentation they should assemble. (2) Recommendations To prevent investment bank abuses and protect the U.S. financial system from future financial crises, this Report makes the following recommendations. 2845 Section 621 of the Dodd-Frank Act (creating a new § 27B(a) in the Securities Act of 1933). 2846 Id. at § 621. 2847 Section 717 and Title IX of the Dodd-Frank Act. 2848 “Interagency Statement on Sound Practices Concerning Complex Structured Finance Activities,” 69 Fed. Reg. 97 (5/19/2004). 2849 “Interagency Statement on Sound Practices Concerning Elevated Risk Complex Structured Finance Activities,” 72 Fed. Reg. 7 (1/11/2007) (issued by the Office of the Comptroller of the Currency; Office of Thrift Supervision; Federal Reserve System; Federal Deposit Insurance Corporation; and Securities and Exchange Commission). 1. Review Structured Finance Transactions. Federal regulators should review the RMBS, CDO, CDS, and ABX activities described in this Report to identify any violations of law and to examine ways to strengthen existing regulatory prohibitions against abusive practices involving structured finance products. 2. Narrow Proprietary Trading Exceptions. To ensure a meaningful ban on proprietary trading under Section 619, any exceptions to that ban, such as for market- making or risk-mitigating hedging activities, should be strictly limited in the implementing regulations to activities that serve clients or reduce risk. 3. Design Strong Conflict of Interest Prohibitions. Regulators implementing the conflict of interest prohibitions in Sections 619 and 621 should consider the types of conflicts of interest in the Goldman Sachs case study, as identified in Chapter VI(C)(6) of this Report. 4. Study Bank Use of Structured Finance. Regulators conducting the banking activities study under Section 620 should consider the role of federally insured banks in designing, marketing, and investing in structured finance products with risks that cannot be reliably measured and naked credit default swaps or synthetic financial instruments. # # # fcic_final_report_full--187 The OTS approved Countrywide’s application for a thrift charter on March , . LEVERAGED LOANS AND COMMERCIAL REAL ESTATE: “YOU ’VE GOT TO GET UP AND DANCE ” The credit bubble was not confined to the residential mortgage market. The markets for commercial real estate and leveraged loans (typically loans to below-investment- grade companies to aid their business or to finance buyouts) also experienced similar bubble-and-bust dynamics, although the effects were not as large and damaging as in residential real estate. From  to , these other two markets grew tremen- dously, spurred by structured finance products—commercial mortgage–backed se- curities and collateralized loan obligations (CLOs), respectively—which were in many ways similar to residential mortgage-backed securities and CDOs. And just as in the residential mortgage market, underwriting standards loosened, even as the cost of borrowing decreased,  and trading in these securities was bolstered by the development of new credit derivatives products.  Historically, leveraged loans had been made by commercial banks; but a market for institutional investors developed and grew in the mid- to late s.  An “agent” bank would originate a package of loans to only one company and then sell or syndi- cate the loans in the package to other banks and large nonbank investors. The pack- age generally included loans with different maturities. Some were short-term lines of credit, which would be syndicated to banks; the rest were longer-term loans syndi- cated to nonbank, institutional investors. Leveraged loan issuance more than dou- bled from  to , but the rapid growth was in the longer-term institutional loans rather than in short-term lending. By , the longer-term leveraged loans rose to  billion, up from  billion in .  Starting in , the longer-term leveraged loans were packaged in CLOs, which were rated according to methodologies similar to those the rating agencies used for CDOs. Like CDOs, CLOs had tranches, underwriters, and collateral managers. The market was less than  billion annually from  to , but then it started grow- ing dramatically. Annual issuance exceeded  billion in  and peaked above  billion in . From  through the third quarter of , more than  of leveraged loans were packaged into CLOs.  As the market for leveraged loans grew, credit became looser and leverage in- creased as well. The deals became larger and costs of borrowing declined. Loans that in  had paid interest of  percentage points over an interbank lending rate were refinanced in early  into loans paying just  percentage points over that same rate. During the peak of the recent leveraged buyout boom, leveraged loans were fre- quently issued with interest-only, “payment-in-kind,” and “covenant-lite” terms.  Payment-in-kind loans allowed borrowers to defer paying interest by issuing new debt to cover accrued interest. Covenant-lite loans exempted borrowers from stan- dard loan covenants that usually require corporate firms to limit their other debts and to maintain minimum levels of cash. Private equity firms, those that specialized in investing directly in companies, found it easier and cheaper to finance their lever- aged buyouts. Just as home prices rose, so too did the prices of the target companies. One of the largest deals ever made involving leveraged loans was announced on April , , by KKR, a private equity firm. KKR said it intended to purchase First Data Corporation, a processor of electronic data including credit and debit card pay- ments, for about  billion. As part of this transaction, KKR would issue  billion in junk bonds and take out another  billion in leveraged loans from a consortium of banks including Citigroup, Deutsche Bank, Goldman Sachs, HSBC Securities, Lehman Brothers, and Merrill Lynch.  CHRG-111hhrg53245--253 Mr. Zandi," Right. And I think that in my own personal view is worth an experiment. I do not know if that works better or not, but I think it probably is an idea that is worth some experimentation. There are a number of things though that I think should be done. I think the reliance on ratings in regulatory requirements is inappropriate. Right now, if you are a money market fund, it can say I can only invest in securities with a rating of above a certain amount, I think that is inappropriate. Regulators are outsourcing their function to the rating agencies, and they should not do that. I think the SEC, as the regulator of the rating agencies, should be more active in monitoring and evaluating what the rating agencies are doing, much like banking regulators do with credit risk officers of major commercial banks. They look at the model. They say does this make sense and should it be doing this? I think it should be required that the data that the rating agencies use in the ratings should be vetted in some way. One of the biggest problems, in my view, was that the rating agencies would say, ``You give me the data, I do not re-underwrite the loan, I take it as given and then I rate.'' And they say that to everybody, the investment bank and the investor, ``That is not what we do, and that is the way it has been since we started our business 100 years ago,'' but that makes no sense to me. There should be a third party firm that vets the data, samples the data, and makes sure it is okay. So, I think all these things could be--should be implemented and tried. But let me say one thing, and this is no win for me, right, because you are not going to believe me anyway? " FinancialCrisisReport--219 OTS officials argued variously that the new proposal would wrongly put the focus on “products” instead of “underwriting,” as well as that it would hurt the business of large thrifts like WaMu. 830 The NTM Guidance was finally issued on October 4, 2006. 831 The final version did not fully reflect the recommendations of OTS on negatively amortizing loans. Among other matters, it called on banks to: • evaluate a borrower’s ability to fully repay a prospective loan, including any balance increase from negative amortization; • qualify borrowers using the higher interest rate that would apply after any teaser or introductory interest rate; • avoid loans whose repayment was dependent solely upon the value of the collateral or the borrower’s ability to refinance the loan; and • implement strong quality control and risk mitigation procedures for loans containing layers of risk, including loans with no documentation requirements, no verification of the borrower’s income or assets, or high loan-to-value ratios. The Guidance also called for capital levels commensurate with risk and adequate allowances for loan losses. The Guidance was not promulgated as a bank regulation that could be enforced in court, and it contained no explicit deadline for compliance. Instead, it provided policies and procedures that regulators could use as benchmarks during examinations. Agencies could penalize noncompliance with the standards through lower CAMELS ratings or enforcement actions. FDIC officials told the Subcommittee that the FDIC expected banks to come into immediate 829 8/14/2006 email from Kurt Kirch to David Henry and Steven Gregovich, “Latest AMP Guidance,” Hearing Exhibit 4/16-72. 830 7/27/2006 email from Steven Gregovich to Grovetta Gardineer, et al., “NTM Open Issues,” OSWMS06-008 0001491-495, Hearing Exhibit 4/16-71. 831 10/4/2006 “Interagency Guidance on Nontraditional Mortgage Product Risks,” (NTM Guidance), 71 Fed. Reg. 192 at 58609. compliance with the Guidance, and that no agency should have been telling a bank that it did not have to comply with the new standards. 832 CHRG-111hhrg53021--244 Secretary Geithner," That is something I have to think about and get back to you on. I don't think I can do justice to the details of what market practice is in that area today. But I will be happy to try to get back to you on that particular question. Several of your colleagues have raised it. " CHRG-111hhrg53021Oth--244 Secretary Geithner," That is something I have to think about and get back to you on. I don't think I can do justice to the details of what market practice is in that area today. But I will be happy to try to get back to you on that particular question. Several of your colleagues have raised it. " CHRG-111hhrg56847--71 Mr. Bernanke," I think you want clarity on both those issues as soon as you practically can. Clearly one of the concerns that many businesses have is policy uncertainty about what is happening in Washington. And to the extent that we can provide clarity, that is certainly a good thing. " CHRG-111hhrg50289--30 Mr. Graves," And my next question is for the lenders out there, and we can start with Mr. McGannon, and it is the same question as far as your lending practices go in light of the economy. Have you all backed off? Have you increased? I mean, are you requiring more from investors? " CHRG-111hhrg48867--26 Mr. Bartlett," Thank you, Mr. Chairman. Beginning about 3 years ago, the Roundtable began to examine the questions of our current regulatory system, many of which are raised today. This dialogue over that time has, over those 3 years, has evolved into a focus on how the current system also undermines the stability and the integrity of the financial services industry. I provided in my written testimony a format that provides at least our answer to many of the questions that were raised today and previously questions and comments. I want to summarize our conclusions as follows: One, the financial services industry is regulated by hundreds of separate independent regulators at various levels. It is a system of fragmentation, inconsistency, and chaos. It is a fragmented system of national and State financial regulation that is based on functional regulation within individual companies, and those companies are also regulated according to their charter type. There is limited coordination and cooperation among different regulators even though firms with different charters often engage in the same, similar, or sometimes exact activities. No Federal agency is responsible for examining and understanding the risk created by the interconnections between firms and between markets. This chaotic system, our conclusion, of financial regulation was a contributing factor to the current crisis. Number two, that is not to say that the fragmented regulation is the only cause. The financial services industry accepts our share of responsibility: badly underwritten mortgages; compensation packages that pay for short-term revenue growth instead of long-term financial soundness; failure to communicate across sectors, even within the same company; and sometimes even downright predatory practices. All of those and more have been part of this crisis. Since early 2007, the industry has formally and aggressively taken actions to correct those practices. Underwriting standards have been upgraded, credit practices have been reviewed and recalibrated, leverage has been reduced, and firms have rebuilt capital, incentives have been realigned, and some management teams have been replaced. We are not seeking credit for that. Clearly the horses are all out of the barn running around in the field. But those are the steps that have been taken in the last 2 years. But the regulatory system that was in place 2 years and 5 years ago is still in place. An absence of coherent comprehensive systemic regulatory structure did fail to identify and prevent the crisis, and we still have the same regulatory system today. Number three, reforming and restructuring the regulatory system in 2009 should be Congress' primary mission moving forward to resolve the crisis and prevent another crisis. Achieving better and more effective regulation does require more than just rearranging regulatory assignments. Better and more effective regulation requires a greater reliance on principle-based regulation, a greater reliance on a system of prudential supervision, a reduction in the pro-cyclical effects of regulatory and accounting principles, and a consistent uniform standard of which similar activities and similar institutions are regulated in similar ways. Number four, we are proposing a comprehensive reform of the regulatory structure that includes clear lines of authority and uniform standards across both State lines and types of business. Within our proposal, we recommend: the consolidation of several existing Federal agencies into single agencies, a single national financial institutions regulator that would be consolidated prudential and consumer protection agency for banking, securities, and insurance; a new capital markets agency through the merger of the SEC and the CFTC to protect depositors and shareholders and investors; and to resolve failing or failed institutions, we propose a creation of the national insurance and resolution authority to resolve institutions that fail in a consistent manner from place to place. Number five, we also advocate a systemic regulator, what we prefer to call a market stability regulator. The market stability regulator would be, as I said in subcommittee testimony, ``NIFO--nose in and fingers out.'' That means a market stability regulator should not replace or add to the primary regulators, but should identify risks and act through and with a firm's primary regulator. We believe that designating the Federal Reserve is the natural complement to the Federal Reserve Board's existing authority as the Nation's central bank and the lender of last resort. The market stability regulator should be authorized to oversee all types of financial markets and financial services firms, whether regulated or unregulated, and we propose an exact definition of at least our proposal of that system of regulation of systemic regulator. And number six, the U.S. regulatory system should be the U.S. system of course, but it should be coordinated and consistent with international standards. Mr. Chairman, the time to act is now. We believe that these reforms should proceed in a comprehensive fashion rather than a piecemeal fashion. The key is to do this correctly, not rapidly, but to do this with the sense of urgency for which the crisis calls. Thank you, Mr. Chairman. [The prepared statement of Mr. Bartlett can be found on page 64 of the appendix.] " CHRG-111hhrg56778--30 Chairman Kanjorski," So if they were awarding assassination contracts there, and you ran across that, since it was outside your realm of activity, they would have been allowed to go on to continue awarding those assassination contracts? Ms. Gardineer. I also think it's important to recognize, Congressman, that the activity of creating these credit default swaps that were in the financial products, they had stopped the origination prior to our becoming their holding company supervisor. Our examiners went in to look at the pipeline of what was left in financial products and then made the senior managers of the company aware of the weaknesses that we found. " CHRG-109hhrg31539--48 Mrs. Maloney," Thank you. Chairman Bernanke, I have been very concerned about the growing gap between the haves and the have-nots in the American people. The Federal Reserve has recently published some pretty disturbing evidence in this regard in the Survey of Consumer Finances. That survey is similar to others in showing weak growth in median income, but it has unique data on wealth. I have seen figures that the top 1 percent of families hold more wealth than the bottom 90 percent of families combined. Is that true? " CHRG-111hhrg56776--140 Mr. Bernanke," Well, the Federal Reserve, or whoever is in charge of consumer protection, needs to make sure that the products are safe for people to use. And we have done--you are right to criticize the Federal Reserve for being late in doing the mortgage regulation. You are correct about that. We did do some things, but we didn't do enough. But once we did it--and under my chairmanship, we have worked hard in these areas--we banned a lot of bad practices. You can't offer a mortgage that has those practices any more, like a pre-payment penalty for a short ARM, for example. I don't know about this particular case you're talking about, we would have to look at it, but we are looking at features of mortgages and other financial instruments. And some of them we just ban, because we don't think they serve any purpose, and they're not--the public can't understand what they're about. Ms. Waters. Thank you, Mr. Chairman. " CHRG-110hhrg44900--156 Mr. Miller," Thank you. I have served on this committee for almost 6 years, and I remember the testimony pretty well on mortgage lending, but I have recently gone back and reviewed some of it to see what the lending industry was saying at the time about the kind of mortgage practices that have led to the problem. And what they have always said was that the provisions of the mortgages that may seem to be a problem, they seem unfavorable to consumers, actually were risk based, they were responding to a greater risk by certain borrowers, and that without those provisions they would not be able to lend to those borrowers, and those borrowers would be denied credit, would be unable to buy a home, and be unable to borrow against their homes to provide for life's rainy days. Looking back on the practices that actually led to the problem, the subprime mortgages made in 2005 and 2006, it is pretty clear that those provisions had nothing to do with risk and nothing to do with benefiting consumers or making credit available to them that would otherwise not have been available. It was a fundamental change in consumer lending from making an honest living off the spread to trying to trap consumers, homeowners into a cycle of having to borrow repeatedly and paying penalties and fees when they did, and that the loans were intended to become unpayable for the borrowers, so the borrower would have to borrow again. Insurance regulation at the State level generally requires that policy forms provisions and policies and premiums be approved in advance by the State regulator, and that the insurer has to justify those provisions. So the kinds of arguments that we heard in this committee that we were not really in a position to judge on a provision by provision basis, a reasonably competent regulator could judge and determine whether that really was related to the risk, whether it really was to the advantage of the consumer, and whether it also presented a solvency issue for an insurer. Secretary Paulson, the proposed regulator to protect consumers, will that regulator have the authority, should it have the authority, to review consumer lending products in advance to see if the practices can be justified both for what it might do to the solvency of the institution and also what it does to the consumer? " CHRG-111shrg56262--90 PREPARED STATEMENT OF PATRICIA A. McCOY George J. and Helen M. England Professor of Law, and Director, Insurance Law Center, University of Connecticut School of Law October 7, 2009 During the housing bubble, private-label securitization financed the majority of subprime and nontraditional mortgages. \1\ This system proceeded on the assumption that housing prices would keep going up. When housing prices fell and people could not refinance out of unaffordable loans, investors lost confidence in private-label mortgage securitization and the system collapsed in August 2007.--------------------------------------------------------------------------- \1\ I use the term ``nonprime'' to refer to subprime loans plus other nontraditional mortgages. Subprime mortgages carry higher interest rates and fees and are designed for borrowers with impaired credit. Nontraditional mortgages encompass a variety of risky mortgage products, including option payment ARMs, interest-only mortgages, and reduced documentation loans. Originally, these nontraditional products were offered primarily in the ``Alt-A'' market to people with near-prime credit scores but intermittent or undocumented income sources. Eventually, interest-only ARMs and reduced documentation loans penetrated the subprime market as well.--------------------------------------------------------------------------- This statement begins with a thumbnail sketch of securitization. Then I describe the role played by securitization in the financial crisis. Following that, I analyze the inherent flaws in private-label mortgage securitization. The statement goes on to describe current conditions in that market. I close by describing needed reforms.I. An Introduction to Securitization Back in the 1970s, banks had to hold home mortgages in portfolio until those loans were paid off. This destabilized banks that made mortgages because they got their financing from demand deposits, but invested those deposits in illiquid mortgages. This ``term mismatch'' between assets and liabilities was a direct cause of the 1980s savings and loan crisis. Starting in the late 1970s, securitization burst on the scene and eliminated the need for lenders to hold their mortgages in portfolio. The idea behind securitization is ingenious: bundle a lender's loans, sell them to a bankruptcy-remote trust, repackage the monthly loan payments into bonds rated by rating agencies, back the bonds with the underlying mortgages as collateral, and sell those bonds to investors.[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] Investment banks ``structured'' these securitization deals by dividing the bonds into ``tranches'' (French for ``slice''). The best tranche, with the lowest expected default rate, carried an AAA rating, was paid off first, and offered the lowest rate of return. The lower tranches were rated AA, A, etc., on down to the junior-most tranche, known as the equity tranche. The equity tranche was paid off last and was the first to absorb any losses from the loans. Securitization was prized for accomplishing four things. First, lenders were able to get their mortgages off their books. Second, securitization appeared to manage the risks of mortgages by slicing and dicing those risks and spreading them among millions of investors with assorted tolerances for risk. Third, securitization opened up huge new pools of capital to finance home mortgages. Finally, securitization freed lenders from relying principally on insured deposits in order to make loans. Instead, in a continuous cycle, lenders could make loans, sell those loans through securitization, and then plow the proceeds into a new batch of loans, which in turn would be securitized. This paved the way for a new breed of nonbank subprime lenders, who had little in the way of capital reserves, were free from Federal banking regulation, and were inured to the reputational constraints of banks and thrifts. At first, securitization was limited to prime loans, which were mostly securitized through the two Government-sponsored entities (GSEs) Fannie Mae and Freddie Mac. Once the market gained confidence about its ability to price subprime mortgages, securitization expanded to the subprime market in the early 1990s. Although the GSEs made limited forays into the subprime market and later expanded those forays around 2005, most subprime securitizations did not take place through the GSEs, but rather through the ``private-label'' securitization market. The private-label market lacked the same degree of public accountability that was expected of Fannie Mae and Freddie Mac as GSEs. By 2006, two-thirds or more of subprime mortgages were being securitized through the private-label market.II. The Role of Securitization in the Financial CrisisA. How Private-Label Securitization Increased the Risk of Mortgage Lending Before securitization, lenders usually did it all: they solicited loan applicants, underwrote and funded the loans, serviced the loans, and held the loans in portfolio. Lenders earned profits on loans from interest payments as well as from upfront fees. If the loans went into default, the lenders bore the losses. Default was such a serious financial event that lenders took care when underwriting loans. All that changed with private-label securitization. Securitization allowed lenders to offload most of the default risk associated with nonprime loans. Under the ``originate-to-distribute'' model, lenders could make loans intending to sell them to investors, knowing that investors would bear the financial brunt if the loans went belly-up. Similarly, securitization altered the compensation structure of nonprime lenders. Lenders made their money on upfront fees collected from borrowers and the cash proceeds from securitization offerings, not on the interest payments on loans. Lenders liked the security of being paid in advance, instead of having to wait for uncertain monthly payments over the life of loans. And, because they could pass the lion's share of the default risk onto faceless investors, lenders had less reason to care about how well their loans performed. In my examinations of internal records of major nonprime lenders, including Federal thrift institutions and national banks, too often I found two sets of underwriting standards: high standards for the loans they kept on their books and lax standards for the loans that they securitized. At their peak, investment grade, \2\ nonprime residential mortgage-backed securities (RMBS) were considered excellent investments because they supposedly posed minimal default risk while offering high returns. Investors clamored for these bonds, creating demand for ever-riskier loans.--------------------------------------------------------------------------- \2\ The top four ratings issued by a rating agency are ``investment grade'' ratings. For Standard & Poor's, these are ratings of AAA, AA, A, and BBB; for Moody's, Aaa, Aa, A, and Baa. Any rating below investment grade is considered junk bond status.--------------------------------------------------------------------------- Lenders were not the only players in the chain between borrowers and investors. Investment banks played significant roles as underwriters of nonprime securitizations. Lehman Brothers, Bear Stearns, Merrill Lynch, JPMorgan, Morgan Stanley, Citigroup, and Goldman Sachs underwrote numerous private-label nonprime securitizations. From 2000 through 2002, when IPO offerings dried up during the 3-year bear market, RMBS and CDO deals stepped into the breach and became one of the hottest profit centers for investment banks. Investment banks profited from nonprime underwriting by collecting a percentage of the sales proceeds, either in the form of discounts, concessions, or commissions. Once an offering was fully distributed, the underwriter collected its fee in full. This compensation system for the underwriters of subprime offerings caused Donna Tanoue, the former Chairman of the Federal Deposit Insurance Corporation, to warn: ``[T]he underwriter's motivation appears to be to receive the highest price . . . on behalf of the issuer--not to help curb predatory loans.'' Tanoue's warning proved prophetic. In February 2008, Fitch Ratings projected that fully 48 percent of the subprime loans securitized by Wall Street in 2006 would go into default. Despite that dismal performance, 2006 produced record net earnings for Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers, and Bear Stearns. That year, manager pay reflected the bottom-line importance that investment banks placed on private-label RMBS, with managing directors in the mortgage divisions of investment banks earning more on average in 2006 than their counterparts in other divisions.B. How Securitization Fueled Contagion Ultimately, private-label mortgage securitization turned out to be an edifice built on a rotting foundation. Once that foundation gave way, rising nonprime delinquencies mushroomed into international contagion for a number of reasons. For example, the same loan often served as collateral for multiple bonds, including an RMBS, a CDO, and a CDO of CDOs. If the loan went into default, it would jeopardize repayment for all three bonds. In addition, if defaults led to downgrades on those bonds, those assets were highly correlated. If rating agencies downgraded one issue, other issues came into question as well. Collateral is another reason why nonprime loans infected other markets. Many large institutional investors bought nonprime bonds that they later pledged as security for other types of loans. Banks, for instance, pledged their nonprime bonds as security for short-term loans from other banks on the market for interbank credit. Major corporations borrowed money from other corporations on the short-term commercial paper market by issuing paper backed by nonprime bonds. As the value of nonprime bonds fell, lenders began calling loans and ultimately the interbank lending and asset-backed commercial paper markets slowed to a crawl. Banks also reinfected themselves with subprime risks by buying private-label RMBS and CDOs and effectively taking those risks back on their books. When they sustained major losses on those bonds, they reined in their lending, adding fuel to the recession. General investor panic is the final reason for contagion. Even in transactions involving no nonprime collateral, concerns about the nonprime crisis had a ripple effect, making it hard for companies and cities across-the-board to secure financing. Banks did not want to lend to other banks out of fear that undisclosed nonprime losses might be lurking on their books. Investors did not want to buy other types of securitized bonds, such as those backed by student loans or car loans, because they lost faith in ratings and could not assess the quality of the underlying collateral. Stocks in commercial banks, insurance companies, and Wall Street firms took a beating because investors did not know where nonprime assets were hidden and feared more nonprime write-downs. Because they did not know exactly who was tainted by nonprime, investors stopped trusting practically everyone.III. Inherent Flaws in Private-Label Mortgage SecuritizationA. The Lemons Problem In hindsight, private-label mortgage securitization turned out to resemble the used car business in one respect. Both businesses have motivations to sell ``lemons.'' In other words, they have structural incentives to sell products carrying hidden defects and a heightened risk of failure. There are two main reasons for this lemons problem. First, securitization resulted in a misalignment of compensation and risk. Each company in the securitization process was able to collect upfront fees, while shifting default risk to downstream purchasers. Although investors tried to protect themselves through recourse clauses and structures making lenders retain the equity tranches, those contractual safeguards often broke down. Lenders were able to hedge their equity tranches or shed them by resecuritizing them as CDOs. Similarly, too many originators lacked the capital to honor their recourse obligations in full. Second, securitization fueled a relentless demand for volume and volume-based commissions. In the process, the quest for volume pushed lending standards steadily downward in order to maintain market share. This became a challenge in 2003, when interest rates began rising again, ending the refinancing boom. Securitizers needed another source of mortgages in order to increase the rate of securitization and the fees it generated. The ``solution'' was to expand the market through nontraditional mortgages, especially interest-only loans and option payment ARMs offering negative amortization. Lenders also relaxed their underwriting standards on traditional products to qualify more borrowers. This expansion of credit swept a larger portion of the population into the potential homeowner pool, driving up housing demand and prices, and consumer indebtedness. Many big investment banks, including Lehman Brothers and Bear Stearns, went so far as to buy subprime lenders in order to have an assured pipeline of mortgages to securitize. In short, the incentive structure of securitization caused the lemons problem to grow worse over time. Not only did private-label securitization sell lemons, those lemons grew more rotten as the housing bubble grew. In the process, securitization actors played the ends against the middle, injuring borrowers and investors alike.B. Harm to Borrowers Private-label securitization hurt numerous borrowers. First, investor appetite for high-yield RMBS caused originators to peddle risky mortgages, to the exclusion of safer loans. Second, compensation methods such as yield spread premiums saddled many borrowers with costlier mortgages than they qualified for. Third, borrowers whose loans were securitized lost important legal rights without their consent. On the first point: As mentioned above, in order to maintain volume while satisfying investor demand for high-yield bonds, investment banks and lenders had to continually tap new groups of borrowers with lower credit scores and less disposable income. For many of these cash-strapped borrowers, low monthly payments were a primary consideration. In order to offer the lure of lower initial payments, lenders concocted bafflingly complex loans combining a host of risky features, including adjustable-rate terms, teaser rates, high margins, stiff prepayment penalties, and no amortization or even negative amortization. Evidence is now coming to light that investment banks or large investors in many cases dictated those underwriting guidelines to originators. The front-end payments of these hazardous mortgages were attractive to unsuspecting borrowers and usually lower than the payments on a plain vanilla fixed-rate mortgage. But the back-end risks of those mortgages were daunting, yet difficult or impossible for borrowers to discern. Worse yet, to qualify individual borrowers, lenders often threw full income verification out the window. There was a second way in which investor demand for higher yield hurt many borrowers. Because investors paid more for higher yields, lenders offered mortgage brokers higher compensation in the form of yield spread premiums to convince borrowers who probably qualified for cheaper loans to unwittingly pay higher interest rates. The Wall Street Journal estimated that by year-end 2006, 61 percent of subprime mortgages went to borrowers with high enough credit scores to qualify for cheaper prime loans. \3\ Yield spread premiums artificially inflated the interest rates that borrowers had to pay, substantially increasing the likelihood that nonprime loans would default and go into foreclosure. Economists have estimated the size of this risk. For every 1 percent increase in the initial interest rate of a home mortgage, the chance that a household will lose its home rises by 16 percent a year.--------------------------------------------------------------------------- \3\ Rick Brooks and Ruth Simon, ``Subprime Debacle Traps Even Very Creditworthy'', Wall St. J., Dec. 3, 2007, at A1.--------------------------------------------------------------------------- Finally, under the Uniform Commercial Code in many States, borrowers whose loans are securitized lose valuable legal rights without their consent or financial compensation. This doctrine, known as the ``holder-in-due-course rule,'' prohibits borrowers whose loans are securitized from raising common types of fraud or other misconduct in the making of their loans against all subsequent purchasers of their loan notes. In many case, this shields investment banks, rating agencies, and investors from borrower suits for fraud. Although borrowers can still raise fraud as a claim or defense against their mortgage brokers and lenders, many of those entities are bankrupt today and thus judgment-proof. More importantly, once a loan is securitized, any suit for foreclosure will be brought by the investor or securitized trust, not the mortgage broker or lender. In those cases, the holder-in-due course rule prevents borrowers who were defrauded from even raising the fraud as a defense to foreclosure.C. Harm to Investors The lack of transparency in securitization also hurt investors. The securities disclosures for private-label RMBS lacked crucial information to investors. In addition, product complexity made it difficult or impossible for investors to grasp the risks associated with many offerings. Finally, both problems caused investors to place undue reliance on credit ratings, which proved to be badly inflated. 1. Inadequate Securities Disclosures--For most of the housing bubble, the Securities and Exchange Commission (SEC) had no rule requiring disclosures specifically tailored to RMBS or CDOs. The SEC adopted Regulation AB in an attempt to redress that gap, but the rule did not go into effect until January 1, 2006, too late to cover earlier private-label offerings. Once the rule went into effect, it was riddled with holes. First, Reg AB only applies to public offerings of asset-backed securities. An investment bank could simply bypass Reg AB by structuring the offering as a private offering limited to big institutional investors. In private offerings, SEC disclosures are lighter or left to private negotiation, based on the idea that institutional investors have clout to demand the information they need. Wall Street took full advantage of this loophole, meaning that CDOs were almost always sold through private offerings with seriously deficient disclosures. Even when Reg AB did apply--i.e., in public offerings of asset-backed securities--the disclosures were too skimpy to be of use. The SEC modeled many of Reg AB's disclosures on the reporting requirements for corporate issuers. Corporations usually have track records to speak of, so securities disclosures for those issuers focus on recent past performance. But past performance was irrelevant for most offerings of RMBS and CDOs, which involved relatively new mortgages. In essence, Reg AB puts the wrong information under the microscope. Instead, investors in nonprime bonds needed standardized information on the risk characteristics of the individual loans in the loan pool. But Reg AB does not require that level of detail. While the rule encouraged investment banks to make tapes with loan level data available to investors online, it did not force them to do so. Instead, Reg AB simply mandates a summary of the aggregate characteristics of the loan pool. That made it difficult to discern whether the riskiest loans were going to the strongest borrowers or to the worst borrowers in the loan pool. Similarly, too many prospectuses and offering memoranda for private-label offerings stated that the lenders reserved the right to make exceptions to their underwriting standards in individual cases. In 2006 and 2007, there were offerings in which the exceptions--in other words, loans that flunked the lender's underwriting standards--outweighed the number of loans that conformed to the lender's stated standards. The exact (and often high) percentage of exceptions was not disclosed to investors. Nor does Reg AB make investment banks disclose the due diligence reports they commissioned from outside firms, even when those reports contained evidence of deteriorating lending standards. Too often, investment banks withheld those reports from investors and ratings agencies. Reg AB is also deficient regarding the performance of individual loans. While Reg AB requires some reporting on loan performance, it is only for the first year following the offering, not for the life of the loans. All told, there was a dearth of useful publicly available information on the loan pools underlying private-label RMBS and CDOs. The SEC disclosure scheme for nonprime RMBS and CDOs was so misbegotten and riddled with exceptions that those securities operated in a fact-free zone. Investors and analysts who wanted to do serious due diligence could not get the facts they needed to figure out the true risk presented by the loans. Without those facts, investors often overpaid for those securities. Furthermore, the dearth of key public information also impeded the development of a healthy resale market in those bonds, which became a big problem later on when banks tried to unload toxic subprime assets off their books. 2. Complex Products--Many private-label RMBS and CDOs were so complex that due diligence was too costly or impossible for investors. CDOs are a good example. Typically, a CDO consisted of junior tranches of RMBS from different offerings, sometimes paired with other types of asset-backed securities involving receivables from things like credit cards or auto loans. At best, the investor received data on the quality of the underlying bonds. But it was impossible for the investor to x-ray the offering in order to analyze the underlying home mortgages, credit card borrowers, or auto loans themselves. That was even more impossible when the CDO was a ``synthetic CDO'' made up of credit default swaps on RMBS and asset-backed securities. Even in regular RMBS, complexity was a big problem. One issue was the sheer number of tranches. Another was the fact that many private-label RMBS offerings featured complex credit enhancement rules about who would receive cash flows from the mortgages in what amounts, depending on changes in the amount of subordination or overcollateralization. This meant that investors could not just stop with estimating expected losses from the mortgages. They also had to analyze who would get what cash flows when, based on a changing kaleidoscope of scenarios. \4\ In addition, too many offerings were made on a ``to be announced'' or ``TBA'' basis, which meant that investors could not scrutinize the underlying loans because the loans had not yet been put in the loan pool. Finally, many securitization deals involved custom features that undermined standardization.--------------------------------------------------------------------------- \4\ Ingo Fender and Janet Mitchell, ``The Future of Securitization: How To Align Incentives?'', Bis. Quarterly Review 27, 30, 32 (Sept. 2009).--------------------------------------------------------------------------- Of course, this discussion begs the question whether investors would have done adequate investigation in any case when the housing bubble was at its height and euphoria prevailed. But back then, even investors who wanted to do serious due diligence would have met insuperable obstacles. More recently, lack of transparency and complexity have blocked the formation of an active, liquid resale market that would enable banks to remove impaired RMBS and CDOs from their books. 3. Overreliance on Credit Ratings--Poor disclosures and overly complex deals caused investors to over rely on credit ratings. Meanwhile, the rating agencies had financial incentives to understate the risks of nonprime RMBS and CDOs. The investment banks that underwrote nonprime securitizations paid the rating agencies to provide them with investment-grade ratings. The rating agencies touted the top-rated nonprime bonds--ranging from AAA down to A--as hardly ever defaulting. Under banking and insurance laws, banks and insurance companies can only invest in types of bonds permitted by law. Private-label RMBS and CDOs carrying investment grade ratings are on the permissible list, so long as those ratings are rendered by rating agencies designated Nationally Recognized Statistical Rating Organizations (NRSROs) by the SEC. These regulatory rules encouraged institutional investors in search of higher yields to buy the top-rated nonprime RMBS and CDOs. During the housing bubble, rating fees on private-label RMBS and CDOs were the fastest-growing sector of the rating agency business. Issuers paid the rating agencies handsome fees from these deals, spurring the rating agencies to rate offerings for which there was scant historical default data. Similarly, the rating agencies used flawed models which assumed never-ending housing price appreciation and were not updated with new default data. Nor did most investors realize that an AAA rating for an RMBS offering was different than, and inferior to, an AAA rating for a corporate bond. \5\--------------------------------------------------------------------------- \5\ In large part, and in contrast with corporate bonds, this is because downgrades of a tranched RMBS tend to make downgrades of other RMBS tranches more likely. Fender and Mitchell, supra note 4, at 33.---------------------------------------------------------------------------D. Impediments to Loan Modifications Deal provisions in private-label securitizations have also paralyzed constructive workouts of many distressed home loans. Today, securitized trusts, not lenders, hold the vast majority of those loans. The complexity of the securitized deals often pits servicers against investors and investors against each other. Too often, the servicers opt for foreclosing on property, instead of arranging workouts that would allow homeowners to stay in their homes. The irony of this approach is that, in many cases, workouts in the form of loan forbearance or loan modifications would result in a higher recovery. There are several explanations for this seemingly irrational behavior, including inadequate staffing levels and compensation clauses that cause servicers to earn more money from foreclosures than workouts. But the main reason why more workouts do not occur is that many pooling and servicing agreements place constraints on servicers' ability to negotiate loan workouts. Some limit the percent of the loan pool that can be modified. Others have vague prohibitions allowing modifications only to the extent they are in the best interests of the investors. Even when those agreements give servicers latitude to modify loans, servicers are reluctant to modify loans because they fear lawsuits by warring trancheholders for breach of fiduciary duty. This hold-up problem has stymied Federal regulators' attempts to speed up loan modifications and halt the vicious cycle of falling home prices. With no Federal legislation to force modifications, regulators have only had limited success. Meanwhile, loan workouts are crawling at a snail's pace, leading foreclosed homes to be dumped on the market in record numbers and pushing home prices further down in the process.IV. Current Conditions in the Private-Label Securitization Markets Due to the problems just described, the markets for private-label RMBS and CDOs are essentially dead. The securitization markets for auto loans, credit cards, and student loans are open, but their volume has dropped sharply due to general concerns about the soundness of the securitization process. For all intents and purposes, the Federal Government has become the financier of first resort for residential mortgages. In 2008, agency mortgage-backed securities--in other words, RMBS issued by Fannie Mae, Freddie Mac, and Ginnie Mae (FHA loans)--accounted for over 96 percent of the U.S. RMBS market. Private-label mortgage-backed securitization accounted for less than 4 percent of the market that year.[GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] This disparity widened in the first 6 months of 2009, when the relative market shares of agency and private-label mortgage-backed securitization were 99 percent and 1 percent. \6\ In second quarter 2009, moreover, 38.4 percent of private-label RMBS transactions were re-REMICs of old loans that were repackaged into tranches of good and bad loans. According to the Securities Industry and Financial Markets Association (SIFMA), the ``private label market remains dormant due to reduced lending, lack of investor demand, low liquidity,'' and rising delinquencies and foreclosures. \7\--------------------------------------------------------------------------- \6\ I use the term ``agency'' to refer to GNMA, Fannie Mae and Freddie Mac mortgage-backed securities and collateralized mortgage obligations. The term ``private-label'' includes RMBS and CMOs. \7\ Securities Industry and Financial Markets Association, Research Report 2009 Q2 (August 2009), at 2, 9.--------------------------------------------------------------------------- As these numbers suggest, private investors are largely shunning the private-label mortgage securitization market in favor of other investments, including agency RMBS. In the meantime, the Federal Reserve has become a major investor in agency RMBS, having begun purchases in this market in December 2008. The Fed has pledged to buying up to $1.25 trillion in agency RMBS before the end of this year, in an effort to help lower home mortgage interest rates. Other securitization markets associated by investors with mortgages are also dormant. SIFMA reports that the private-label commercial MBS primary market ``remains closed.'' \8\ Similarly, global issuance of CDOs has essentially come to a halt.--------------------------------------------------------------------------- \8\ Id. at 9. [GRAPHIC(S) NOT AVAILABLE IN TIFF FORMAT] fcic_final_report_full--193 OFHEO, the GSEs’ regulator, noted their increasing purchases of riskier loans and securities in every examination report. But OFHEO never told the GSEs to stop. Rather, year after year, the regulator said that both companies had adequate capital, strong asset quality, prudent credit risk management, and qualified and active officers and directors. In May , at the same time as it paid a  million penalty related to deficien- cies in its accounting practices, Fannie agreed to limit its on-balance-sheet mortgage portfolio to  billion, the level on December , .  Two months later, Fred- die agreed to limit the growth of its portfolio to  per year.  In examination re- ports for the year , issued to both companies in May , OFHEO noted the growth in purchases of risky loans and non-GSE securities but concluded that each GSE had “strong” asset quality and was adequately capitalized. OFHEO reported that management at Freddie was committed to resolving weaknesses and its Board was “qualified and active.” The  examination of Fannie was limited in scope—focus- ing primarily on the company’s efforts to fix accounting and internal control defi- ciencies—because of the extensive resources needed to complete a three-year special examination initiated in the wake of Fannie’s accounting scandal.  In that special examination, OFHEO pinned many of the GSEs’ problems on their corporate cultures. Its May  special examination report on Fannie Mae detailed the “arrogant and unethical corporate culture where Fannie Mae employees manipulated accounting and earnings to trigger bonuses for senior executives from  to .”  OFHEO Director James Lockhart (who had assumed that position the month the re- port was issued) recalled discovering during the special examination an email from Mudd, then Fannie’s chief operating officer, to CEO Franklin Raines. Mudd wrote, “The old political reality [at Fannie] was that we always won, we took no prisoners . . . we used to . . . be able to write, or have written rules that worked for us.”  Soon after his arrival, Lockhart began advocating for reform. “The need for legis- lation was obvious as OFHEO was regulating two of the largest and most systemati- cally important US financial institutions,” he told the FCIC.  But no reform legislation would be passed until July , , and by then it would be too late. : “Increase our penetration into subprime” After several years during which Fannie Mae purchased riskier loans and securities, then-Chief Financial Officer Robert Levin proposed a strategic initiative to “increase our penetration into subprime” at Fannie’s January  board meeting.  In the next month the board gave its approval.  Fannie would become more and more ag- gressive in its purchases. During a summer retreat for Fannie’s senior officers, as fcic_final_report_full--319 The Treasury’s inspector general would later criticize OTS’s supervision of Wash- ington Mutual: “We concluded that OTS should have lowered WaMu’s composite rat- ing sooner and taken stronger enforcement action sooner to force WaMu’s management to correct the problems identified by OTS. Specifically, given WaMu management’s persistent lack of progress in correcting OTS-identified weaknesses, we believe OTS should have followed its own policies and taken formal enforcement action rather than informal enforcement action.”  Regulators: “A lot of that pushback” In these examples and others that the Commission studied, regulators either failed or were late to identify the mistakes and problems of commercial banks and thrifts or did not react strongly enough when they were identified. In part, this failure reflects the nature of bank examinations conducted during periods of apparent financial calm when institutions were reporting profits. In addition to their role as enforcers of regu- lation, regulators acted something like consultants, working with banks to assess the adequacy of their systems. This function was, to a degree, a reflection of the supervi- sors’ “risk-focused” approach. The OCC Large Bank Supervision Handbook published in January  explains, “Under this approach, examiners do not attempt to restrict risk-taking but rather determine whether banks identify, understand, and control the risks they assume.”  As the crisis developed, bank regulators were slow to shift gears. Senior supervisors told the FCIC it was difficult to express their concerns force- fully when financial institutions were generating record-level profits. The Fed’s Roger Cole told the FCIC that supervisors did discuss issues such as whether banks were growing too fast and taking too much risk, but ran into pushback. “Frankly a lot of that pushback was given credence on the part of the firms by the fact that—like a Citigroup was earning  to  billion a quarter. And that is really hard for a supervi- sor to successfully challenge. When that kind of money is flowing out quarter after quarter after quarter, and their capital ratios are way above the minimums, it’s very hard to challenge.”  Supervisors also told the FCIC that they feared aggravating a bank’s already-exist- ing problems. For the large banks, the issuance of a formal, public supervisory action taken under the federal banking statutes marked a severe regulatory assessment of the bank’s risk practices, and it was rarely employed for banks that were determined to be going concerns. Richard Spillenkothen, the Fed’s head of supervision until early , attributed supervisory reluctance to “a belief that the traditional, nonpublic (behind-the-scenes) approach to supervision was less confrontational and more likely to induce bank management to cooperate; a desire not to inject an element of contentiousness into what was felt to be a constructive or equable relationship with management; and a fear that financial markets would overreact to public actions, possibly causing a run.” Spillenkothen argued that these concerns were relevant but that “at times they can impede effective supervision and delay the implementation of needed corrective action. One of the lessons of this crisis . . . is that the working pre- sumption should be earlier and stronger supervisory follow up.”  fcic_final_report_full--496 I could not find a record of reports by Fannie and Freddie required under this section of the act, but it would have been fairly clear to both companies, and to HUD, what Congress wanted in asking for these studies. Prevailing underwriting standards were inhibiting mortgage financing for low and moderate income (LMI) families, and would have to be substantially relaxed in order to meet the goals of the Act. Whatever the motivation, HUD set out to assure that downpayment requirements were substantially reduced (eventually they reached zero) and past credit history became a much less important issue when mortgages were made (permitting subprime mortgages to become far more common). Until 1995, HUD enforced the temporary AH goals originally put in place by the GSE Act. With the exception of the special affordable requirements, which were small at this point, these goals were not burdensome. In the ordinary course of their business, the GSEs seem to have bought enough mortgages made to borrowers below the AMI to qualify for the 30 percent AH goal. In 1995, however, HUD raised the LMI goal to 40 percent, applicable to 1996, and to 42 percent for subsequent years. In terms of its effect on Fannie and Freddie, HUD’s most important move at this time was to set a Special Affordable goal (low and very low income borrowers) of 12 percent, which increased to 14 percent in 1997. Efforts to find loans to low or very low income borrowers (80 percent and 60 percent of AMI, respectively) that did not involve high risks would prove diffi cult. As early as November 1995, even before the effect of these new and higher goals, Fannie’s staff had already recognized that Fannie’s Community Homebuyer Program (CHBP), which featured a 97 percent loan-to-value (LTV) ratio—i.e., 3 percent downpayment 75 —was showing significant rates of serious delinquency that exceeded Fannie’s expected rates by 26percent in origination year 1992, 93 percent in 1993 and 57 percent in 1994. 76 In 1995, continuing its efforts to erode underwriting standards in order to increase homeownership, HUD issued a policy statement entitled “The National Homeownership Strategy: Partners in the American Dream.” The Strategy was prepared by HUD, “under the direction of Secretary Henry G. Cisneros, in response 74 75 76 Id., Section 1354(a). Fannie Mae, “Opening Doors with Fannie Mae’s Community Lending Products,” 1995, p.3. Fannie Mae, Memo from Credit Policy Staff to Credit Policy Committee, “CHBP Performance,” November 14, 1995, p.1. to a request from President Clinton.” 77 The first paragraph of Chapter 1 stated: “The purpose of the National Homeownership Strategy is to achieve an all-time high level of homeownership in America within the next 6 years through an unprecedented collaboration of public and private housing industry organizations.” CHRG-110hhrg46591--240 Mr. Washburn," Thank you, Congressman. You took my first paragraph away. My name is Mike Washburn. I am here from Red Mountain Bank; I am president and CEO of that bank. We are a $351 million community bank in Hoover, Alabama. I am here to testify today on behalf of the Independent Community Bankers of America. I appreciate the opportunity to share the views of our Nation's community banks on the issue of financial restructuring and reform. Even though we are in the midst of very uncertain financial times, and there are many signs that we are headed for a recession, I am pleased to report that the community banking industry is sound. Community banks are strong. We are commonsense, small-business people who have stayed the course with sound underwriting that has worked well for us for many years. We have not participated in the practices that have caused the current crisis, but our doors are open to helping resolve it through prudent lending and restructuring. As we examine the roots of the current problems, one thing stands out: Our financial system has become too concentrated. As a result of the Federal Reserve and Treasury action, the four largest banking companies in the United States today now control more than 40 percent of the Nation's deposits and more than 50 percent of the Nation's assets. This is simply overwhelming. Congress should seriously consider whether it is prudent to put so much economic power and wealth into the hands of so few. Our current system of banking regulation has served this Nation well for decades. It should not be suddenly scrapped in the zeal for reform. Perhaps the most important point I would like to make to you today is the importance of deliberation and contemplation. Government and the private sector need to work together to get this right. We would like to make the following suggestions: Number 1: Preserve the system of multiple Federal regulators who provide checks and balances and who promote best practices among these agencies. Number 2: Protect the dual banking system, which ensures community banks have a choice of charters and of supervisory authority. Number 3: Address the inequity between the uninsured depositors at too-big-to-fail banks, which have 100 percent deposit protection, versus uninsured depositors at the too-small-to-save banks that could lose money, giving the too-big-to-fail banks a tremendous competitive advantage in attracting deposits. Number 4: Maintain the 10 percent deposit cap. There is a dangerous overconcentration of financial resources in too few hands. Number 5: Preserve the thrift charter and its regulator, the OTS. Number 6: Maintain GSEs in a viable manner to provide valuable liquidity and a secondary market outlet for mortgage loans. Number 7: Maintain the separation of banking and commerce and close the ILC loophole. Think how much worse this crisis would have been if the regulators had to unwind commercial affiliates as well as the financial firms. We also believe Congress should consider the following: Number 1: Unregulated institutions must be subject to Federal supervision. Like banks, these firms should pay for this supervision to reduce the risk of future failure. Number 2: Systemic risk institutions should be reduced in size. Allowing four companies to control the bulk of our Nation's financial resources invites future disasters. These huge firms should be either split up or be required to divest assets so they no longer pose a systemic risk. Number 3: There should be a tiered regulatory system that subjects large, complex institutions to a more thorough regulatory system, and they should pay a risk premium for the possible future hazard they pose to taxpayers. Number 4: Finally, mark-to-market and fair value accounting rules should be suspended. Mr. Chairman and members of the committee, thank you for inviting ICBA to present our views. Red Mountain Bank and the other 8,000 community banks in this country look forward to working with you as you address the regulatory and supervisory issues facing the financial services industry today. Thank you. [The prepared statement of Mr. Washburn can be found on page 168 of the appendix.] " CHRG-111hhrg54873--154 Mr. Donnelly," One more minute. Ms. Speier. Thank you. I just want to get to this liability issue, this private right of action. As I understand it, you only want to be sued if you knowingly make a false statement. Now that is akin to a doctor only being sued when he knowingly leaves sponges in a body during a surgery. And we all know that is just not the case. For most professionals in this country, you can be sued for negligence. You can be sued for gross negligence. And most professionals don't have this huge benefit that you have, which basically allows you to not be sued by anyone unless you knowingly make false statements. I am going to read to you one little section here, and I want you to tell me whether or not you could live with this kind of a standard: ``Knowingly or recklessly failed either to conduct a reasonable investigation of the rated security with respect to the factual elements relied upon by its own methodology for evaluating credit risk or to obtain reasonable verification of such factual elements from other sources that it considered to be competent and were independent of the issuer and underwriter.'' Ms. Speier. So it is a different standard. " CHRG-111shrg54789--10 Mr. Barr," Thank you, Mr. Chairman. I think we have had a long experiment with having the prudential supervisors over banks responsible for consumer protection supervision, having another agency--the Federal Reserve--responsible for rule writing, having yet another agency--the Federal Trade Commission--responsible for after-the-fact enforcement in the nonbanking sector. And I think what we have seen and what the American public has just experienced is a massive failure of that system. And it was a massive failure of that system because of the very structure of the system. There were good people at the Federal Reserve, for example, who wanted to effectuate strong consumer protections. You might even say there were heroic people at the Federal Reserve who wanted to effectuate consumer protection. Ned Gramlich, who was a dear friend of mine, the Vice Chair of the Federal Reserve, wanted to get consumer protection done, and the very structure of the Federal Reserve, its very focus on what it viewed as prudential supervision, its inability to move quickly on consumer protection blocked reform in the mortgage market that could have helped avert this crisis. So I think we have had a long and disastrous experience with having bank agencies with a mixed mission, with no one focused on protecting consumers, with no one able to set rules and supervise across the financial services marketplace, with no one able to say there is going to be a level playing field with high standards for everybody. And what we saw is the market tipped to bad practices. We saw it tip to bad practices in credit cards, practices which you and Mr. Shelby so effectively blocked in the credit card bill this spring. We saw it shift, tilt to bad practices in the mortgage market in ways that were disastrous for the American people. And I just don't think we can afford that experiment any longer. We have to have a fresh start with a new agency whose sole mission is standing up for the American people. " CHRG-110hhrg41184--22 Mr. Bernanke," Yes, I will. The Reg Z regulations are still out for comment. We are receiving comments, which we are going to review very carefully. But the intent of Reg Z was to provide clearer disclosure so people could understand what their credit card account involved. In particular, we have created a new Schumer Box, as it is called. It has new information about fees and penalties and provides more information to the consumer about the terms and conditions of their account. In addition, we propose to lengthen the period of time over which a consumer must receive notice before there is a change in terms of their credit card. These disclosures have been consumer tested. We have used companies to go out and use actual consumers to see what works, how much they recall, how much they understand. And we think there will be a substantial improvement in terms of allowing people to understand what is involved in their credit card accounts. We are beginning, as I mentioned, to look at some practices under the Unfair and Deceptive Acts and Practices rules. We anticipate setting out a proposal for comments within a couple of months, this spring, to address some issues that the disclosure rules themselves cannot address. The final release of both sets of rules will probably take place later this year. If possible, to minimize burden on the industry, would be to release the Reg Z disclosures and the new rules on unfair and deceptive acts and practices at about the same time, if possible. So I don't have a specific date yet for that release. " CHRG-111shrg50814--28 Mr. Bernanke," I don't have a precise number. From a spending perspective, though, it is certainly true that unemployment benefits are much more likely to be spent than the average dollar because people don't have the income. They need those benefits. Senator Reed. Also, in the Open Market Committee report, they indicate that the labor market is very weak but the declines might be tempered a bit because of the availability of extended unemployment benefits, that, in fact, people are still in the market looking for jobs because they have the benefits to sustain them in that search. Again, I assume you share that conclusion? " FinancialCrisisInquiry--95 Mr. Dimon, you said that residential mortgages were, quote, “poorly underwritten.” And I think you implied that one of the reasons was that there was so much money around that—and losses were not being suffered, but—and that is probably true. But were there any other reasons that traditional mortgage standards, such as an 80 percent loan-to-value ratio and so forth, were eliminated, eroded over time in this period of the 2000’s up until the mortgage meltdown? VICE CHAIRMAN THOMAS: Mr. Chairman, I’d yield the commissioner three additional minutes? WALLISON: Oh, my goodness. OK. Time does go fast. Go ahead. DIMON: So I think the standards eroded over a long period of time, and the losses were masked by the fact that home prices were going up. WALLISON: Right. 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. WALLISON: Let me ask a question of Mr. Moynihan in my very limited time now available. CHRG-111hhrg48867--167 Mr. Silvers," Congressman, I think it is a very good point. You know, Angela Merkel, the Chancellor of Germany, came to Hank Paulson in 2007 and suggested that perhaps we ought to have more regulation of hedge funds. The Bush Administration didn't like that idea and thought that we didn't need more transparency. And then they found themselves in the middle of the night thinking about what to do about Bear Stearns without the very transparency that they could have had when Angela Merkel brought it to them. We are now back facing the G20 meeting coming up where, once again, the proposition is going to be put on the table by Europeans, of all people, that we ought to be more serious about transparency and regulation of shadow markets on a routine basis. And we have the opportunity not to be the drag on that process but to lead. It is not necessary to lead to have a global regulator. A global regulator is a thing that may be far in the future, but it is necessary and quite possible to have coordinated action. And if we don't have coordinated action, poor practices in other countries may leak into our markets, and we may be perceived as being the source of poor practices elsewhere, as we were, say, in Norway when our subprime loans blew up their municipal finance. That challenge is right in front of us, and we can lead. And it ought to be a priority of the Administration, and I am hopeful it will be, to do just that. " CHRG-111shrg49488--105 Mr. Clark," Yes. Although when I started my first house, I bought the insurance and put down less than 20 percent. But you can do it. But, again, we would not lend to that person unless we were sure they were going to pay us back because we are responsible for the collections, we are responsible for managing that, and it is really our customer relationship, which is how we regard it. Senator Collins. I think it is fascinating that homeownership levels are actually higher in Canada than in the United States, because the justification for all these policies that encouraged the subprime mortgage market was to increase homeownership. And, in fact, it has caused a lot of people to lose homes that they could not afford in the first place, and the Canadian experience is very instructive. Mr. Green, last question to you. In the United Kingdom, what are the lending policies? Are they more similar to the Canadian practices or to the American practices? " CHRG-110shrg46629--17 Chairman Bernanke," Thank you. Chairman Dodd, Ranking Member Shelby, and Members of the Committee, I am pleased to present the Federal Reserve's Monetary Policy Report to the Congress. As you know, this occasion marks the 30th year of semiannual testimony on the economy and monetary policy by the Federal Reserve. And in establishing these hearings, the Congress proved prescient in anticipating the worldwide trend toward greater transparency and accountability of central banks in the making of monetary policy. Over the years, these testimonies and the associated reports have proved an invaluable vehicle for the Federal Reserve's communication with the public about monetary policy even as they have served to enhance the Federal Reserve's accountability for achieving that dual objectives of maximum employment and price stability set forth by the Congress. I take this opportunity to reiterate the Federal Reserve's strong support of the dual mandate. In pursuing maximum employment and price stability, monetary policy makes its greatest possible contribution to the general economic welfare. Let me now review the current economic situation and the outlook beginning with developments in the real economy and the situation regarding inflation before turning to monetary policy. I will conclude with comments on issues related to lending to households and to consumer protection, topics not normally addressed in monetary policy testimony but, in light of recent developments, deserving of our attention today. After having run at an above trend rate earlier in the current economic recovery, U.S. economic growth has proceeded during the past year at a pace more consistent with sustainable expansion. Despite the downshift in growth, the demand for labor has remained solid, with more than 850,000 jobs having been added to payrolls thus far in 2007 and the unemployment rate having remained at 4.5 percent. The combination of moderate gains in output and solid advances in employment implies that recent increases in labor productivity have been modest by the standards of the past decade. The cooling of productivity growth in recent quarters is likely the result of cyclical or other temporary factors but the underlying pace of productivity gains may also have slowed somewhat. To a considerable degree, the slower pace of economic growth in recent quarters reflects the ongoing adjustment in the housing sector. Over the past year, home sales and construction have slowed substantially and house prices have decelerated. Although a leveling off of home sales in the second half of 2006 suggested some tentative stabilization of housing demand, sales have softened further this year, leading the number of unsold new homes in builders' inventories to rise further relative to the pace of new home sales. Accordingly, construction of new homes has sunk further, with starts of new single-family houses thus far this year running 10 percent below the pace of the second half of last year. The pace of home sales seems likely to remain sluggish for a time partly as a result of some tightening in lending standards and the recent increase in mortgage interest rates. Sales should ultimately be supported by growth in income and employment as well as by mortgage rates that--despite the recent increase--remain fairly low relative to historical norms. However, even if demand stabilizes as we expect, the pace of construction will probably fall somewhat further as builders work down stocks of unsold new homes. Thus, declines in residential construction will likely continue to weigh on economic growth over coming quarters, although the magnitude of the drag on growth should diminish over time. Real consumption expenditures appear to have slowed last quarter, following two quarters of rapid expansion. Consumption outlays are likely to continue growing at a moderate pace aided by a strong labor market. Employment should continue to expand, though possibly at a somewhat slower pace than in recent years, as a result of the recent moderation in the growth of output and ongoing demographic shifts that are expected to lead to a gradual decline in labor force participation. Real compensation appears to have risen over the past year and, barring further sharp increases in consumer energy costs, it should rise further as labor demand remains strong and productivity increases. In the business sector, investment in equipment and software showed a modest gain in the first quarter. A similar outcome is likely for the second quarter as weakness in the volatile transportation equipment category appears to have been offset by solid gains in other categories. Investment in nonresidential structures, after slowing sharply late last year, seems to have grown fairly vigorously in the first half of 2007. Like consumption spending, business fixed investment overall seems poised to rise at a moderate pace bolstered by gains in sales and generally favorable financial conditions. Late last year and early this year motor vehicle manufacturers and firms in several other industries found themselves with elevated inventories, which led them to reduce production to better align inventories with sales. Excess inventories now appear to have been substantially eliminated and should not prove a further restraint on growth. The global economy continues to be strong. Supported by solid economic growth abroad U.S. exports should expand further in coming quarters. Nonetheless our trade deficit, which was about 5.25 percent of nominal gross domestic product in the first quarter is likely to remain high. For the most part, financial markets have remained supportive of economic growth. However, conditions in the subprime mortgage sector have deteriorated significantly, reflecting mounting delinquency rates on adjustable-rate loans. In recent weeks, we have also seen increased concerns among investors about credit risk on some other types of financial instruments. Credit spreads on lower quality corporate debt have widened somewhat, and terms for some leveraged business loans have tightened. Even after their recent rise, however, credit spreads remain near the low end of their historical ranges and financing activity in the bond and business loan markets has remained fairly brisk. Overall, the U.S. economy appears likely to expand at a moderate pace over the second half of 2007, with growth then strengthening a bit in 2008 to a rate close to the economy's underlying trend. Such an assessment was made around the time of the June meeting of the Federal Open Market Committee by the members of the Board of Governors and the Presidents of the Reserve Banks, all of whom participate in deliberations on monetary policy. The central tendency of the growth forecasts, which are conditioned on the assumption of appropriate monetary policy, is for real GDP to expand roughly 2.25 to 2.5 percent this year and 2.5 to 2.75 percent in 2008. The forecasted performance for this year is about one-quarter percentage point below that projected in February, the difference being largely the result of weaker than expected residential construction activity this year. The unemployment rate is anticipated to edge up to between 4.5 and 4.75 percent over the balance of this year and about 4.75 percent in 2008, a trajectory about the same as the one expected in February. I turn now to the inflation situation. Sizable increases in food and energy prices have boosted overall inflation and eroded real incomes in recent months, both unwelcome developments. As measured by changes in the price index for personal consumption expenditures, PCE inflation, inflation ran at an annual rate of 4.4 percent over the first 5 months of this year, a rate that if maintained would clearly be inconsistent with the objective of price stability. Because monetary policy works with a lag, however, policymakers must focus on the economic outlook. Food and energy prices tend be quite volatile so that, looking forward, core inflation, which excludes food and energy prices, may be a better gauge than overall inflation of underlying inflation trends. Core inflation has moderated slightly over the past few months with core PCE inflation coming in at an annual rate of about 2 percent so far this year. Although the most recent readings on core inflation have been favorable, month-to-month movements in inflation are subject to considerable noise and some of the recent improvement could also be the result of transitory influences. However, with long-term inflation expectations contained, futures prices suggesting that investors expect energy and other commodity prices to flatten out, and pressures in both labor and product markets likely to ease modestly, core inflation should edge a bit lower on net over the remainder of this year and next year. The central tendency of FOMC participants forecast for core PCE inflation--2 to 2.25 percent for all of 2007 and 1.75 to 2 percent in 2008--is unchanged from February. If energy prices level off as currently anticipated, overall inflation should slow to a pace close to that of core inflation in coming quarters. At each of its four meeting so far this year, the FOMC maintained its target for the Federal funds rate at 5.25 percent, judging that the existing stance of policy was likely to be consistent with growth running near trend and inflation staying on a moderating path. As always, in determining the appropriate stance of policy, we will be alert to the possibility that the economy is not evolving in the way we currently judge to be the most likely. One risk to the outlook is that the ongoing housing correction might prove larger than anticipated, with possible spillovers onto consumer spending. Alternatively consumer spending, which has advanced relatively vigorously on balance in recent quarters, might expand more quickly than expected. In that case, economic growth could rebound to a pace above its trend. With the level of resource utilization already elevated, the resulting pressures in labor and product markets could lead to increased inflation over time. Yet another risk is that energy and commodity prices could continue to rise sharply, leading to further increases in headline inflation and, if those costs pass through to the prices of nonenergy goods and services, to higher core inflation as well. Moreover, if inflation were to move higher for an extended period and increase became embedded in longer-term inflation expectations, the reestablishment of price stability would become more difficult and costly to achieve. With the level of resource utilization relatively high and with a sustained moderation in inflation pressures yet to be convincingly demonstrated, the FOMC has consistently stated that upside risks to inflation are its predominant policy concern. In addition to its dual mandate to promote maximum employment and price stability, the Federal Reserve has an important responsibility to help protect consumers in financial services transactions. For nearly 40 years, the Federal Reserve has been active in implementing, interpreting, and enforcing consumer protection laws. I would like to discuss with you this morning some of our recent initiatives and actions, particularly those related to subprime mortgage lending. Promoting access to credit and to homeownership are important objectives and responsible subprime mortgage can help to advance both goals. In designing regulations, policymakers should seek to preserve those benefits. That said, the recent rapid expansion of the subprime market was clearly accompanied by deterioration in underwriting standards, and in some cases by abusive lending practices and outright fraud. In addition, some households took on mortgage obligations they could not meet, perhaps in some cases because they did not fully understand the terms. Financial losses have subsequently induced lenders to tighten their underwriting standards. Nevertheless, rising delinquencies and foreclosures are creating personal, economic, and social distress for many homeowners and communities, problems that will likely get worse before they get better. The Federal Reserve is responding to these difficulties at both the national and the local levels. In coordination with the other Federal supervisory agencies we are encouraging the financial industry to work with borrowers to arrange prudent loan modifications to avoid unnecessary foreclosures. Federal Reserve Banks around the country are cooperating with community and industry groups that work directly with borrowers having trouble meeting their mortgage obligations. We continue to work with organizations that provide counseling about mortgage product to current and potential homeowners. We are also meeting with market participants--including lenders, investors, servicers, and community groups--to discuss their concerns and to gain information about market development. We are conducting a top to bottom review of possible actions we might take to help prevent recurrence of these problems. First, we are committed to providing more effective disclosures to help consumers defend against improper lending. Three years ago, the Board began a comprehensive review of Regulation Z, which implements the Truth in Lending Act, or TILA. The initial focus of our review was on disclosures related to credit cards and other revolving credit accounts. After conducting extensive consumer testing, we issued a proposal in May that would require credit card issuers to provide clearer and easier to understand disclosures to consumers. In particular, the new disclosures would highlight applicable rates and fees, particularly penalties that might be imposed. The proposed rules would also require card issuers to provide 45 days advance notice of a rate increase or any other change in account terms so that consumers will not be surprised by unexpected charges and will have time to explore alternatives. We are now engaged in a similar review of the TILA rules for mortgage loans. We began this review last year by holding four public hearings across the country, during which we gathered information on the adequacy of disclosures for mortgages, particularly for nontraditional, traditional, and adjustable rate products. As we did with credit card lending, we will conduct extensive consumer testing of proposed disclosures. Because the process of designing and testing disclosures involves many trial runs, especially given today's diverse and sometimes complex credit products, it may take some time to complete our review and propose new disclosures. However, some other actions can be implemented more quickly. By the end of the year, we will propose changes to TILA rules to address concerns about mortgage loan advertisements and solicitations they may be incomplete or misleading and to require lenders to provide mortgage disclosures more quickly so that consumers can get the information they need when it is most useful to them. We already have improved a disclosure that creditors must provide to every applicant for an adjustable rate mortgage product to explain that better the features and risks of these products such as ``payment shock'' and rising loan balances. We are certainly aware, however, that disclosure alone may not be sufficient to protect consumers. Accordingly, we plan to exercise our authority under the Home Ownership and Equity Protection Act, HOEPA, to address specific practices that are unfair or deceptive. We held a public hearing on June 14 to discuss industry practices including those pertaining to prepayment penalties, the use of escrow accounts for taxes and insurance, stated income and low documentation lending, and the evaluation of a borrower's ability to repay. The discussion and ideas we heard were extremely useful and we look forward to receiving additional public comments in coming weeks. Based on the information we are gathering, I expect the Board will propose additional rules under HOEPA later this year. In coordination with the other Federal supervisory agencies, last year we issued principles-based guidance for nontraditional mortgages, and in June of this year we issued supervisory guidance on subprime lending. These statements emphasized the fundamental consumer protection principles of sound underwriting and effective disclosures. In addition, we reviewed our policies related to the examination of nonbank subsidiaries of bank and financial holding companies for compliance with consumer protection laws and guidance. As a result of that review and following discussions of the Office of Thrift Supervision, the Federal Trade Commission, and State regulators as represented by the Conference of State Bank Supervisors and the American Association of Residential Mortgage Regulators, we are launching a cooperative pilot aimed at expanding consumer protection compliance reviews at selected nondepository lenders with significant subprime mortgage operations. The reviews will begin in the fourth quarter of this year and will include independent state-licensed mortgage lenders, nondepository mortgage lending subsidies of bank and thrift holding companies, and mortgage brokers doing business with or serving as agents of these entities. The agencies will collaborate in determining the lessons learned and in seeking ways to better cooperate in ensuring effective and consistent examination of and improved enforcement for nondepository mortgage lenders. Working together to address jurisdictional issues and to improve information sharing among agencies, we will seek to prevent abusive and fraudulent lending while ensuring that consumers retain access to beneficial credit. I believe that the actions I have described today will help address the current problems. The Federal Reserve looks forward to working with Congress on these important issues. Thank you. " FOMC20071031meeting--188 186,MS. PIANALTO.," Thank you, Mr. Chairman. I, like several of my colleagues who have gone ahead of me, find myself torn between alternatives A and B. I also wrestled with many of the issues that President Plosser articulated so well. I left our September meeting thinking that the 50 basis point cut pretty much put us close to where we needed to be given our outlook, and my outlook hasn’t changed much in the past six weeks. As I said yesterday, I’m not certain about whether the weakness that I’m hearing or have heard about during this intermeeting period is simply evidence of the business conditions that are unfolding as I thought they would or whether there is more weakness than I anticipated in September and more weakness than I have reflected in my projection. The Committee has said repeatedly and for good reason that our decisions are going to be dependent on the incoming data, and as many have already said, the data seem to be confirming my outlook. But financial markets do remain on edge. Moreover, many of the incoming data are backward looking and, hence, don’t provide me with great comfort when we’re trying to ascertain what might lie ahead. The projection that I submitted for this meeting, as I said yesterday, is rather fragile, and it wouldn’t take much additional market turmoil or deterioration in household and business confidence to push my near-term growth outlook even lower. So I think this risk is the predominant one that we face today, and it is a risk that has weighed heavily on my deliberations for this meeting. The assessment of risk language in alternative B addresses these concerns, and I was contemplating supporting no change in the fed funds rate and the language in alternative B. However, in the climate that we find ourselves, I believe that just saying that the risk to the outlook is to the downside isn’t enough. I do think that we should be taking out some insurance against possible further deterioration in the near-term outlook. So I support a 25 basis point cut in the fed funds rate target today, and I support the language that’s embodied in alternative A. I believe that the language does acknowledge the likely slowdown in the economic expansion. It also acknowledges that, if we take this action today, the risks are roughly balanced, and importantly, it suggests that further policy easing may not be forthcoming. I also like the language that was added regarding the recent inflation numbers. Finally, as Governor Mishkin pointed out, it is difficult to express all of these issues in our short statement. It seems to me that we can draw some comfort from the fact that the minutes will be providing the public with a greater understanding of the different views that were expressed today and some of the challenges that I wrestled with. Thank you, Mr. Chairman." CHRG-111shrg52619--143 Mr. Tarullo," That is one role. The second role, which you also identified, practices that are pervasive in an industry, no matter what the size of the entity, which rise to the level of posing true systemic risk--probably unusual, but certainly possible. " CHRG-111hhrg53234--123 Mr. Kohn," I would have to see the question in writing. We supervise lots of institutions, and in the process of supervising those institutions, we make lots of requests to them to change their practices. So I am not sure exactly what you are getting at. So perhaps the chairman's suggestion of a written question would be best. " CHRG-111hhrg54868--69 Mr. Dugan," If it is adequately disclosed to consumers that can happen to their balances when they do something, it is not an unfair and deceptive practice to raise it. It is now unlawful to do that because Congress acted. Mr. Miller of North Carolina. Right. " CHRG-111hhrg53241--48 The Chairman," They got insufficient attention. Thank you. And I would say this now: It is not simply ideological. Sure, there is an ideology. But there is both an ideology and an institutional role, and I do not think that it is purely personal that they got insufficient attention. When you give people a lot of responsibility, they can do some, but they can't do them all equally. I think it is very clear that that is the explanation, that they--as you acknowledge, and I appreciate--got insufficient attention because the primary mission was seen as other. Now, I do want to address in this time what I think is an inaccurate analogy between the Fannie and Freddie situation and this one. People have said, well, after all, you had OFHEO and you had HUD and HUD overruled OFHEO. By the way, I agree with that. In 2004, when Secretary Jackson in the Bush Administration ordered Fannie Mae and Freddie Mac to substantially increase the number of subprime mortgages they bought, I objected. I said at the time--quoted in Bloomberg--that it was a mistake. That was not a favor to these people to push them into these mortgages. My own view consistently was that we should have been doing more rental housing. I was frustrated that we couldn't get enough of that. And, by the way, when you talk about the housing goals, it was the home purchases for people who couldn't afford it rather than rental housing that were the cause of these problems. But here is the point. Everybody agreed by then that OFHEO was too weak a regulator. In fact, in 2005, this committee did recommend a change. Now, many of those critical of Fannie and Freddie opposed the change. Mr. Oxley, looking down on us, put the bill through. There was then a dispute among the Republicans in the House, the Republicans in the Senate, and the President. I must say I am flattered by those who think that I somehow was the arbiter of this intra-Republican dispute and that I was responsible for the outcome. Would that I was responsible for mediating Republican disputes. We wouldn't be in Iraq today. But that is another story. In any case, what we had was, in 2007, the passage out of this committee and onto the Floor of the House a tough regulator. And, in fact, people have said, where is your regulation of Fannie and Freddie? Well, the fact is that we did pass the regulation. Unfortunately, in the United States Senate, it was bogged down. It didn't pass until 2008. But people have said, how can you do this without doing Fannie and Freddie? Well, one of the key points that the Bush Administration wanted was to put it into conservatorship. We have done that. The Fannie and Freddie today is nothing like what it was before in part because too long had gone by without legislation and in part because of the legislation we adopted. But the point is this: The weakness of OFHEO--in fact, people have said, well, see, you had a consumer regulator, HUD, and a safety and soundness regulator, OFHEO, and that caused the problem. But the very people making that argument are the ones who argued that OFHEO was too weak a safety and soundness regulator. They explicitly, in fact, disavowed the comparison between OFHEO and the OCC and the Fed. In other words, it is not the case that we tried having a separate safety and soundness regulator and a separate consumer regulator. Those making the argument today argued correctly that OFHEO was not in the class of OCC, was not in the class. At first, I didn't think it had to be. I later changed my mind by 2005 and thought it should be because of these subprime mortgages. But the argument that because we had an OFHEO and a HUD that means you can't do these together misses the point that the big problem was not that you had a separate consumer and safety and soundness regulator but that the safety and soundness regulator was too weak. And people who argued again that it was not comparable to the bank regulators can't use that now as an analogy. I think we have tough bank regulation, and I think we can have a system in which we also get tough consumer regulation. The gentleman from Texas. " FinancialCrisisReport--135 This exchange acknowledges that not all of the saleable Option ARM loans were diverted from the HFI to the HFS portfolio. WaMu chose to keep some Option ARMs and make other Option ARMs available for sale. The internal WaMu documents and communications reviewed by the Subcommittee strongly suggest that the decision to transfer the most recently originated Option ARMs from the Held-for-Investment portfolio to the Held-for-Sale portfolio was part of an effort to sell loans thought to be prone to delinquency, before they became delinquent. None of the hearing witnesses recalled how these loans were specifically selected for securitization, nor did any deny that they may have been selected for their propensity toward delinquency. 480 The Subcommittee investigation determined that WaMu carried out the plan as approved, and transferred at least $1.5 billion Option ARMs originated in the first quarter of 2007, from the HFI to HFS portfolio. Of these loans, about 1,900 with a total value of a little over $1 billion were assembled into a pool and used in the WMALT 2007-OA3 securitization in March 2007. 481 WMALT 2007-OA3 securities were issued with WaMu as the sole underwriter and sold to investors. 482 None of the materials associated with the sale of the WMALT 2007-OA3 securities informed investors of the process used to select the delinquency-prone Option ARMs from WaMu’s investment portfolio and include them in the securitization. 483 Nor did WaMu inform investors of the internal analysis it performed to identify the delinquency-prone loans. Senator Levin questioned Mr. Beck about this point at the April 13 Subcommittee hearing: Senator Levin. When you said that investors were told of the characteristics of loans, they were told of all the characteristics of loans. Did they know, were they informed that loans with those or some of those characteristics had a greater propensity towards delinquency in WaMu’s analysis? Were they told that? Mr. Beck. They were not told of the WaMu analysis. 484 Predictably, the securitization performed badly. Approximately 87% of the securities received AAA ratings. 485 Within 9 months, by January 2008, those ratings began to be downgraded. 486 As of February 2010, more than half of the loans in WMALT Series 2007-OA3 480 Mr. Schneider and Mr. Beck were asked about this matter at the hearing. See April 13, 2010 Subcommittee Hearing at 75-82. 481 4/10/2010 Subcommittee email from Brent McIntosh, Sullivan & Cromwell LLP, Counsel for JPMorgan Chase [Sealed Exhibit]. 482 3/22/2007 WaMu Prospectus Supplement, “Washington Mutual Mortgage Pass-Through Certificates, WMALT Series 2007-OA3,” at S-102, Hearing Exhibit 4/13-86b. 483 See, e.g., id. See also April 13, 2010 Subcommittee Hearing at 80. 484 April 13, 2010 Subcommittee Hearing at 82. 485 4/11/2007 “New Issue: Washington Mutual Mortgage Pass-Through Certificates WMALT Series 2007-OA3 Trust,” S&P’s Global Credit Portal , www.globalcreditportal.com. 486 See 1/14/2008 “Moody’s takes negative rating actions on certain WaMu Option Arm deals issued in 2007,” Moody’s, http://www.moodys.com/viewresearchdoc.aspx?lang=en&cy=global&docid=PR_147683. were delinquent, and more than a quarter were in foreclosure. 487 All of the investment grade ratings have been downgraded to junk status, and the investors have incurred substantial losses. (4) WaMu Loan Sales to Fannie Mae and Freddie Mac CHRG-111hhrg67816--79 Mr. Rush," The chair thanks the chairman. The chair recognizes himself for 5 minutes for the purposes of questioning our witness. Chairman Leibowitz, during the housing boom the FTC had clear jurisdiction over many of the worse predatory lenders with the most objectionable practices, but the Commission arguably didn't do much to address any of these activities. As a matter of fact, it was the states that successfully brought actions against lenders such as Countrywide and AmeriQuest when there are abusive lending practices in the sub-prime mortgage market. In the second panel Attorney Jim Tierney will talk about these and other issues a little more. But to begin with, I want to ask a simple question to you. What happened at the FTC? Why did the FTC not take aggressive action against mortgage lenders in the earlier part of this decade? " CHRG-111hhrg67816--212 Mr. Peterson," Thank you, Mr. Chairman, ranking member. It is an honor to be here today and share a few thoughts. I would like to start with two quick statistics, if I could, about the sub-prime and alternative mortgage product crisis. The first is roughly 6 million foreclosures coming through the pipe according to Credit Suisse, and then foreclosure rescue scam cases brought by the Federal Trade Commission, 6. According to their testimony in the Senate last month, they brought 6 foreclosure rescue scam cases for 6 million foreclosures. That is 1 in a million. Where I come from that is sort of a cliche you talk about when you said he is not doing anything, right? In my view, honorably, the Federal Trade Commission is a good agency that does their best but they are not doing anything. We are talking about taking teacups of water out of an ocean. It is just not even close to the sort of magnitude of problems that we are talking about. And so if I could just quickly, you talk about the rule of the law. We all have been talking about all these generalizations about separating good loans from bad loans. Just talk about the laws for a second. There is equal credit--they have four titles of the Consumer Credit Protection Act, and then they have their deceptive trade practices authority. The Equal Credit Opportunity Act is designed to prevent discrimination in awarding credit. It doesn't do anything in the way of preventing bad loans from being made. The Fair Credit Reporting Act tries to clear up inaccurate credit information, but that is not the problem that we had here. Lots of people had prime credit histories and were still getting non-amortizing loans that have gone in waves into foreclosure. The Fair Debt Collection Practices Act is a nice gesture but it generally doesn't apply to home mortgage loan servicers and it comes too late. I mean at the point where the loan is already in default and there is debt collection problems, it is too late at that point. Then the Truth in Lending Act is a nice idea but it is too late. The disclosures are confusing. People generally just don't read them. They ignore the disclosures. And even if that was a great strategy the statute that is designed to promote honesty in origination of loans doesn't apply to mortgage brokers who are the people that actually talk to consumers. What sort of a truth in lending idea doesn't apply to the people who talk to the borrower? And then in addition to those four statutes, they also have two significant regulations that they have done under their deceptive trade practices authority. The holder in due course notice rule which doesn't apply to home mortgages, and that was back in 1975 and it has never been updated. And, second, the credit practices rule which bans about 5 different problematic contractual provisions including confessions of judgment and pyramiding late fees, but it hasn't been updated since 1984. And this regulation doesn't talk about any of the non-amortizing products and sub-prime products that we are talking about in the past few months. And that is it. I just did it. In 3 minutes I summed up their entire regulatory structure, and it really doesn't do much of anything to try and prevent home mortgage fraud. And what are the barriers that prevent more stuff from taking place? Well, it is true that they have this inefficient regulatory rulemaking process, and it seems to me it would be helpful to speed that up. But the real problem is the fragmented federal regulatory system. On my hand I can count 11 different agencies that are supposed to be dealing with this problem, the Federal Reserve Board of Governors, the Office of the Comptroller, the Office of Thrift Supervision, FDIC, the National Credit Union Administration, the new Federal Housing Finance Administration, if I am getting that right, the new OFHEO, HUD, SEC, the FBI and Justice at the same time, and then finally the Federal Trade Commission. In this fragmented system, the capital flows to the weakest regulator like water going down into the basement. And the result is that there is very, very little actual rulemaking to try and deal with the problematic practices that are actually in our industry. So I have been coming up with a list of all the things that I think needs to get done, and I have this gigantic list of problems in our statutory system. It is a big list. We are talking a lot of changes that need to be made. Congress could do that but it is going to be a long and complicated bill. It is going to be very controversial. You could give it to a federal agency to try and do it but which one would you choose? The only plausible existing candidates are the Federal Reserve, which already have that authority under the Home Ownership and Equity Protection Act or the Federal Trade Commission, which is a good choice but has nowhere near the resources and has a too expansive mission. In my view, respectfully, it is time for a new regulatory agency that deals exclusively with this issue and has authority to pursue protection of consumers on consumer finance issues. And if you are not talking about that, if you are just talking about more tinkering then you are just kind of kidding yourself and you are not really going to fix anything. [The prepared statement of Mr. Peterson follows:] [GRAPHIC] [TIFF OMITTED] T7816A.049 CHRG-111shrg53176--29 Chairman Dodd," Thank you very much. Just on that last point Senator Warner has raised, as well, I wonder if you will also look at margin requirements. The difference between exposing weakness, which short selling does and has very great value, versus speculation, which has been, I think--you know, people have talked about mark-to-market. The quickest thing you might do about mark-to-market is get this uptick rule in place, in my view, and then look at the margin requirements as Richard Breeden talked about. Ms. Schapiro. Yes, it is in former Chairman Breeden's testimony. " FOMC20060808meeting--134 132,VICE CHAIRMAN GEITHNER.," I think Bill’s reservations about it are right. Of course, they would have applied the last time we used it, too. I guess I would argue for keeping housing in on the grounds that it’s happening. It is the principal area in which we see some weakness going on in the economy, and not to make reference to that reality seems a little awkward. It would be like having a statement that didn’t mention what’s happening in either energy prices or housing, and that would be hard to justify. So I would keep it, on the simple grounds that it is happening and it’s an accurate description of reality. I don’t think it’s a problem." FOMC20070321meeting--207 205,MR. KROSZNER.," As I said in my discussion, obviously I’m very concerned about a reference to financial conditions, especially “still-favorable financial conditions.” But as I also said, I think that it hangs out there a bit naked without some color around it. I would be fine with keeping personal income gains and the gradually waning correction to the housing market. My preference would be just something like “income gains, among other factors” to put something there. But that may be so weak that it may be better to cut off. I’m sympathetic to having some color, but I think the wrong color is the financial market condition." FOMC20081029meeting--188 186,MR. MORIN.," One quick follow-on comment. In exhibit 3, in the middle left panel, if you look at our financial turmoil effects, with the gray shading, the bulk of the markdown in 2008 actually is what we're labeling the financial turmoil. But those are data we pretty much already have in hand. We are calling much of the shortfall in consumption that we expect to see in the third quarter as ""financial turmoil."" So much of the weakness in the second half of this year isn't just taking a flyer on what we think turmoil is going to do; some of it is already in the data. " fcic_final_report_full--546 LIBOR London Interbank Offered Rate, an interest rate at which banks are willing to lend to each other in the London interbank market. liquidity Holding cash and/or assets that can be quickly and easily converted to cash. liquidity put A contract allowing one party to compel the other to buy an asset under certain cir- cumstances. It ensures that there will be a buyer for otherwise illiquid assets. loan-to-value ratio Ratio of the amount of a mortgage to the value of the house, typically ex- pressed as a percentage. “Combined” loan-to-value includes all debt secured by the house, in- cluding second mortgages. LTV ratio see loan-to-value ratio. mark-to-market The process by which the reported amount of an asset is adjusted to reflect the market value. monoline Insurance company, such as AMBAC and MBIA, whose single line of business is to guarantee financial products. mortgage servicer Company that acts as an agent for mortgage holders, collecting and distribut- ing payments from borrowers and handling defaults, modifications, settlements, and foreclo- sure proceedings. mortgage underwriting Process of evaluating the credit characteristics of a mortgage and bor- rower. mortgage-backed security Debt instrument secured by a pool of mortgages, whether residential or commercial. NAV see net asset value . negative amortization loan Loan that allows a borrower to make monthly payments that do not fully cover the interest payment, with the unpaid interest added to the principal of the loan. net asset value Value of an asset minus any associated costs; for financial assets, typically changes each trading day. net charge-off rate Ratio of loan losses to total loans. non-agency mortgage-backed securities Mortgage-backed securities sponsored by private compa- nies other than a government-sponsored enterprise (such as Fannie Mae or Freddie Mac ); also known as private-label mortgage-backed securities. notional amount A measure of the outstanding amount of over-the-counter derivatives contracts, based on the amount of the underlying referenced assets. novation A process by which counterparties may transfer derivatives positions. OCC see Office of the Comptroller of the Currency . Office of Federal Housing Enterprise Oversight Created in  to oversee financial soundness of Fannie Mae and Freddie Mac ; its responsibilities were assumed in  by its successor, the Federal Housing Finance Agency . Office of the Comptroller of the Currency Independent bureau within Department of Treasury that charters, regulates, and supervises all national banks and certain branches and agencies of foreign banks in the United States. Office of Thrift Supervision Independent bureau within Treasury that regulates all federally chartered and many state-chartered savings and loans/thrift institutions and their holding companies. OFHEO see Office of Federal Housing Enterprise Oversight . originate-to-distribute When lenders make loans with the intention of selling them to other fi- nancial institutions or investors, as opposed to holding the loans through maturity. originate-to-hold When lenders make loans with the intention of holding them through maturity, as opposed to selling them to other financial institutions or investors. 543 origination Process of making a loan, including underwriting, closing, and providing the funds. OTS see Office of Thrift Supervision . par Face value of a bond. payment-option adjustable-rate mortgage (also called payment ARM or option ARM ) Mort- gages that allow borrowers to pick the amount of payment each month, possibly low enough to increase the principal balance. CHRG-111shrg57319--157 Mr. Melby," Concerned. The specific investigation I am referring to goes back to--Senator Levin had referred to a request by an insurance agency relative to fraud, and so we had conducted an investigation back in--the report was issued in 2008. Those results were very telling from the standpoint that we had this pattern of conduct that had been occurring for a period of years where limited or no action had been taken. So a report was addressed again up through executive management and up through the board. Senator Kaufman. This sounds suspiciously like fraud. I mean, if you know that you are selling a product that is not truthful--I guess is this just caveat emptor, or is this something that could be considered, let us say, poor business practice? " fcic_final_report_full--123 HOEPA (Home Ownership and Equity Protection Act) hearings in San Francisco. At the hearing, consumers testified to being sold option ARM loans in their primary non-English language, only to be pressured to sign English-only documents with sig- nificantly worse terms. Some consumers testified to being unable to make even their initial payments because they had been lied to so completely by their brokers.”  Mona Tawatao, a regional counsel with Legal Services of Northern California, de- scribed the borrowers she was assisting as “people who got steered or defrauded into entering option ARMs with teaser rates or pick-a-pay loans forcing them to pay into—pay loans that they could never pay off. Prevalent among these clients are seniors, people of color, people with disabilities, and limited English speakers and seniors who are African American and Latino.”  Underwriting standards: “We’re going to have to hold our nose” Another shift would have serious consequences. For decades, the down payment for a prime mortgage had been  (in other words, the loan-to-value ratio (LTV) had been ). As prices continued to rise, finding the cash to put  down became harder, and from  on, lenders began accepting smaller down payments. There had always been a place for borrowers with down payments below . Typically, lenders required such borrower to purchase private mortgage insurance for a monthly fee. If a mortgage ended in foreclosure, the mortgage insurance company would make the lender whole. Worried about defaults, the GSEs would not buy or guarantee mortgages with down payments below  unless the borrower bought the insurance. Unluckily for many homeowners, for the housing industry, and for the financial system, lenders devised a way to get rid of these monthly fees that had added to the cost of homeownership: lower down payments that did not require insurance. Lenders had latitude in setting down payments. In , Congress ordered federal regulators to prescribe standards for real estate lending that would apply to banks and thrifts. The goal was to “curtail abusive real estate lending practices in order to reduce risk to the deposit insurance funds and enhance the safety and soundness of insured depository institutions.”  Congress had debated including explicit LTV stan- dards, but chose not to, leaving that to the regulators. In the end, regulators declined to introduce standards for LTV ratios or for documentation for home mortgages.  The agencies explained: “A significant number of commenters expressed concern that rigid application of a regulation implementing LTV ratios would constrict credit, impose additional lending costs, reduce lending flexibility, impede economic growth, and cause other undesirable consequences.”  In , regulators revisited the issue, as high LTV lending was increasing. They tightened reporting requirements and limited a bank’s total holdings of loans with LTVs above  that lacked mortgage insurance or some other protection; they also reminded the banks and thrifts that they should establish internal guidelines to man- age the risk of these loans.  High LTV lending soon became even more common, thanks to the so-called piggyback mortgage. The lender offered a first mortgage for perhaps  of the home’s value and a second mortgage for another  or even . Borrowers liked these because their monthly payments were often cheaper than a traditional mort- gage plus the required mortgage insurance, and the interest payments were tax de- ductible. Lenders liked them because the smaller first mortgage—even without mortgage insurance—could potentially be sold to the GSEs. CHRG-111shrg55278--30 Mr. Tarullo," So, I think here it is important to draw this distinction. Right now, if we have a supervised institution, there is a set of rules and supervisory expectations. There are rules on leverage, rules on capital, rules on liquidity. They are supposed to be conforming to those, and if they are conforming to those, there should be a containment of the kind of risks you are talking about. The backup effort there is supervisory examination, which goes beyond the rules, and if that works well, it identifies these things, and then allows the supervisor to give guidance to the firm to say we think you ought to be moving away from this practice or it creates certain risks. But I think your question raises an important point, which is--let us just assume the Administration's proposal on Tier 1 FHCs was enacted--there would still be a substantial universe of firms out there which would not be regulated by the Fed, which might be engaging in the kind of practices you are talking about. Even if no one firm is systemically important, in the aggregate a practice engaged in by a lot of firms can still create problems. So you would have to ask who would be able to regulate that. Senator Corker. My time is up. I think that answer was really interesting, Mr. Chairman, from this standpoint: Nothing--I mean, the answer is nothing. So the notion of having a single person, a single entity overseeing so they can act swiftly is not even relevant, because there would be no power. Again, if it is all conversation, looking, regulation, those things can be done by a group. And I just think that is worthy of hearing one of the Governors saying, no action. So---- " CHRG-111shrg50564--111 Chairman Dodd," So there is a value in maybe talking about that model, as well. Senator Crapo has been, of all the members of this Committee, probably has worked as hard on Government regulation, reform regulation as any member, so we welcome your continuing participation in the Committee, Mike. Thank you. Senator Crapo. Thank you, Mr. Chairman. Chairman Volcker, I want to go back to the Group of 30 report just to kind of try to understand maybe in a little more detail with you what was intended by it. I am going to first focus on one of the concepts that Senator Schumer mentioned--I apologize for my voice, I might lose it during the questions--and that is the principle of unifying our regulatory system. For some time even before we ran into this crisis, I have been arguing that we need to unify our regulatory system and really make sure that we had the right regulatory system for our financial system and for our capital markets. In that context, as I look at what we have today, it seems to me we have a lot of overlap that is unnecessary. We have gaps where there is no regulation where there should be. And we have weaknesses in some parts of our system. And what we need to do, as I think you said earlier, we need to get good regulation, not necessarily a lot of it. We have got to be thorough. We have got to cover everything, and in my opinion, eliminate overlaps. As I look at the first principle of the Group of 30's report, it talks about dealing with gaps and weaknesses and so forth in the system. But one of your first points is that the activities of banks should be subject to prudential regulation and supervision by a single consolidated regulator. Do I understand you or the report at that point to be talking about something like merging the functions of the OCC and the OTS and perhaps other regulators? " FOMC20060808meeting--30 28,MR. WILCOX.," Let me take those concerns in turn. First, with regard to the speed of adjustment of consumption to potential GDP—perhaps it is ironic, but our assumption is that we are the most ignorant ones in this little morality play; that households and businesses have been aware of the slower growth of potential GDP; and that, as far as households and businesses are concerned, what goes on in the basement of the BEA is utterly without consequence. You can see that as well, for example, in our leaving the stock market projection unrevised. Implicit in the way we have reacted to the news from the BEA is that households and businesses knew of the slower trajectory. Investors knew of the slower trajectory for potential GDP. It was we who were off in previously assuming an erroneously steep upward trend for potential GDP. It does change the error pattern: The pattern of errors over history is changed a bit, and at the margin, that sends us into the projection period with slightly different dynamics; but those are very small effects. (Sandy is alerting me that an important piece of news that we received was the weakness of disposable income growth in the second quarter.)" CHRG-111hhrg51592--123 Mr. Bachus," Yes. And I ask the other panel members, and the law professor--this may be outside your field, but other than the professor--who--you know, we all say there appears to be a conflict when an issuer pays for it, but who else would pay for it? I mean, is there a practical substitute? " CHRG-111hhrg48873--256 Secretary Geithner," Congressman, you are absolutely right, this goes well beyond the AIG. And the President proposed on February 4th a range of reforms to broad compensation practices, including proposing that boards of directors submit-- " CHRG-111hhrg53248--151 Mr. Scott," We continue to get complaints from some in the banking industry with certain practices. We have the Consumer Protection Agency which we are pushing, which unfortunately some are fighting very hard. And yet they are not doing the basic things that need to be done. They are not lending. What can you do to increase pressure on our banks to lend? " CHRG-111hhrg48873--281 Secretary Geithner," Technically, I think most of those will have to be fundamentally renegotiated for the risk you are raising to materialize. But it is very important that compensation practice across the industry be fundamentally reformed so that compensation is tied to long-term performance of outcomes by the firm itself. And what the President proposed on February 4th is that compensation above a certain limit, particularly in cases where the firms are getting assistance from the government, be it in the form of restricted stock that is at risk, only pays back over time only after the taxpayer is repaid. And for all firms that participate in these markets, we want them to subject their compensation proposals to a shareholder vote, so the shareholders will have the opportunity to look at these compensation practices and make their own judgment about whether they are appropriately rewarding risk and not incenting excessive risk-taking at the expense of the system as a whole. " FOMC20071211meeting--57 55,MR. STERN.," Dave, I’m having difficulty reconciling the employment and hours data for the current quarter with your forecast of no growth whatsoever. It seems to me that, even if domestic final demand doesn’t grow or grows little, we still have inventories and exports that could take up whatever output turns out to be, and we don’t know very much about those two components for the current quarter, if I understand the situation right. Alternatively, obviously you can get a very bad productivity number, and that would square the circle. But I’m wondering what we know in particular about inventories and exports that would lead us to something as weak as this forecast." CHRG-111shrg57320--225 Mr. Carter," We elevated our review of fraud risk management practices as the market began to heat up---- Senator Kaufman. Yes, but I mean, back in the beginning, and this is what scares me. We start using things like fraud, examination, whatever you just said, and it all sounds so nice and cold-blooded, but when you look down at this thing, as you say, and you look at this and you say, there is somebody committing fraud down here, and it isn't just some clerk down at the bottom doing this. They are doing something that Mr. Reich has qualified as an anathema, that everyone considers as poor banking policy, and they are doing it within 90 percent of their prime loans and 53 percent of their--somebody down there is doing something. And so it doesn't matter whether you are making money or not, to go back to the Chairman's point. This institution is making money or isn't making money. You still look at this thing and say, what is going on here? And if you knew that, I think all three of you agree, you would look into it, and I suggest that if you looked into it based on what others have said, you would have found that this just wasn't happening. This was not a coincidence. That is the only point I want to make. Am I making a fair statement, Mr. Reich? " CHRG-111shrg57320--207 Mr. Dochow," They are smaller in dollars. They are large in volumes. And the credit score, their credit reports, their loan-to-value ratios were historically the most predictive of ability to pay and those loans' performance. Senator Kaufman. So why not just ask people what their income was and have some verification for it? That is the part I am having trouble with. I got all the rest of it. I mean, we could poll everybody in this room. I don't think anyone has ever gone in, outside of maybe if they were with WaMu or some of the other banks in California which did practice this, Mr. Reich, or this business as WaMu--I don't think anybody in this room has ever gone into a loan and they said, what is your income, and they said, OK, that is enough. I am going to check your FICO score and everything else, but you don't have to document where your income is coming from. You don't have to give me a W-2 form. You don't have to do anything else. I have credit cards, I have never seen that as an experience for me. And again, I realize it started in this industry, and I think maybe it started for a good reason. And as Mr. Reich said, I think everyone would say this is an anathema. A stated loan is anathema. I think that is what most people would say. I think the two regulators who were here earlier kind of went, wow. When the folks from the two risk managers that testified the other day were concerned about this and reported their concern to management. So I am trying to figure out--because every time something like this has come down over history, the standard answer you hear--well, everybody did it. Everybody did it. And when you hear that, that is when I get very scared because what are we going to do here in the Senate so that we deal with a concept that everybody did it is--we are a Nation of laws, not a Nation of everybody did it. Mr. Reich and Mr. Dochow, would you like to comment on my concern? " CHRG-111shrg56262--19 Mr. Irving," Good afternoon, Chairman Reed, Ranking Member Bunning, and Members of the Subcommittee. Thank you for the opportunity to participate in today's panel. I have a very simple three-part message that I want to convey today. First, securitization can be a very effective mechanism for channeling capital into our economy to benefit the consumer and commercial sectors. Second, as a result of the financial crisis, the residential mortgage-backed security market and the asset-backed market are sharply bifurcated. As I will describe, some are performing well, some less so. And then, finally, third, there are four broad areas of reform worthy of pursuit to help the securitized markets function better. In my remaining time, I will elaborate on these three points. One of the most important benefits of the securitization process is that it provides loan originators an additional funding source as an alternative to conventional retail deposits. As an example, I manage the Fidelity Ginnie Mae Fund, which has doubled in size in the past year to over $7 billion in assets. The mortgage-backed security market effectively brings together shareholders in this Ginnie Mae Fund with individuals all over the country who want to purchase a home or refinance a mortgage. In this manner, securitization breaks down geographic barriers between lenders and borrowers, thereby improving the availability and cost of credit across regions. Second, to provide further insight into the value of securitization, consider what happened to the consumer ABS sector. From 2005 through 2007, auto and credit card ABS issuance was roughly $170 billion per year. However, after the collapse of Lehman Brothers in September of 2008, new issuance came to a virtual halt. As a result, the interest rate on new car loans provided by finance companies increased by about 5 percentage points between July of 2008 and year end. Issuance did not resume until March of this year, when the TALF program began. Thanks to TALF, between March and September, there was $91 billion of card and auto ABS issuance. Coincident with the resumption of a functioning auto ABS market, new car financing fell back into the 3 percent range. I will now turn to the agency mortgage market, which is also performing well, thanks to the extraordinary Government intervention over the past year. This intervention has had two parts. First, in September of 2008, Fannie Mae and Freddie Mac were placed into conservatorship, thus reassuring tens of thousands of skittish agency MBS investors that the Government stood behind their investments. Second, the Federal Reserve pledged to purchase $1.25 trillion of agency MBS by the end of 2009. So far, the Fed has purchased just over $900 billion, thus reducing significantly the spread between the yields on agency MBS and Treasuries. As of this week, the conforming balance 30-year fixed mortgage rate is approximately 4.85 percent, which is very close to a generational low. Furthermore, the agency MBS market is deep and liquid. In contrast, the new issued private label mortgage market has received no Government support and has effectively shut down. From 2001 to 2006, issuance in this market had increased almost fourfold, to $1.2 trillion. But when the financial crisis hit, the issuance quickly fell to zero. Virtually the only source of financing for mortgage above the conforming loan limit, so-called ``jumbo loans,'' is a bank loan, and generally the available rates are not that attractive. At first glance, the higher cost of jumbo financing may not seem to be an issue that should concern policymakers. But consider the following. If the cost of jumbo financing puts downward pressure on the price of homes costing, say, $800,000, then quite likely there is going to be downward pressure on the homes costing $700,000 and so forth. So in my opinion, at the same time that policymakers deliberate the future of Fannie Mae and Freddie Mac, they should consider the future of mortgage finance in all price and credit quality tiers. To help improve the functioning of the securitized markets, I recommend that regulatory and legislative efforts be concentrated in four key areas. First, promote improved disclosure to investors at the initial marketing of transactions as well as during the life of a deal. For example, there should be ample time before a deal is priced for investors to review and analyze a full prospectus, not just a term sheet. Second, strengthen credit underwriting standards in the originating process. One way to support this goal is to discourage up-front realization of issuers' profits. This issue is complex and likely will require specialized rules tailored to each market sector. Third, facilitate greater transparency of the methodology and assumptions used by the rating agencies to determine credit ratings. In particular, there should be a public disclosure of the main assumptions behind rating methodologies and models. Finally, support simpler, more uniform capital structures in securitization deals. This goal may not be readily amenable to legislative action, but should be a focus of industry best practices. Taking such steps to correct the defects of recent securitization practices will restore much-needed confidence to this critical part of our capital markets, thereby providing improved liquidity and capital to foster continued growth in the U.S. economy. Thank you, and I look forward to answering your questions. " CHRG-111hhrg51698--158 Mr. Gooch," Yes, sir. I am certainly in favor of free markets, but to some extent maybe I have been painted into a corner as somehow not being supportive of this proposed regulation. My strong position here today, and in my opening statement, was in this concept of disallowing naked credit derivatives, because of my knowledge about the market and my concern that you will kill the CDS market. That might be one of Mr. Greenberger's goals, but that it would be a big mistake for the American economy. Right now, as we know, it is very difficult for anyone to borrow money. The banks aren't lending. But some corporations can still issue debt. But one of the things that is going on in the marketplace right now is those debt issuances are very often now tied to CDS prices. Without the willing sellers of CDS that are your speculators, if you like, but I call them risk takers, who are willing to sell that credit risk, you take away a huge portion of willing lenders. They are synthetic lenders. When they sell a credit default swap, they are not lending the money, but they are a synthetic lender. They are effectively underwriting the risk. " FinancialCrisisReport--159 The FDIC risk retention requirement, followed by the risk retention requirement to be developed under the Dodd-Frank Act, should, if well implemented, end the ability of banks to magnify risk through issuing asset backed securities and then walking away from that risk. Instead, banks will be required to keep “skin in the game” until each securitization concludes. Ban on Steering. The Washington Mutual case history also exposed another problem: compensation incentives that encouraged loan officers and mortgage brokers to steer borrowers to higher risk loans. Compensation incentives called “overages” at WaMu and “yield spread premiums” at other financial institutions also encouraged loan officers and mortgage brokers to charge borrowers higher interest rates and points than the bank would accept, so that the loan officer or mortgage banker could split the extra money taken from the borrower with the bank. To ban these compensation incentives, Section 1403 of the Dodd-Frank Act creates a new Section 129B(c) in TILA prohibiting the payment of any steering incentives, including yield spread premiums. It states: “no mortgage originator shall receive from any person and no person shall pay to a mortgage originator, directly or indirectly, compensation that varies based on the terms of loan (other than the amount of the principal).” It also states explicitly that no provision of the section should be construed as “permitting any yield spread premium or other similar compensation.” In addition, it directs the Federal Reserve to issue regulations to prohibit a range of abusive and unfair mortgage related practices, including prohibiting lenders and brokers from steering borrowers to mortgages for which they lack a reasonable ability to repay. The Dodd-Frank provisions were enacted into law shortly before the Federal Reserve, in September 2010, promulgated new regulations prohibiting a number of unfair or abusive lending practices, including certain payments to mortgage originators. 593 In its notice, the Federal Reserve noted that its new regulations prohibit many of the same practices banned in Section 1403 of the Dodd Frank Act, but that it will fully implement the new Dodd-Frank measures in a future rulemaking. 594 High Risk Loans. Still another problem exposed by the Washington Mutual case history is the fact that, in the years leading up to the financial crisis, many U.S. insured banks held highly risky loans and securities in their investment and sale portfolios. When those loans and securities lost value in 2007, many banks had to declare multi-billion-dollar losses that triggered shareholder flight and liquidity runs. Section 620 of the Dodd-Frank Act requires the federal banking regulators, within 18 months, to prepare a report identifying the activities and investments that insured banks and their affiliates are allowed to engage in under federal and state law, regulation, order, and guidance, and analyzing the risks associated with those activities and investments. The federal banking agencies are also asked to make recommendations on whether each allowed activity or investment is appropriate, could negatively affect the safety and soundness of the banking entity or the U.S. financial system, and should be restricted to reduce risk. 593 75 Fed. Reg. 185 (9/24/2010). 594 Id. at 58509. (2) Recommendations CHRG-110shrg50409--101 Mr. Bernanke," At a given time, yes. Senator Bayh. Is there any limit to the amount that can be utilized through that mechanism, any practical limit? We have the investment banks partaking. If we get the GSEs partaking, I am just wondering how much more there is to be had from that mechanism. " CHRG-110hhrg34673--209 Mr. Ellison," Thank you, Mr. Chairman. I only have 5 minutes. So is the proposal--the rule proposal regarding regulation Part D, is that basically a rule--do you anticipate that rule focusing on disclosure, or will it include barring certain practices? " CHRG-111shrg57320--147 Mr. Reich," I believe the 2006 examination report states in the cover letter that risk management practices and internal control environment continue to improve in 2005. Senator Levin. Well, I read you 2006. " CHRG-111shrg51303--120 Mr. Kohn," Exactly. Senator Warner. And that AIG's practices, whether it would be in effect a mortgage securities lending business that went from $1 billion of exposure to about $100 billion of exposure between 1999 and 2007, it was a huge rise. " CHRG-111hhrg54868--64 Mr. Dugan," But we can't write a rule under that. Only the Federal Reserve can. We have requested that authority. Mr. Miller of North Carolina. You can bring enforcement actions with respect to specific practices as a violation of the-- " FOMC20061025meeting--15 13,MS. YELLEN.," Thank you, Mr. Chairman. I have a question for David, and it concerns the Greenbook alternative scenarios and the morals we should draw from them concerning the Committee’s ability to affect inflation. The Greenbook this time had two scenarios showing how the forecast would be affected by shocks to aggregate demand. One was a stronger demand scenario; the other a housing correction with spillovers. Demand, of course, is much weaker in that second scenario. In both of them, unemployment by the end of 2008 deviates markedly from baseline, but even so there is virtually no effect on core inflation. It falls just 0.1 percent by the end of 2008 in the negative housing shock scenario, even though unemployment rises to 6 percent. When I actually took a magnifying glass to the panel on page I-21 to look at the core inflation paths, the shocks appeared actually to have a perverse effect on core inflation. The housing correction shock has a perverse effect on core inflation in mid-2007, with inflation actually up in the weak demand scenario and down a bit in the case where demand strengthens. Now, I scratched my head and asked myself if I could I invent a reason that this might occur. My thoughts went to possible repercussions on the exchange rate that might have an inflationary effect. But my trusty staff told me that it might be something else entirely—namely, the way inflation expectations are modeled in FRB/US. They told me that inflation expectations in these simulations aren’t much affected by any movement in unemployment with shocks like this because implicitly those forming inflation expectations take the shock to be transitory. But expectations are perturbed, and perversely so, by the reaction of the Fed to the shocks. In other words, the Taylor rule type response that’s embodied in the scenarios has the Fed lowering the fed funds rate to address economic weakness following a downside housing shock. My staff tells me that the Fed’s cut to address the weakness then raises expected inflation, which passes through into inflation in these scenarios, and that’s why we get a stronger housing correction perversely raising inflation. Would you comment generally on this? Do I have the correct understanding of how it works? If I do, do these simulations give an unduly pessimistic assessment of the effect of aggregate demand shocks both on inflation and on our Committee’s ability to affect inflation through policy? Is it plausible to assume in your view that easier monetary policy has this direct effect on inflation expectations, even when all it’s doing is offsetting a demand shock?" FOMC20080130meeting--396 394,MR. LOCKHART.," I'd like to ask as a practical matter what weighting we should put in our expectations or even our recommendations on reform of the rating system versus the expectation that investors would actually reduce their reliance on ratings. My impression is that many institutional investors, especially public pension funds, are notoriously understaffed. Then they work for, as you pointed out in your presentation, boards that either represent the beneficiaries or in some respects are quite political in nature and not necessarily financially sophisticated. That would lead me to the conclusion that, as a practical matter, they're going to be highly reliant on ratings. The ratio of professional employees to the volume of investment is so low that they have to choose their restaurants by stars because they don't have time to do the tasting themselves or they're not given the budgets to do that now. So I'm curious about this tension between getting the rating system right versus having the investors reduce their reliance on ratings. " CHRG-111hhrg54867--173 Mr. Watt," I am not minimizing the people who were outside any regulatory framework, but folks who were inside the regulatory framework got involved in these things with regulators that had responsibility first and foremost for their safety and soundness which they didn't do a real good job of either, as it turned out, because of these bad consumer products. But even when they turned their attention to it, their primary focus was getting out of the ditch on safety and soundness and getting the economy back on an even keel. Even then, it really wasn't about consumers. And it seems to me that if we are going to talk about practical considerations, the only way you are going to solve that practical consideration is to create an agency that goes to work every morning saying, my primary responsibility is to protect consumers. And if I run into a conflict between that and the safety and soundness regulator, then there is a mechanism for resolving that conflict, but there is no question what responsibility I have every day of the week when I go to work. Do you agree with that? " FOMC20060328meeting--289 287,MS. YELLEN.," I would just endorse President Minehan’s summary of reactions and the comments that have been made around the table. I think the innovations in this meeting have been excellent. I think the meeting has run very well. Having more time has certainly enriched the discussion of both the economy and the policy situation. I agree, too, with President Minehan’s suggestion that there will be times when we probably do not need two days. I have also been around through some calm times, when there was just not that much to discuss on the policy front, and I think we need some flexibility. Special topics, I completely agree, are very, very worthwhile, and I would not want to see them go. On the practical front, I would endorse President Poole’s concern about conflicts with board meetings. You know, for me there would be no way of getting back for Wednesday afternoon. We begin our board meetings on Wednesday afternoon as well. So that’s a practical concern." CHRG-110hhrg38392--11 Mr. Bernanke," I will do my opening statement. Thank you. Chairman Frank, Ranking Member Bachus, and members of the committee, I am pleased to present the Federal Reserve's Monetary Policy Report to the Congress. As you know, this occasion marks the 30th year of semiannual testimony on the economy and monetary policy for the Federal Reserve. In establishing these hearings--Mr. Hawkins and Mr. Humphrey were mentioned--the Congress proved prescient in anticipating the worldwide trend toward greater transparency and accountability of central banks in making monetary policy. Over the years, these testimonies and the associated reports have proved an invaluable vehicle for the Federal Reserve's communication with the public about monetary policy, even as they have served to enhance the Federal Reserve's accountability for achieving the dual objectives of maximum employment and price stability set forth by the Congress. I take this opportunity to reiterate the Federal Reserve's strong support of the dual mandate. In pursuing maximum employment and price stability, monetary policy makes its greatest possible contribution to the general economic welfare. Let me now review the current economic situation and the outlook beginning with developments in the real economy and the situation regarding inflation before turning to monetary policy. I will conclude with comments on issues related to lending to households and consumer protection, topics not normally addressed in monetary policy testimony, but in light of recent developments deserving of our attention today. After having run at an above-trend rate earlier in the current economic recovery, U.S. economic growth has proceeded during the past year at a pace more consistent with sustainable expansion. Despite the downshift in growth, the demand for labor has remained solid with more than 850,000 jobs being added to payrolls thus far in 2007 and the unemployment rate having remained at 4\1/2\ percent. The combination of moderate gains in output and solid advances in employment implies that recent increases in labor productivity have been modest by the standards of the last decade. The cooling of productivity growth in recent quarters is likely the result of cyclical or other temporary factors, but the underlying pace of productivity gains may also have slowed somewhat. To a considerable degree, the slower pace of economic growth in recent quarters reflects the ongoing adjustment in the housing sector. Over the past year, home sales in construction have slowed substantially and house prices have decelerated. Although a leveling off of home sales in the second half of 2006 suggested some tentative stabilization of housing demand, sales have softened further this year, leading the number of unsold new homes in builders' inventories to rise further relative to the pace of new home sales. Accordingly, construction of new homes has sunk further, with starts of new single family houses thus far this year running 10 percent below the pace in the second half of last year. The pace of home sales seems likely to remain sluggish for a time, partly as a result of some tightening and lending standards and the recent increase in mortgage interest rates. Sales should ultimately be supported by growth in income and employment, as well as by mortgage rates that--despite the recent increase--remain fairly low relative to historical norms. However, even if demand stabilizes as we expect, the pace of construction will probably fall somewhat further as builders work down the stocks of unsold new homes. Thus, declines in residential construction will likely continue to weigh on economic growth over coming quarters, although the magnitude of the drag on growth should diminish over time. Real consumption expenditures appear to have slowed last quarter following two quarters of rapid expansion. Consumption outlays are likely to continue growing at a moderate pace, aided by a strong labor market. Employment should continue to expand, though possibly at a somewhat slower pace than in recent years as a result of the recent moderation in the growth of output and ongoing demographic shifts that are expected to lead to a gradual decline in labor force participation. Real compensation appears to have risen over the past year, and barring further sharp increases in consumer energy costs, it should rise further as labor demand remains strong and productivity increases. In the business sector, investment in equipment and software showed a modest gain in the first quarter. A similar outcome is likely for the second quarter, as weakness in the volatile transportation equipment category appears to have been offset by solid gains in other categories. Investment in nonresidential structures, after slowing sharply late last year, seems to have grown fairly vigorously in the first half of 2007. Like consumption spending, business fixed investment overall seems poised to rise at a moderate pace, bolstered by gains in sales and generally favorable financial conditions. Late last year and early this year, motor vehicle manufacturers and firms in several other industries found themselves with elevated inventories, which led them to reduce production to better align inventories with sales. Excess inventories now appear to have been substantially eliminated and should not prove a further restraint on growth. The global economy continues to be strong. Supported by solid economic growth abroad, U.S. exports should expand further in coming quarters. Nonetheless our trade deficit, which was about 5\1/4\ percent of nominal gross domestic product in the first quarter, is likely to remain high. For the most part, financial markets have remained supportive of economic growth. However, conditions in the subprime mortgage sector have deteriorated significantly reflecting mounting delinquency rates on adjustment rate loans. In recent weeks, we have also seen increased concerns among investors about credit risk on some other types of financial instruments. Credit spreads on lower quality corporate debt have widened somewhat and terms for some leveraged business loans have tightened. Even after their recent rise, however, credit spreads remain near the low end of their historical ranges and financing activity in the bond and business loan markets has remained fairly brisk. Overall, the U.S. economy appears likely to expand at a moderate pace over the second half of 2007 with growth then strengthening a bit in 2008 to a rate close to the economy's underlying trend. Such an assessment was made around the time of the June meeting of the Federal Market Committee by the members of the Board of Governors and the presidents of the Reserve Banks, all of whom participate in deliberations on monetary policy. The central tendency of the growth forecast, which are conditioned on the assumption of appropriate monetary policy, is for real GDP to expand roughly 2\1/4\ to 2\1/2\ percent this year and 2\1/2\ to 2\3/4\ percent in 2008. The forecasted performance for this year is about \1/4\ percentage point below that projected in February, the difference being largely a result of weaker than expected residential construction activity this year. The unemployment rate is anticipated to edge up between 4\1/2\ and 4\3/4\ percent over the balance of this year and about 4\3/4\ percent in 2008, a trajectory about the same as the one expected in February. I turn now to the inflation situation. Sizable increases in food and energy prices have boosted overall inflation and eroded real incomes in recent months, both unwelcome developments. As measured by changes in the price index for personal consumption expenditures (PCE inflation), inflation ran at an annual rate of 4.4 percent over the first 5 months of this year, a rate that, if maintained, would clearly be inconsistent with the objective of price stability. Because monetary policy works with a lag, however, policymakers must focus on the economic outlook. Food and energy prices tend to be quite volatile, so that, looking forward, core inflation (which excludes food and energy prices) may be a better gauge than overall inflation of underlying inflation trends. Core inflation has moderated slightly over the past few months, with core PCE inflation coming in at an annual rate of about 2 percent so far this year. Although the most recent readings on core inflation have been favorable, month-to-month movements in inflation are subject to considerable noise, and some of the recent improvement could also be the result of transitory influences. However, with long-term inflation expectations contained, futures prices suggesting that investors expect energy and other commodity prices to flatten out, and pressures in both labor and product markets likely to ease modestly, core inflation should edge a bit lower, on net, over the remainder of this year and next year. The central tendency of FOMC participants' forecast for core PCE inflation--2 to 2\1/4\ percent for 2007 and 1\3/4\ to 2 percent in 2008--is unchanged from February. If energy prices level off as currently anticipated, overall inflation should slow to a pace close to that of core inflation in coming quarters. At each of its four meetings so far this year, the FOMC has maintained its target for the Federal funds rate at 5\1/4\ percent, judging that the existing stance of policy was likely to be consistent with growth running near trend and inflation staying on a moderating path. As always, in determining the appropriate stance of policy, we will be alert to the possibility that the economy is not evolving in the way we currently judge to be the most likely. One risk to the outlook is that the ongoing housing correction might prove larger than anticipated with possible spillovers onto consumer spending. Alternatively, consumer spending, which has advanced relatively vigorously, on balance, in recent quarters, might expand more quickly than expected; in that case, economic growth could rebound to a pace above its trend. With the level of resource utilization already elevated, the resulting pressures in labor and product markets could lead to increased inflation over time. Yet another risk is that energy and commodity prices could continue to rise sharply leading to further increases in headline inflation, and if those costs pass through to the prices of nonenergy goods and services, to higher core inflation as well. Moreover, if inflation were to move higher for an extended period and the increase became embedded in longer-term inflation expectations, the reestablishment of price stability would become more difficult and costly to achieve. With the level of resource utilization relatively high and with the sustained moderation in inflation pressures yet to be convincingly demonstrated, the FOMC has consistently stated that upside risks to inflation are its predominant policy concern. In addition to its dual mandate to promote maximum employment and price stability, the Federal Reserve has an important responsibility to help protect consumers in financial services transactions. For nearly 40 years, the Federal Reserve has been active in implementing, interpreting, and enforcing consumer protection laws. I would like to discuss with you this morning some of our recent initiatives and actions, particularly those related to subprime mortgage lending. Promoting access to credit and to home ownership are important objectives, and responsible subprime mortgage lending can help to advance both goals. In designing regulations, policymakers should seek to preserve those benefits. That said, the recent rapid expansion of the subprime market was clearly accompanied by deterioration in underwriting standards, and in some cases, by abusive lending practices and outright fraud. In addition, some households took on mortgage obligations they could not meet, perhaps in some cases because they did not fully understand the terms. Financial losses have subsequently induced lenders to tighten their underwriting standards. Nevertheless, rising delinquencies in foreclosures are creating personal, economic, and social distress for many homeowners and communities, problems that likely will get worse before they get better. The Federal Reserve is responding to these difficulties at both the national and the local levels. In coordination with other Federal supervisory agencies, we are encouraging the financial industry to work with borrowers to arrange prudent loan modifications to avoid unnecessary foreclosures. Federal Reserve banks around the country are cooperating with community and industry groups that work directly with borrowers who are having trouble meeting their mortgage obligations. We continue to work with organizations that provide counseling about mortgage products to current and potential homeowners. We are also meeting with market participants--including lenders, investors, servicers, and community groups--to discuss their concerns and to gain information about market developments. We are conducting a top-to-bottom review of possible actions we might take to help prevent recurrence of these problems. First, we are committed to providing more effective disclosures to help consumers defend against improper lending. Three years ago, the Board began a comprehensive review of Regulation Z, which implements the Truth in Lending Act (TILA). The initial focus of our review was on disclosures related to credit cards and other revolving credit accounts. After conducting extensive consumer testing, we issued a proposal in May that would require credit card issuers to provide clearer and easier-to-understand disclosures to customers. In particular, the new disclosures would highlight applicable rates and fees, particularly penalties that might be imposed. The proposed rules would also require card issuers to provide 45 days' advance notice of a rate increase or any other change in account terms so that consumers will not be surprised by unexpected charges and will have time to explore alternatives. We are now engaged in a similar review of the TILA rules for mortgage loans. We began this review last year by holding four public hearings across the country during which we gathered information on the adequacy of disclosures for mortgages, particularly for nontraditional and adjustable rate products. As we did with credit card lending, we will conduct extensive consumer testing of proposed disclosures. Because the process of designing and testing disclosures involves many trial runs, especially given today's diverse and sometimes complex credit products, it may take some time to complete our review and propose new disclosures. However, some other actions can be implemented more quickly. By the end of this year, we will propose changes to TILA rules to address concerns about mortgage loan advertisements and solicitations that may be incomplete or misleading and to require lenders to provide mortgage disclosures more quickly so that consumers can get the information they need when it is most useful to them. We already have improved a disclosure that creditors must provide to every applicant for an adjustable rate mortgage to explain better the features and risks of these products, such as ``payment shock'' and rising loan balances. We are certainly aware, however, that disclosure alone may not be sufficient to protect consumers. Accordingly, we plan to exercise our authority under the Home Ownership and Equity Protection Act (HOEPA) to address specific practices that are unfair or deceptive. We held a public hearing on June 14th to discuss industry practices, including those pertaining to prepayment penalties, the use of escrow accounts for taxes and insurance, stated income and low documentation lending, and the evaluation of a borrower's ability to repay. The discussion and ideas we heard were extremely useful, and we look forward to receiving additional public comments in coming weeks. Based on the information we are gathering, I expect that the Board will propose additional rules under HOEPA later this year. In coordination with the other Federal supervisory agencies, last year we issued principles-based guidance on nontraditional mortgages, and in June of this year, we issued supervisory guidance on subprime lending. These statements emphasize the fundamental consumer protection principles of sound underwriting and effective disclosures. In addition, we reviewed our policies related to the examination of nonbank subsidiaries of bank and financial holding companies for compliance with consumer protection laws and guidance. As a result of that review, and following discussions with the Office of Thrift Supervision, the Federal Trade Commission, and State regulators, as represented by the Conference of State Bank Supervisors and the American Association of Residential Mortgage Regulators, we are launching a cooperative pilot project aimed at expanding consumer protection compliance reviews at selected nondepository lenders with significant subprime mortgage operation. These reviews will begin in the fourth quarter of this year and will include independent State-licensed mortgage lenders, nondepository mortgage lending subsidiaries of bank and thrift holding companies, and mortgage brokers doing business with or serving as agents of these entities. The agencies will collaborate in determining the lessons learned and in seeking ways to better cooperate in ensuring effective and consistent examinations and improved enforcement for nondepository mortgage lenders. Working together to address jurisdictional issues and to improve information sharing among agencies, we will seek to prevent abusive and fraudulent lending while ensuring that consumers retain access to beneficial credit. I believe that the actions I have described today will help address the current problems. The Federal Reserve looks forward to working with the Congress on these important issues. Thank you, Mr. Chairman. [The prepared statement of Chairman Bernanke can be found on page 65 of the appendix.] " CHRG-111hhrg58044--70 Mr. Snyder," Mr. Price, the FTC estimated that 59 percent of the people pay less as a result of credit-based insurance scores. Frankly, in public testimony given by companies in the States, the numbers are really much higher for many companies. We would envision first of all a very negative effect on the vast majority of policyholders directly. Secondly, it would deprive the market of a critical tool that has allowed the market to evolve much more toward objective underwriting individually tailored to each risk, which in turn is giving the companies the confidence to write virtually everybody. Under the old system that was sort of pass/fail, you were either very good, normal or you were relegated to the high cost assigned risk plans. Now, because of the tool that is capable of individual accurate and objective risk assessment, insurance companies are pretty much able to write anyone who comes to them, which has resulted in the shrinkage to historic lows of these high risk pools, so there are a number of harms that would come, some directly, to the majority of policyholders, and then indirectly to a market as a whole resulting in less competition and potentially less availability of insurance. " CHRG-110shrg46629--144 PREPARED STATEMENT OF BEN S. BERNANKE Chairman, Board of Governors of the Federal Reserve System July 19, 2007 Chairman Dodd, Ranking Member Shelby, and Members of the Committee, I am pleased to present the Federal Reserve's Monetary Policy Report to the Congress. As you know, this occasion marks the 30th year of semiannual testimony on the economy and monetary policy by the Federal Reserve. In establishing these hearings, the Congress proved prescient in anticipating the worldwide trend toward greater transparency and accountability of central banks in the making of monetary policy. Over the years, these testimonies and the associated reports have proved an invaluable vehicle for the Federal Reserve's communication with the public about monetary policy, even as they have served to enhance the Federal Reserve's accountability for achieving the dual objectives of maximum employment and price stability set for it by the Congress. I take this opportunity to reiterate the Federal Reserve's strong support of the dual mandate; in pursuing maximum employment and price stability, monetary policy makes its greatest possible contribution to the general economic welfare. Let me now review the current economic situation and the outlook, beginning with developments in the real economy and the situation regarding inflation before turning to monetary policy. I will conclude with comments on issues related to lending to households and consumer protection--topics not normally addressed in monetary policy testimony but, in light of recent developments, deserving of our attention today. After having run at an above-trend rate earlier in the current economic recovery, U.S. economic growth has proceeded during the past year at a pace more consistent with sustainable expansion. Despite the downshift in growth, the demand for labor has remained solid, with more than 850,000 jobs having been added to payrolls thus far in 2007 and the unemployment rate having remained at 4\1/2\ percent. The combination of moderate gains in output and solid advances in employment implies that recent increases in labor productivity have been modest by the standards of the past decade. The cooling of productivity growth in recent quarters is likely the result of cyclical or other temporary factors, but the underlying pace of productivity gains may also have slowed somewhat. To a considerable degree, the slower pace of economic growth in recent quarters reflects the ongoing adjustment in the housing sector. Over the past year, home sales and construction have slowed substantially and house prices have decelerated. Although a leveling-off of home sales in the second half of 2006 suggested some tentative stabilization of housing demand, sales have softened further this year, leading the number of unsold new homes in builders' inventories to rise further relative to the pace of new home sales. Accordingly, construction of new homes has sunk further, with starts of new single-family houses thus far this year running 10 percent below the pace in the second half of last year. The pace of home sales seems likely to remain sluggish for a time, partly as a result of some tightening in lending standards and the recent increase in mortgage interest rates. Sales should ultimately be supported by growth in income and employment as well as by mortgage rates that--despite the recent increase--remain fairly low relative to historical norms. However, even if demand stabilizes as we expect, the pace of construction will probably fall somewhat further as builders work down stocks of unsold new homes. Thus, declines in residential construction will likely continue to weigh on economic growth over coming quarters, although the magnitude of the drag on growth should diminish over time. Real consumption expenditures appear to have slowed last quarter, following two quarters of rapid expansion. Consumption outlays are likely to continue growing at a moderate pace, aided by a strong labor market. Employment should continue to expand, though possibly at a somewhat slower pace than in recent years as a result of the recent moderation in the growth of output and ongoing demographic shifts that are expected to lead to a gradual decline in labor force participation. Real compensation appears to have risen over the past year, and barring further sharp increases in consumer energy costs, it should rise further as labor demand remains strong and productivity increases. In the business sector, investment in equipment and software showed a modest gain in the first quarter. A similar outcome is likely for the second quarter, as weakness in the volatile transportation equipment category appears to have been offset by solid gains in other categories. Investment in nonresidential structures, after slowing sharply late last year, seems to have grown fairly vigorously in the first half of 2007. Like consumption spending, business fixed investment overall seems poised to rise at a moderate pace, bolstered by gains in sales and generally favorable financial conditions. Late last year and early this year, motor vehicle manufacturers and firms in several other industries found themselves with elevated inventories, which led them to reduce production to better align inventories with sales. Excess inventories now appear to have been substantially eliminated and should not prove a further restraint on growth. The global economy continues to be strong. Supported by solid economic growth abroad, U.S. exports should expand further in coming quarters. Nonetheless, our trade deficit--which was about 5\1/4\ percent of nominal gross domestic product (GDP) in the first quarter--is likely to remain high. For the most part, financial markets have remained supportive of economic growth. However, conditions in the subprime mortgage sector have deteriorated significantly, reflecting mounting delinquency rates on adjustable-rate loans. In recent weeks, we have also seen increased concerns among investors about credit risk on some other types of financial instruments. Credit spreads on lower-quality corporate debt have widened somewhat, and terms for some leveraged business loans have tightened. Even after their recent rise, however, credit spreads remain near the low end of their historical ranges, and financing activity in the bond and business loan markets has remained fairly brisk. Overall, the U.S. economy appears likely to expand at a moderate pace over the second half of 2007, with growth then strengthening a bit in 2008 to a rate close to the economy's underlying trend. Such an assessment was made around the time of the June meeting of the Federal Open Market Committee (FOMC) by the members of the Board of Governors and the presidents of the Reserve Banks, all of whom participate in deliberations on monetary policy. The central tendency of the growth forecasts, which are conditioned on the assumption of appropriate monetary policy, is for real GDP to expand roughly 2\1/4\ to 2\1/2\ percent this year and 2\1/2\ to 2\3/4\ percent in 2008. The forecasted performance for this year is about \1/4\ percentage point below that projected in February, the difference being largely the result of weaker-than-expected residential construction activity this year. The unemployment rate is anticipated to edge up to between 4\1/2\ and 4\3/4\ percent over the balance of this year and about 4\3/4\ percent in 2008, a trajectory about the same as the one expected in February. I turn now to the inflation situation. Sizable increases in food and energy prices have boosted overall inflation and eroded real incomes in recent months--both unwelcome developments. As measured by changes in the price index for personal consumption expenditures (PCE inflation), inflation ran at an annual rate of 4.4 percent over the first 5 months of this year, a rate that, if maintained, would clearly be inconsistent with the objective of price stability.\1\ Because monetary policy works with a lag, however, policymakers must focus on the economic outlook. Food and energy prices tend to be quite volatile, so that, looking forward, core inflation (which excludes food and energy prices) may be a better gauge than overall inflation of underlying inflation trends. Core inflation has moderated slightly over the past few months, with core PCE inflation coming in at an annual rate of about 2 percent so far this year.--------------------------------------------------------------------------- \1\ Despite the recent surge, total PCE inflation is 2.3 percent over the past 12 months.--------------------------------------------------------------------------- Although the most recent readings on core inflation have been favorable, month-to-month movements in inflation are subject to considerable noise, and some of the recent improvement could also be the result of transitory influences. However, with long-term inflation expectations contained, futures prices suggesting that investors expect energy and other commodity prices to flatten out, and pressures in both labor and product markets likely to ease modestly, core inflation should edge a bit lower, on net, over the remainder of this year and next year. The central tendency of FOMC participants' forecasts for core PCE inflation--2 to 2\1/4\ percent for 2007 and 1\3/4\ to 2 percent in 2008--is unchanged from February. If energy prices level off as currently anticipated, overall inflation should slow to a pace close to that of core inflation in coming quarters. At each of its four meetings so far this year, the FOMC maintained its target for the Federal funds rate at 5\1/4\ percent, judging that the existing stance of policy was likely to be consistent with growth running near trend and inflation staying on a moderating path. As always, in determining the appropriate stance of policy, we will be alert to the possibility that the economy is not evolving in the way we currently judge to be the most likely. One risk to the outlook is that the ongoing housing correction might prove larger than anticipated, with possible spillovers onto consumer spending. Alternatively, consumer spending, which has advanced relatively vigorously, on balance, in recent quarters, might expand more quickly than expected; in that case, economic growth could rebound to a pace above its trend. With the level of resource utilization already elevated, the resulting pressures in labor and product markets could lead to increased inflation over time. Yet another risk is that energy and commodity prices could continue to rise sharply, leading to further increases in headline inflation and, if those costs passed through to the prices of nonenergy goods and services, to higher core inflation as well. Moreover, if inflation were to move higher for an extended period and that increase became embedded in longer-term inflation expectations, the reestablishment of price stability would become more difficult and costly to achieve. With the level of resource utilization relatively high and with a sustained moderation in inflation pressures yet to be convincingly demonstrated, the FOMC has consistently stated that upside risks to inflation are its predominant policy concern. In addition to its dual mandate to promote maximum employment and price stability, the Federal Reserve has an important responsibility to help protect consumers in financial services transactions. For nearly 40 years, the Federal Reserve has been active in implementing, interpreting, and enforcing consumer protection laws. I would like to discuss with you this morning some of our recent initiatives and actions, particularly those related to subprime mortgage lending. Promoting access to credit and to homeownership are important objectives, and responsible subprime mortgage lending can help advance both goals. In designing regulations, policymakers should seek to preserve those benefits. That said, the recent rapid expansion of the subprime market was clearly accompanied by deterioration in underwriting standards and, in some cases, by abusive lending practices and outright fraud. In addition, some households took on mortgage obligations they could not meet, perhaps in some cases because they did not fully understand the terms. Financial losses have subsequently induced lenders to tighten their underwriting standards. Nevertheless, rising delinquencies and foreclosures are creating personal, economic, and social distress for many homeowners and communities--problems that likely will get worse before they get better. The Federal Reserve is responding to these difficulties at both the national and the local levels. In coordination with the other Federal supervisory agencies, we are encouraging the financial industry to work with borrowers to arrange prudent loan modifications to avoid unnecessary foreclosures. Federal Reserve Banks around the country are cooperating with community and industry groups that work directly with borrowers having trouble meeting their mortgage obligations. We continue to work with organizations that provide counseling about mortgage products to current and potential homeowners. We are also meeting with market participants--including lenders, investors, servicers, and community groups--to discuss their concerns and to gain information about market developments. We are conducting a top-to-bottom review of possible actions we might take to help prevent recurrence of these problems. First, we are committed to providing more-effective disclosures to help consumers defend against improper lending. Three years ago, the Board began a comprehensive review of Regulation Z, which implements the Truth in Lending Act (TILA). The initial focus of our review was on disclosures related to credit cards and other revolving credit accounts. After conducting extensive consumer testing, we issued a proposal in May that would require credit card issuers to provide clearer and easier-to-understand disclosures to customers. In particular, the new disclosures would highlight applicable rates and fees, particularly penalties that might be imposed. The proposed rules would also require card issuers to provide 45 days' advance notice of a rate increase or any other change in account terms so that consumers will not be surprised by unexpected charges and will have time to explore alternatives. We are now engaged in a similar review of the TILA rules for mortgage loans. We began this review last year by holding four public hearings across the country, during which we gathered information on the adequacy of disclosures for mortgages, particularly for nontraditional and adjustable-rate products. As we did with credit card lending, we will conduct extensive consumer testing of proposed disclosures. Because the process of designing and testing disclosures involves many trial runs, especially given today's diverse and sometimes complex credit products, it may take some time to complete our review and propose new disclosures. However, some other actions can be implemented more quickly. By the end of the year, we will propose changes to TILA rules to address concerns about mortgage loan advertisements and solicitations that may be incomplete or misleading and to require lenders to provide mortgage disclosures more quickly so that consumers can get the information they need when it is most useful to them. We already have improved a disclosure that creditors must provide to every applicant for an adjustable-rate mortgage product to explain better the features and risks of these products, such as ``payment shock'' and rising loan balances. We are certainly aware, however, that disclosure alone may not be sufficient to protect consumers. Accordingly, we plan to exercise our authority under the Home Ownership and Equity Protection Act (HOEPA) to address specific practices that are unfair or deceptive. We held a public hearing on June 14 to discuss industry practices, including those pertaining to prepayment penalties, the use of escrow accounts for taxes and insurance, stated-income and low-documentation lending, and the evaluation of a borrower's ability to repay. The discussion and ideas we heard were extremely useful, and we look forward to receiving additional public comments in coming weeks. Based on the information we are gathering, I expect that the Board will propose additional rules under HOEPA later this year. In coordination with the other Federal supervisory agencies, last year we issued principles-based guidance on nontraditional mortgages, and in June of this year we issued supervisory guidance on subprime lending. These statements emphasize the fundamental consumer protection principles of sound underwriting and effective disclosures. In addition, we reviewed our policies related to the examination of nonbank subsidiaries of bank and financial holding companies for compliance with consumer protection laws and guidance. As a result of that review and following discussions with the Office of Thrift Supervision, the Federal Trade Commission, and State regulators, as represented by the Conference of State Bank Supervisors and the American Association of Residential Mortgage Regulators, we are launching a cooperative pilot project aimed at expanding consumer protection compliance reviews at selected nondepository lenders with significant subprime mortgage operations. The reviews will begin in the fourth quarter of this year and will include independent State-licensed mortgage lenders, nondepository mortgage lending subsidiaries of bank and thrift holding companies, and mortgage brokers doing business with or serving as agents of these entities. The agencies will collaborate in determining the lessons learned and in seeking ways to better cooperate in ensuring effective and consistent examinations of and improved enforcement for nondepository mortgage lenders. Working together to address jurisdictional issues and to improve information-sharing among agencies, we will seek to prevent abusive and fraudulent lending while ensuring that consumers retain access to beneficial credit. I believe that the actions I have described today will help address the current problems. The Federal Reserve looks forward to working with the Congress on these important issues." FOMC20070509meeting--39 37,MR. STOCKTON.," Well, you could do it either way. We did not take, for example, the last month’s incredible weakness in new-home sales at face value. We take a six-month moving average, calculate what we think the months’ supply is based on that, and have months’ supply come back to a more normal level over time. So it is like an inventory-sales ratio. The production adjustments that we have incorporated in this forecast basically bring that inventory-sales ratio most of the way back toward normal by the end of 2008, but not all the way." FOMC20080310confcall--41 39,MR. DUDLEY.," We are proposing the rough size of the facility today. As we gain experience with the facility and examine market conditions, we will be keeping the FOMC apprised of the programs and certainly seeking the input of the Committee on how to take this going forward. I hope that we will get a lot of feedback as we go through this auction process. If the bidding is very strong and if the markets are under tremendous distress, then we would probably want to increase the size of the program. Conversely, if the bidding is weak and if the markets settle down, then we would want to wrap up this program pretty quickly. " CHRG-111shrg56415--83 PREPARED STATEMENT OF DANIEL K. TARULLO Member, Board of Governors of the Federal Reserve System October 14, 2009 Chairman Johnson, Ranking Member Crapo, and members of the Subcommittee, thank you for your invitation to discuss the condition of the U.S. banking industry. First, I will review the current conditions in financial markets and the overall economy and then turn to the performance of the banking system, highlighting particular challenges in commercial real estate (CRE) and other loan portfolios. Finally, I will address the Federal Reserve's regulatory and supervisory responses to these challenges.Conditions in Financial Markets and the Economy Conditions and sentiment in financial markets have continued to improve in recent months. Pressures in short-term funding markets have eased considerably, broad stock price indexes have increased, risk spreads on corporate bonds have narrowed, and credit default swap spreads for many large bank holding companies, a measure of perceived riskiness, have declined. Despite improvements, stresses remain in financial markets. For example, corporate bond spreads remain quite high by historical standards, as both expected losses and risk premiums remain elevated. Economic growth appears to have moved back into positive territory last quarter, in part reflecting a pickup in consumer spending and a slight increase in residential investment--two components of aggregate demand that had dropped to very low levels earlier in the year. However, the unemployment rate has continued to rise, reaching 9.8 percent in September, and is unlikely to improve materially for some time. Against this backdrop, borrowing by households and businesses has been weak. According to the Federal Reserve's Flow of Funds accounts, household and nonfinancial business debt contracted in the first half of the year and appears to have decreased again in the third quarter. For households, residential mortgage debt and consumer credit fell sharply in the first half; the decline in consumer credit continued in July and August. Nonfinancial business debt also decreased modestly in the first half of the year and appears to have contracted further in the third quarter as net decreases in commercial paper, commercial mortgages, and bank loans more than offset a solid pace of corporate bond issuance. At depository institutions, loans outstanding fell in the second quarter of 2009. In addition, the Federal Reserve's weekly bank credit data suggests that bank loans to households and to nonfinancial businesses contracted sharply in the third quarter. These declines reflect the fact that weak economic growth can both damp demand for credit and lead to tighter credit supply conditions. The results from the Federal Reserve's Senior Loan Officer Opinion Survey on Bank Lending Practices indicate that both the availability and demand for bank loans are well below pre-crisis levels. In July, more banks reported tightening their lending standards on consumer and business loans than reported easing, although the degree of net tightening was well below levels reported last year. Almost all of the banks that tightened standards indicated concerns about a weaker or more uncertain economic outlook, and about one-third of banks surveyed cited concerns about deterioration in their own current or future capital positions. The survey also indicates that demand for consumer and business loans has remained weak. Indeed, decreased loan demand from creditworthy borrowers was the most common explanation given by respondents for the contraction of business loans this year. Taking a longer view of cycles since World War II, changes in debt flows have tended to lag behind changes in economic activity. Thus, it would be unusual to see a return to a robust and sustainable expansion of credit until after the overall economy begins to recover. Credit losses at banking organizations continued to rise through the second quarter of this year, and banks face risks of sizable additional credit losses given the outlook for production and employment. In addition, while the decline in housing prices slowed in the second quarter, continued adjustments in the housing market suggest that foreclosures and mortgage loan loss severities are likely to remain elevated. Moreover, prices for both existing commercial properties and for land, which collateralize commercial and residential development loans, have declined sharply in the first half of this year, suggesting that banks are vulnerable to significant further deterioration in their CRE loans. In sum, banking organizations continue to face significant challenges, and credit markets are far from fully healed.Performance of the Banking System Despite these challenges, the stability of the banking system has improved since last year. Many financial institutions have been able to raise significant amounts of capital and have achieved greater access to funding. Moreover, through the rigorous Supervisory Capital Assessment Program (SCAP) stress test conducted by the banking agencies earlier this year, some institutions demonstrated that they have the capacity to withstand more-adverse macroeconomic conditions than are expected to develop and have repaid the government's Troubled Asset Relief Program (TARP) investments.\1\ Depositors' concerns about the safety of their funds during the immediate crisis last year have also largely abated. As a result, financial institutions have seen their access to core deposit funding improve.--------------------------------------------------------------------------- \1\ For more information about the SCAP, see Ben S. Bernanke (2009), ``The Supervisory Capital Assessment Program,'' speech delivered at the Federal Reserve Bank of Atlanta 2009 Financial Markets Conference, held in Jekyll Island, Ga., May 11, www.Federalreserve.gov/newsevents/speech/bernanke20090511a.htm.--------------------------------------------------------------------------- However, the banking system remains fragile. Nearly 2 years into a substantial recession, loan quality is poor across many asset classes and, as noted earlier, continues to deteriorate as lingering weakness in housing markets affects the performance of residential mortgages and construction loans. Higher loan losses are depleting loan loss reserves at many banking organizations, necessitating large new provisions that are producing net losses or low earnings. In addition, although capital ratios are considerably higher than they were at the start of the crisis for many banking organizations, poor loan quality, subpar earnings, and uncertainty about future conditions raise questions about capital adequacy for some institutions. Diminished loan demand, more-conservative underwriting standards in the wake of the crisis, recessionary economic conditions, and a focus on working out problem loans have also limited the degree to which banks have added high quality loans to their portfolios, an essential step to expanding profitable assets and thus restoring earnings performance. These developments have raised the number of problem banks to the highest level since the early 1990s, and the rate of bank and thrift failures has accelerated throughout the year. Moreover, the estimated loss rates for the deposit insurance fund on bank failures have been very high, generally hovering near 30 percent of assets. This high loss level reflects the rapidity with which loan quality has deteriorated during the crisis and suggests that banking organizations may need to continue their high level of loan loss provisioning for some time. Moreover, some of these institutions, including those with capital above minimum requirements, may need to raise more capital and restrain their dividend payouts for the foreseeable future. Indeed, the buildup in capital ratios at large banking organizations has been essential to reassuring the market of their improving condition. However, we must recognize that capital ratios can be an imperfect indicator of a bank's overall strength, particularly in periods in which credit quality is deteriorating rapidly and loan loss rates are moving higher.Comparative Performance of Banking Institutions by Asset Size Although the broad trends detailed above have affected all financial institutions, there are some differences in how the crisis is affecting large financial institutions and more locally focused community and regional banks. Consider, for example, the 50 largest U.S. bank holding companies, which hold more than three-quarters of bank holding company assets and now include the major investment banks in the United States. While these institutions do engage in traditional lending activities, originating loans and holding them on their balance sheets like their community bank competitors, they also generate considerable revenue from trading and other fee-based activities that are sensitive to conditions in capital markets. These firms reported modest profits during each of the first two quarters of 2009. Second-quarter net income for these companies at $1.6 billion was weaker than that of the first quarter, but was still a great improvement over the $19.8 billion loss reported for the second quarter of last year. Net income was depressed by the payment of a significant share of the Federal Deposit Insurance Corporation's (FDIC) special deposit insurance assessment and a continued high level of loan loss provisioning. Contributing significantly to better performance was the improvement of capital markets activities and increases in related fees and revenues. Community and small regional banks have also benefited from the increased stability in financial markets. However, because they depend largely on revenues from traditional lending activities, as a group they have yet to report any notable improvement in earnings or condition since the crisis took hold. These banks--with assets of $10 billion or less representing almost 7,000 banks and 20 percent of commercial bank assets--reported a $2.7 billion loss in the second quarter. Earnings remained weak at these banks due to a historically narrow net interest margin and high loan loss provisions. More than one in four of these banks reported a net loss. Earnings at these banks were also substantially affected by the FDIC special assessment during the second quarter. Loan quality deteriorated significantly for both large and small institutions during the second quarter. At the largest 50 bank holding companies, nonperforming assets climbed more than 20 percent, raising the ratio of nonperforming assets to 4.3 percent of loans and other real estate owned. Most of the deterioration was concentrated in residential mortgage and construction loans, but commercial, CRE, and credit card loans also experienced rising delinquency rates. Results of the banking agencies' Shared National Credit review, released in September, also document significant deterioration in large syndicated loans, signaling likely further deterioration in commercial loans.\2\ At community and small regional banks, nonperforming assets increased to 4.4 percent of loans at the end of the second quarter, more than six times the level for this ratio at year-end 2006, before the crisis started. Home mortgages and CRE loans accounted for most of the increase, but commercial loans have also shown marked deterioration during recent quarters. Importantly, aggregate equity capital for the top 50 bank holding companies, and thereby for the banking industry, increased for the third consecutive quarter and reached 8.8 percent of consolidated assets as of June 30, 2009. This level was almost 1 percentage point above the year-end 2008 level and exceeded the pre-crisis level of midyear 2007 by more than 2 percentage points. Risk-based capital ratios for the top 50 bank holding companies also remained relatively high: Tier 1 capital ratios were at 10.75 percent, and total risk-based capital ratios were at 14.09 percent. Signaling the recent improvement in financial markets since the crisis began, capital increases during the first half of this year largely reflected common stock issuance, supported also by reductions in dividend payments. However, asset contraction also accounts for part of the improvement in capital ratios. Additionally, of course, the Treasury Capital Purchase Program also contributed to the increase in capital in the time since the crisis emerged.--------------------------------------------------------------------------- \2\ See Board of Governors of the Federal Reserve System, FDIC, Office of the Comptroller of the Currency, and Office of Thrift Supervision (2009), ``Credit Quality Declines in Annual Shared National Credits Review,'' joint press release, September 24, www.Federalreserve.gov/newsevents/press/bcreg/20090924a.htm.--------------------------------------------------------------------------- Despite TARP capital investments in some banks and the ability of others to raise equity capital, weak earnings led to modest declines in the average capital ratios of smaller banks over the past year--from 10.7 percent to 10.4 percent of assets as of June 30 of this year. However, risk-based capital ratios remained relatively high for most of these banks, with 96 percent maintaining risk-based capital ratios consistent with a ``well capitalized'' designation under prompt corrective action standards. Funding for the top 50 bank holding companies has improved markedly over the past year. In addition to benefiting from improvement in interbank markets, these companies increased core deposits from 24 percent of total assets at year-end 2008 to 27 percent as of June 30, 2009. The funding profile for community and small regional banks also improved, as core deposit funding rose to 62 percent of assets and reliance on brokered deposits and Federal Home Loan Bank advances edged down from historically high levels. As already noted, substantial financial challenges remain for both large and small banking institutions. In particular, some large regional and community banking firms that have built up unprecedented concentrations in CRE loans will be particularly affected by emerging conditions in real estate markets. I will now discuss the economic conditions and financial market dislocations affecting CRE markets and the implications for banking organizations.Current Conditions in Commercial Real Estate Markets Prices of existing commercial properties are estimated to have declined 35 to 40 percent since their peak in 2007, and market participants expect further declines. Demand for commercial property has declined as job losses have accelerated, and vacancy rates have increased. The higher vacancy levels and significant decline in the value of existing properties have placed particularly heavy pressure on construction and development projects that generate no income until completion. Developers typically depend on the sales of completed projects to repay their outstanding loans, and with the volume of property sales at especially low levels and with prices depressed, the ability to service existing construction loans has been severely impaired. The negative fundamentals in the CRE property markets have caused a sharp deterioration in the credit performance of loans in banks' portfolios and loans in commercial mortgage-backed securities (CMBS). At the end of the second quarter of 2009, approximately $3.5 trillion of outstanding debt was associated with CRE, including loans for multifamily housing developments. Of this, $1.7 trillion was held on the books of banks and thrifts, and an additional $900 billion represented collateral for CMBS, with other investors holding the remaining balance of $900 billion. Also at the end of the second quarter, about 9 percent of CRE loans on banks' books were considered delinquent, almost double the level of a year earlier.\3\ Loan performance problems were the most striking for construction and development loans, especially for those that finance residential development. More than 16 percent of all construction and development loans were considered delinquent at the end of the second quarter.--------------------------------------------------------------------------- \3\ The CRE loans considered delinquent on banks' books were non-owner occupied CRE loans that were 30 days or more past due.--------------------------------------------------------------------------- Almost $500 billion of CRE loans will mature each year over the next few years. In addition to losses caused by declining property cash-flows and deteriorating conditions for construction loans, losses will also be boosted by the depreciating collateral value underlying those maturing loans. These losses will place continued pressure on banks' earnings, especially those of smaller regional and community banks that have high concentrations of CRE loans. The current fundamental weakness in CRE markets is exacerbated by the fact that the CMBS market, which had financed about 30 percent of originations and completed construction projects, has remained virtually inoperative since the start of the crisis. Essentially no CMBS have been issued since mid-2008. New CMBS issuance came to a halt as risk spreads widened to prohibitively high levels in response to the increase in CRE-specific risk and the general lack of liquidity in structured debt markets. Increases in credit risk have significantly softened demand in the secondary trading markets for all but the most highly rated tranches of these securities. Delinquencies of mortgages backing CMBS have increased markedly in recent months. Market participants anticipate these rates will climb higher by the end of this year, driven not only by negative fundamentals but also by borrowers' difficulty in rolling over maturing debt. In addition, the decline in CMBS prices has generated significant stresses on the balance sheets of financial institutions that must mark these securities to market, further limiting their appetite for taking on new CRE exposure.Federal Reserve Activities to Help Revitalize Credit Markets The Federal Reserve, along with other government agencies, has taken a number of actions to strengthen the financial sector and to promote the availability of credit to businesses and households. In addition to aggressively easing monetary policy, the Federal Reserve has established a number of facilities to improve liquidity in financial markets. One such program is the Term Asset-Backed Securities Loan Facility (TALF), begun in November 2008 to facilitate the extension of credit to households and small businesses. Before the crisis, securitization markets were an important conduit of credit to the household and business sectors; some have referred to these markets as the ``shadow banking system.'' Securitization markets (other than those for mortgages guaranteed by the government) have virtually shut down since the onset of the crisis, eliminating an important source of credit. Under the TALF, eligible investors may borrow to finance purchases of the AAA-rated tranches of certain classes of asset-backed securities. The program originally focused on credit for households and small businesses, including auto loans, credit card loans, student loans, and loans guaranteed by the Small Business Administration. More recently, CMBS were added to the program, with the goal of mitigating a severe refinancing problem in that sector. The TALF has had some success. Rate spreads for asset-backed securities have declined substantially, and there is some new issuance that does not use the facility. By improving credit market functioning and adding liquidity to the system, the TALF and other programs have provided critical support to the financial system and the economy.Availability of Credit The Federal Reserve has long-standing policies in place to support sound bank lending and the credit intermediation process. Guidance issued during the CRE downturn in 1991 instructs examiners to ensure that regulatory policies and actions do not inadvertently curtail the availability of credit to sound borrowers.\4\ This guidance also states that examiners should ensure loans are being reviewed in a consistent, prudent, and balanced fashion to prevent inappropriate downgrades of credits. It is consistent with guidance issued in early 2007 addressing risk management of CRE concentrations, which states that institutions that have experienced losses, hold less capital, and are operating in a more risk-sensitive environment are expected to employ appropriate risk-management practices to ensure their viability.\5\--------------------------------------------------------------------------- \4\ See Board of Governors of the Federal Reserve System, Division of Banking Supervision and Regulation (1991), ``Interagency Examination Guidance on Commercial Real Estate Loans,'' Supervision and Regulation Letter SR 91-24 (November 7), www.Federalreserve.gov/BoardDocs/SRLetters/1991/SR9124.htm; and Office of the Comptroller of the Currency, Federal Deposit Insurance Corporation, Federal Reserve Board, and Office of Thrift Supervision (1991), ``Interagency Policy Statement on the Review and Classification of Commercial Real Estate Loans,'' joint policy statement, November 7, www.Federalreserve.gov/BoardDocs/SRLetters/1991/SR9124a1.pdf. \5\ See Board of Governors of the Federal Reserve System, Division of Banking Supervision and Regulation (2007), ``Interagency Guidance on Concentrations in Commercial Real Estate,'' Supervision and Regulation Letter SR 07 1 (January 4), www.Federalreserve.gov/boarddocs/srletters/2007/SR0701.htm.--------------------------------------------------------------------------- We are currently in the final stages of developing interagency guidance on CRE loan restructurings and workouts. This guidance supports balanced and prudent decisionmaking with respect to loan restructuring, accurate and timely recognition of losses and appropriate loan classification. The guidance will reiterate that classification of a loan should not be based solely on a decline in collateral value, in the absence of other adverse factors, and that loan restructurings are often in the best interest of both the financial institution and the borrower. The expectation is that banks should restructure CRE loans in a prudent manner, recognizing the associated credit risk, and not simply renew a loan in an effort to delay loss recognition. On one hand, banks have raised concerns that our examiners are not always taking a balanced approach to the assessment of CRE loan restructurings. On the other hand, our examiners have observed incidents where banks have been slow to acknowledge declines in CRE project cash-flows and collateral values in their assessment of the potential loan repayment. This new guidance, which should be finalized shortly, is intended to promote prudent CRE loan workouts as banks work with their creditworthy borrowers and to ensure a balanced and consistent supervisory review of banking organizations. Guidance issued in November 2008 by the Federal Reserve and the other Federal banking agencies encouraged banks to meet the needs of creditworthy borrowers, in a manner consistent with safety and soundness, and to take a balanced approach in assessing borrowers' ability to repay and making realistic assessments of collateral valuations.\6\ In addition, the Federal Reserve has directed examiners to be mindful of the effects of excessive credit tightening in the broader economy and we have implemented training for examiners and outreach to the banking industry to underscore these intentions. We are aware that bankers may become overly conservative in an attempt to ameliorate past weaknesses in lending practices, and are working to emphasize that it is in all parties' best interests to continue making loans to creditworthy borrowers.--------------------------------------------------------------------------- \6\ See Board of Governors of the Federal Reserve System, FDIC, Office of the Comptroller of the Currency, and Office of Thrift Supervision (2008), ``Interagency Statement on Meeting the Needs of Creditworthy Borrowers,'' joint press release, November 12, www.Federalreserve.gov/newsevents/press/bcreg/20081112a.htm.---------------------------------------------------------------------------Strengthening the Supervisory Process The recently completed SCAP of the 19 largest U.S. bank holding companies demonstrates the effectiveness of forward-looking horizontal reviews and marked an important evolutionary step in the ability of such reviews to enhance supervision. Clearly, horizontal reviews--reviews of risks, risk-management practices and other issues across multiple financial firms--are very effective vehicles for identifying both common trends and institution-specific weaknesses. The SCAP expanded the scope of horizontal reviews and included the use of a uniform set of stress parameters to apply consistently across firms. An outgrowth of the SCAP was a renewed focus by supervisors on institutions' own ability to assess their capital adequacy--specifically their ability to estimate capital needs and determine available capital resources during very stressful periods. A number of firms have learned hard, but valuable, lessons from the current crisis that they are applying to their internal processes to assess capital adequacy. These lessons include the linkages between liquidity risk and capital adequacy, the dangers of latent risk concentrations, the value of rigorous stress testing, the importance of strong governance over their processes, and the importance of strong fundamental risk identification and risk measurement to the assessment of capital adequacy. Perhaps one of the most important conclusions to be drawn is that all assessments of capital adequacy have elements of uncertainty because of their inherent assumptions, limitations, and shortcomings. Addressing this uncertainty is one among several reasons that firms should retain substantial capital cushions. Currently, we are conducting a horizontal assessment of internal processes that evaluate capital adequacy at the largest U.S. banking organizations, focusing in particular on how shortcomings in fundamental risk management and governance for these processes could impair firms' abilities to estimate capital needs. Using findings from these reviews, we will work with firms over the next year to bring their processes into conformance with supervisory expectations. Supervisors will use the information provided by firms about their processes as a factor--but by no means the only factor--in the supervisory assessment of the firms' overall capital levels. For instance, if a firm cannot demonstrate a strong ability to estimate capital needs, then supervisors will place less credence on the firm's own internal capital results and demand higher capital cushions, among other things. Moreover, we have already required some firms to raise capital given their higher risk profiles. In general, we believe that if firms develop more-rigorous internal processes for assessing capital adequacy that capture all the risks facing those firms--including under stress scenarios--and maintain adequate capital based on those processes, they will be in a better position to weather financial and economic shocks and thereby perform their role in the credit intermediation process. We also are expanding our quantitative surveillance program for large, complex financial organizations to include supervisory information, firm-specific data analysis, and market-based indicators to identify developing strains and imbalances that may affect multiple institutions, as well as emerging risks to specific firms. Periodic scenario analyses across large firms will enhance our understanding of the potential impact of adverse changes in the operating environment on individual firms and on the system as a whole. This work will be performed by a multidisciplinary group composed of our economic and market researchers, supervisors, market operations specialists, and accounting and legal experts. This program will be distinct from the activities of onsite examination teams so as to provide an independent supervisory perspective, as well as to complement the work of those teams. As we adapt our internal organization of supervisory activities to build on lessons learned from the current crisis, we are using all of the information and insight that the analytic abilities the Federal Reserve can bring to bear in financial supervision.Conclusion A year ago, the world financial system was profoundly shaken by the failures and other serious problems at large financial institutions here and abroad. Significant credit and liquidity problems that had been building since early 2007 turned into a full-blown panic with adverse consequences for the real economy. The deterioration in production and employment, in turn, exacerbated problems for the financial sector. It will take time for the banking industry to work through these challenges and to fully recover and serve as a source of strength for the real economy. While there have been some positive signals of late, the financial system remains fragile and key trouble spots remain, such as CRE. We are working with financial institutions to ensure that they improve their risk management and capital planning practices, and we are also improving our own supervisory processes in light of key lessons learned. Of course, we are also committed to working with the other banking agencies and the Congress to ensure a strong and stable financial system. ______ FinancialCrisisReport--319 Investment banks sometimes matched up parties who wanted to take opposite sides in a structured finance transaction, and other times took one or the other side of a transaction to accommodate a client. At still other times, investment banks used these financial instruments to make their own proprietary wagers. In extreme cases, some investments banks set up structured finance transactions which enabled them to profit at the expense of their clients. Two case studies, involving Goldman Sachs and Deutsche Bank, illustrate a variety of troubling and sometimes abusive practices involving the origination or use of RMBS, CDO, CDS, and ABX financial instruments. Those practices included at times constructing RMBS or CDOs with assets that senior employees within the investment banks knew were of poor quality; underwriting securitizations for lenders known within the industry for issuing high risk, poor quality mortgages or RMBS securities; selling RMBS or CDO securities without full disclosure of the investment bank’s own adverse interests; and causing investors to whom they sold the securities to incur substantial losses. In the case of Goldman Sachs, the practices included exploiting conflicts of interest with the firm’s clients. For example, Goldman used CDS and ABX contracts to place billions of dollars of bets that specific RMBS securities, baskets of RMBS securities, or collections of assets in CDOs would fall in value, while at the same time convincing customers to invest in new RMBS and CDO securities. In one instance, Goldman took the entire short side of a $2 billion CDO known as Hudson 1, selected assets for the CDO to transfer risk from Goldman’s own holdings, allowed investors to buy the CDO securities without fully disclosing its own short position, and when the CDO lost value, made a $1.7 billion gain at the expense of the clients to whom it had sold the securities. While Goldman sometimes told customers that it might take an adverse investment position to the RMBS or CDO securities it was selling them, Goldman did not disclose that, in fact, it already had significant proprietary investments that would pay off if the particular security it was selling or if RMBS and CDO securities in general fell in value. In another instance, Goldman marketed a CDO known as Abacus 2007-AC1 to clients without disclosing that it had allowed the sole short party in the CDO, a hedge fund, to play a major role in selecting the assets. The Abacus securities quickly lost value, and the three long investors together lost $1 billion, while the hedge fund profited by about the same amount. In still other instances, Goldman took on the role of a collateral put provider or liquidation agent in a CDO, and leveraged that role to obtain added financial benefits to the fiscal detriment of the clients to whom it sold the CDO securities. In the case of Deutsche Bank, during 2006 and 2007, the bank’s top CDO trader, Greg Lippmann, repeatedly warned and advised his Deutsche Bank colleagues and some of his clients seeking to buy short positions about the poor quality of the RMBS securities underlying many CDOs, describing some of those securities as “crap” and “pigs.” At one point, Mr. Lippmann was asked to buy a specific CDO security and responded that it “rarely trades,” but he “would take it and try to dupe someone” into buying it. He also disparaged RMBS securities that, at the same time, were being included in Gemstone 7, a CDO being assembled by the bank for sale to investors. Gemstone 7 included or referenced 115 RMBS securities, many of which carried BBB, BBB-, or even BB credit ratings, making them among the highest risk RMBS securities sold to the public, yet received AAA ratings for its top three tranches. Deutsche Bank sold $700 million in Gemstone securities to eight investors who saw their investments rapidly incur delinquencies, rating downgrades, and losses. Mr. Lippmann at times referred to the industry’s ongoing CDO marketing efforts as a “CDO machine” or “ponzi scheme,” and predicted that the U.S. mortgage market as a whole would eventually plummet in value. Deutsche Bank’s senior management disagreed with his negative views, and used the bank’s own funds to make large proprietary investments in mortgage related securities that, in 2007, had a notional or face value of $128 billion and a market value of more than $25 billion. At the same time, Deutsche Bank allowed Mr. Lippmann to develop for the bank a $5 billion proprietary short position in the RMBS market, which it later cashed in for a profit of approximately $1.5 billion. Despite that gain, in 2007, due to its substantial long investments, Deutsche Bank incurred an overall loss of about $4.5 billion from its mortgage related proprietary investments. CHRG-110hhrg41184--196 Mr. Garrett," And just to close, the two gentlemen raised the issue about the dollar and the falling value there, the old axiom in there is, you know, inflation comes when too many dollars are chasing too few goods. So far, what we've done on the fiscal side of this is basically throw more dollars into it with a stimulus package, and my two questions to you are: One, does that do anything to actually change the mind set of creditors as far as their lending practice as a short-term lending like that? Does that really change their actual lending practices. And two, with the overall dollar value, there was an article in the Wall Street Journal today by David Ranson, I believe it is, which looks to say as far as the CPI and the way that we're evaluating the value of these things, that they're really backwards-looking and not forwards-looking, and that maybe we need to change the structure as to how we looked and measured the CPI and some of these valuations as well, in addition. " CHRG-110hhrg44901--130 Mr. Bernanke," Education is very important, but I have become persuaded over time now that you need three things: education on the consumers' part; good, effective consumer-tested disclosures; and as a last resort, when those two things do not adequately protect the consumer, then you need to use the ability to ban certain practices. " CHRG-111hhrg54872--132 Mr. John," No. When it comes right down to it, if you don't focus on the safety and soundness aspects of products and proposed regulations of those products, you are very likely to find a situation where a practice is encouraged which may be detrimental to the financial institution and therefore to the customer. " FinancialCrisisInquiry--721 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? FinancialCrisisReport--215 OTS’ deference to WaMu management appeared to be the result of a deliberate posture of reliance on the bank to take the steps needed to ensure that its personnel were engaged in 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 own self interest, competence, and discipline to ensure the problems were corrected, with no need for tough enforcement action. It was a regulatory approach with disastrous results. While OTS may have hoped that it could accomplish its regulatory responsibilities by simply identifying problems without the threat of enforcement action, that approach proved ineffective. (b) Demoralized Examiners For five years, OTS examiners identified serious problems with WaMu’s lending practices and risk management, but OTS senior officials failed to support their efforts by using the agency’s enforcement tools to compel the bank to correct the identified problems. WaMu’s chief risk officer from 2004 to 2005, James Vanasek, remarked at the Subcommittee hearing on how OTS examiners seemed to receive little support from more senior officials in terms of enforcement: “[T]he OTS Examiner-in-Charge during the period time in which I was involved … did an excellent job of finding and raising the issues. Likewise, I found good performance from … the FDIC Examiner-in-Charge. … What I cannot explain is why the superiors in the agencies didn’t take a tougher tone with the banks given the degree of … negative findings. My experience with the OTS, versus with the OCC, was completely different. So there seemed to be a tolerance there or a political influence on senior management of those agencies that prevent them from taking a more active stance. By a more active stance, I mean putting the banks under letters of agreement and forcing change.” 814 Internal OTS documents and emails indicate that the result was a cadre of OTS examiners who were skeptical of their ability to effect meaningful change at WaMu, who were too often rebuffed by their own management when they tried to reduce risk or strengthen bank controls, and whose leaders worked to weaken rather than strengthen the standards used by examiners to hold banks accountable. 813 Subcommittee interview of OTS Examiner-in-Charge Benjamin Franklin (2/17/2010 ) . 814 April 13, 2010 Subcommittee Hearing at 39 (testimony of James G. Vanasek, former WaMu Chief Risk Officer, 2004-2005). FOMC20060629meeting--50 48,MR. STOCKTON.," It’s a big revision, and as you can imagine, we agonized a lot about “isn’t this is a big revision for just six weeks of information.” The problem we confronted was that, if just the incoming data had been worse than we thought, we would not have made a revision as large as this. But in each case, the weakness in the data was being reinforced by weaker readings in the underlying fundamentals for those sectors. In consumption, for example, we have had a string of weak numbers. We lost $60 billion worth of income in downward revisions in the fourth quarter and the first quarter, and we’re starting out with a much lower saving rate than we thought. The stock market when we closed the Greenbook was off 7 percent. Those were big fundamentals. And housing, for the most part, continued to come in worse than we thought: Although new home sales came in a bit above our expectations, starts were below what we had in May, and the permits were continuing to come down. Even in this forecast, we basically have housing activity not declining a whole lot further in terms of housing starts going forward from where they are today. So we could see some downside risks still to that. If you ask where I think some of the vulnerabilities might be and how we could get to August and not be looking at a forecast as weak as this, I can imagine that by the end of the next week we could get 200,000 on payroll employment with some upward revisions. We could get a strong retail sales report for June with a little upward revision. This is all going to look a bit as though we overreacted. Things weren’t so strong. But in each case it was not as though we had actual data or fundamentals that we could hold onto to tell us not to revise as much as we did. So we thought we had things reasonably well balanced in this case. I could see more downside risks than upside risks to our housing forecast. The risks around our consumption forecast look pretty balanced to me. On the one hand, given how low the saving rate is and some recent weakening in employment growth, I could see how things could come in lower. On the other hand, it is easy to see that the consumer has been more resilient in recent years and could continue to be so. So I see the risks there as more balanced. On the business-sector side, however, I probably see a little more upside risk than downside risk to the forecast. In the end, we felt as though we were compelled by our normal analytical apparatus to produce a forecast that was noticeably weaker than the last time, even though the revision looks big and showing a forecast that changed as much in such a short time certainly made us very nervous. So I think you are right to be a bit taken aback by how much we revised in a short period; however, I still think the forecast probably has both upside and downside risks to it." FOMC20080130meeting--180 178,MR. HOENIG.," Thank you, Mr. Chairman. Let me talk a bit about the region. The Tenth District is generally moving forward at a fairly steady pace, but there are some mixed data. The obvious wide variances are in real estate. Housing is weak--not as weak as some parts of the country but still weak. Also, it is interesting that commercial real estate in each of our major cities right now continues to do well. I recently talked with several developers. They are all doing well but are very concerned, and they are beginning to cut back on their plans and move away from them. So you can see the worry carrying forward in terms of what actions they are taking. In the agricultural area and in the energy area, real estate is a different story. It is booming. Land values have gone up in the ag part--non-irrigated land, something like 20 percent over the past year. If you are near an ethanol plant, it has gone up 25 to 30 percent. It is also interesting that the ag credit system is helping to fund that. Their increase in lending was about 12 percent this past year. That is up from about 9 percent the year before, so they are providing that. They are also now involved in lending to these ethanol plants in a very significant way, helping to carry that boom forward. That gives me some pause in terms of what is going on in some of the rural areas. Related to that, the energy and lease values are also accelerating at a fairly high rate. I found it reminiscent and somewhat disturbing in talking to a couple of individuals when they noted that the land values have about doubled over the past two or three years in some areas, and they said that I should relax because on current ag prices they should have tripled. [Laughter] Where have I seen that before? On the other side, actually, manufacturing in our region has held steady. We have a lot of aircraft manufacturing, which is really strong, and some other smaller manufacturers providing support in both ag and energy, and they seem to be doing well. Technology is also doing well in the region, especially in the mountain areas--the Colorado and Denver areas. Engineering firms are still very strong--the strong demand for engineers and the unfilled positions continue. They are supplying that service across the globe and see continued demand there. So it is mixed, but overall probably our region is doing better than average relative to the rest of the nation. On the national level, my projections suggest that we are going to grow below our potential growth rate. I am not as pessimistic as the Greenbook. I also have inflation coming down, but that is on the assumption that we are able to reverse our monetary policy at a fairly quick pace as we move through this year and into 2009. I will leave it there. Thank you. " CHRG-111hhrg67816--101 Mr. Terry," Thank you, Mr. Chairman. I appreciate this. The gentlelady brings up, I think, several good points, and I think really gets to the heart of the matter, and that is if we are going to stream line rules, the procedures for the rules, we want to make sure that it is going to be effective in protecting consumers and that you will be able to use the FTC's authority. But the argument here about advance fees begs the question of who is ultimately going to be able to decide what is deceptive and what is not. Sometimes it is obvious where you can put 100 people together and they will say that practice is deceptive. There are other things like maybe advance fees that some people will say are deceptive or that are wrong, but they are not deceptive. And so how are we going to split those hairs if you are coming to us and asking us to streamline the rules or the procedures to make your rulemaking. Who should have the authority in there to determine which specific practice is deceptive or not deceptive? " FOMC20071211meeting--126 124,MR. ROSENGREN.," Thank you, Mr. Chairman. Weakness in economic data reported since the last meeting, continued financial turmoil, and a forecast that places us uncomfortably close to a recession calls for action, and my strong preference is for the decisive action reflected in alternative A. With well-anchored inflation expectations and the possibility of unemployment rising above our estimate of the NAIRU, the risks to inflation from this action seem quite low. However, the possibility that the economy will soon be in a recession is too high, and our action should be significant enough to substantially reduce that risk." FOMC20080805meeting--171 169,MR. ROSENGREN.," I support alternative B. I would actually prefer President Yellen's language but definitely believe that we should have the word ""also"" in there. Tightening at this time would sap more strength from an already weak economy, and should the forecast look like the ""severe financial stress"" scenario or the ""typical recession"" scenario, it would be extremely poorly timed. If the data indicate that inflation is not ebbing as I expect and the economy is on a surer footing than I fear, then it would be appropriate to begin what is likely to be a series of increases in the federal funds target. But the data to date don't indicate that, so I support alternative B. " FinancialCrisisReport--69 Mr. Vanasek shared his concerns with Mr. Killinger. At the Subcommittee’s hearing, Mr. Killinger testified: “Now, beginning in 2005, 2 years before the financial crisis hit, I was publicly and repeatedly warning of the risks of a potential housing downturn.” 177 In March 2005, he engaged in an email exchange with Mr. Vanasek, in which both agreed the United States was in the midst of a housing bubble. On March, 10, 2005, Mr. Vanasek emailed Mr. Killinger about many of the issues facing his risk management team, concluding: “My group is working as hard as I can reasonably ask any group to work and in several cases they are stretched to the absolute limit. Any words of support and appreciation would be very helpful to the morale of the group. These folks have stepped up to fixing any number of issues this year, many not at all of their own making.” 178 Mr. Killinger replied: “Thanks Jim. Overall, it appears we are making some good progress. Hopefully, the Regulators will agree that we are making some progress. I suspect the toughest thing for us will be to navigate through a period of high home prices, increased competitive conditions for reduced underwriting standards, and our need to grow the balance sheet. I 177 April 13, 2010 Subcommittee Hearing at 85. 178 3/2005 WaMu internal email chain, Hearing Exhibit 4/13-78. have never seen such a high risk housing market as market after market thinks they are unique and for whatever reason are not likely to experience price declines. This typically signifies a bubble.” CHRG-110hhrg41184--193 Mr. Bernanke," I don't think we're at that point, but I do think it's worthwhile to keep thinking about those issues. I think that are a lot of difficulties, practical difficulties. How would you, for example, determine who to help? How would you ensure that the loans that you bought were not the bad apples in the barrel? There are a lot of difficult, technical problems. The Federal Reserve is working on issues like this just to try to understand how these things might work. Again, my attitude is that we need to be thinking about different alternatives and preparing for contingencies, but at the moment I am satisfied with the general approach that we're currently taking. " CHRG-111shrg57321--161 Mr. McDaniel," Thank you, Mr. Chairman and Senator Kaufman. I am Ray McDaniel, Chairman and CEO of Moody's Corporation, the parent of the credit rating agency Moody's Investor Service. I want to thank you for the opportunity to contribute Moody's views today.--------------------------------------------------------------------------- \1\ The joint prepared statement of Mr. McDaniel and Ms. Yoshizawa appears in the Appendix on page 186.--------------------------------------------------------------------------- The global financial crisis has sparked a necessary debate about the role and performance of numerous participants in the financial markets. With respect to credit rating agencies, many market observers have expressed concerns that ratings did not better predict the deteriorating conditions in the subprime mortgage market. Let me assure you that Moody's is not satisfied, and I am not satisfied, with the performance of our ratings during the unprecedented market downturn of the past 2 years. We did not anticipate the extraordinary confluence of forces that drove the unusually poor performance of subprime mortgages. We were not alone in this regard, but I believe that we should be at the leading edge for predictive opinions about credit risk. Some key issues influencing the unanticipated performance included the steep and sudden nationwide decline in home prices and the sharp contraction that followed in credit available from banks for mortgage refinancing. Moody's did observe a trend of loosening mortgage underwriting and escalating home prices. We highlighted that trend in our reports and incorporated it into our analysis of mortgage-backed securities. And, as conditions in the U.S. housing market began to deteriorate beyond our expectations, we took the rating actions that we believed at the time were appropriate based on the information we had. Let me summarize our actions during the 2003 to 2007 time frame. First, starting in 2003, we identified and began commenting on the loosening of underwriting standards and escalating housing prices through our sector publications. Second, we tightened our ratings criteria in response to these loosening standards. In fact, between 2003 and 2006, we steadily increased our loss expectations and the levels of credit protection required for a given rating level. In practical terms, this meant that by 2006, half the mortgages in a pool would have to default and provide a recovery of just half the appraised value of the home before a subprime RMBS bond rated AAA by Moody's would suffer its first dollar of loss. This is a level of anticipated loss that far exceeded the losses that actually occurred in the past four real estate recessions. But even these conservative assumptions proved insufficient. Third, we took steps to watch and analyze the unprecedented market conditions and the behavior of various market participants as the crisis continued to unfold. For example, one question before the market was how borrowers, servicers, and banks would respond to the resetting of mortgage interest rates and how that behavior would affect default rates. Faced with extraordinary conditions, we saw market participants, including borrowers, mortgage servicers, mortgage originators, and the Federal Government, behave in historically unprecedented ways. Fourth, we took rating actions when the mortgage performance data warranted. Moody's monitors the actual performance of the mortgages and the securities that we rate throughout the life of the security. The early performance of the 2006 loans was, in fact, comparable to the performance of similar subprime loans during the 2000 and 2001 recession. And not until performance data from the second quarter of 2007 was available did it become clear that many of the 2006 vintage bonds might perform worse than those from the prior recession. In short, Moody's did see the loosening of some prime lending standards. We reported our observations to the market and we incorporated our increasingly unfavorable views into the ratings we assigned. However, let me emphasize again that we, like most other market participants, did not anticipate the severity or the speed of deterioration that occurred in the U.S. housing market, nor did we anticipate the behavior of market participants in response to the housing downturn, including the speed of credit tightening by financial institutions that followed and exacerbated the situation. The unprecedented events of the last few years provide critical lessons to all market participants, certainly including us. At Moody's over the past 2 years, we have undertaken a wide range of initiatives to strengthen the quality, transparency, and independence of our ratings. Some of these measures include establishing common macroeconomic scenarios for rating committees, publishing volatility scores and sensitivity analysis on structured finance securities, consolidating surveillance activities and structured finance under one leadership, and further bolstering the independence of and resources for our credit policy function. Moody's is firmly committed to meeting the highest standards of integrity in our rating practices. We wholeheartedly support constructive reforms and we are eager to work with Congress, regulators, and other market participants to that end. I am happy to respond to your questions. Senator Levin. Thank you very much, Mr. McDaniel. Ms. Corbet. TESTIMONY OF KATHLEEN A. CORBET,\1\ FORMER PRESIDENT (2004- 2007), STANDARD AND POOR'S Ms. Corbet. Thank you, Mr. Chairman and Senator Kaufman.--------------------------------------------------------------------------- \1\ The prepared statement of Ms. Corbet appears in the Appendix on page 210.--------------------------------------------------------------------------- My name is Kathleen Corbet and my career spans over 25 years of experience within the financial services industry. For a 3-year period during my career, I served as President as Standard and Poor's, a division of the McGraw-Hill Companies, from April 2004 until my voluntary departure in September 2007. Before turning to the substantive issues raised by the Subcommittee's investigation, I would like to acknowledge the important work of the Subcommittee and Congress more broadly in its examination of the causes and consequences of the financial crisis. It is difficult not to feel personally touched by the pain experienced by many as a result of the turmoil in the subprime market and the financial crisis that followed. Many people feel anger, and in my view, that anger is understandable. Accordingly, I believe strongly that we should collectively use the lessons from this crisis to focus on effective reforms, stronger investor protections, better industry practices, and accountability. As background, I was recruited to join the McGraw-Hill Companies as an Executive Vice President of its Financial Services Division in April 2004 and served as President of Standard and Poor's until my successor, Deven Sharma, took over that position in September 2007. During my 3-year tenure, I led an organization of 8,000 employees based in 23 countries which provided financial information and market analysis to its customers and the broader market as a whole. The company was organized across four primary business units, including Rating Services, Equity Research Services, Index Services, and Data and Information Services. Each business unit was led by a seasoned executive having direct operating responsibility in the respective area and reporting directly to me. One of those units was Rating Services, which issued credit ratings on hundreds of thousands of securities across the globe, including corporate securities, government securities, and structured finance securities. Rating Services was led by an Executive Vice President for Ratings, an executive with over 30 years of experience in the ratings business, who had day-to-day operational responsibility for that business. Among her direct reports was the Executive Managing Director of Structured Finance Ratings, who was responsible for the day-to-day operations of the Structured Finance Ratings Group, the group that issued the ratings that are the subject of this Subcommittee's focus. Consistent with S&P's longstanding and publicly disclosed practice, ratings decisions were and are solely the province of committees comprised of experienced analysts in the relevant area. This practice is based on the principle that the highest quality analysis comes from the exercise of independent analytical judgment free from both undue external or internal pressure. Accordingly, during my tenure, I did not participate in any rating or analytical criteria committee meetings regarding ratings on any type of security, including mortgage-backed securities. All that said, I do hope to be able to provide a business perspective that is helpful to the Subcommittee, and in my view, it is clear that many of the ratings S&P issued on securities backed by subprime mortgages have performed extremely poorly. S&P has publicly stated its profound disappointment with that performance, and I deeply share that sentiment. From my personal perspective, I believe the primary reason for these downgrades is that, despite its efforts to get the rating right and despite rooting its analysis in historical data, S&P's assumptions did not capture the unprecedented and unexpected outcomes that later occurred with respect to the housing market, borrower behavior and credit correlations. S&P, along with others, has been criticized for its failure to predict what happened in the subprime market, and in many ways, that criticism is justifiable. Moreover, the subsequent outcome of the severe economic downturn and downgrades of securities backed by subprime mortgages highlight the challenges inherent in the nature of ratings. At their core, ratings are opinions about what may happen in the future, specifically, the likelihood that a particular security may default. I think that most people agree that predicting the future is always challenging and outcomes can often turn out very differently than even the most carefully derived predictions anticipate. The key from my perspective is to learn from these experiences and to take specific actions to improve. The credit rating industry has begun to respond in a constructive fashion, but there is much more to be done. Through the course of history and through many market cycles, the credit rating industry has played an important role in the financial system for nearly a century, and I do believe that it has the opportunity to continue to do so through the commitment to continual improvements and from appropriate regulatory reform. Again, I appreciate the goals of the Subcommittee's work and would be glad to answer any questions that you have. Senator Levin. Thank you, Ms. Corbet. Thank you both. Before we start with questions, let me put into the record a statement of the Attorney General of the State of Connecticut, Richard Blumenthal. He has made a very powerful statement about the topic of the hearing today, which is ``Wall Street and the Financial Crisis: The Role of Credit Rating Agencies,'' and that will be made part of the record at an appropriate place.\1\--------------------------------------------------------------------------- \1\ The prepared statement of Mr. Blumenthal appears in the Appendix as Exhibit 109, on page 1201.--------------------------------------------------------------------------- Were you both here earlier? Ms. Corbet. Yes, I was. Senator Levin. Mr. McDaniel, were you here, too? " CHRG-110hhrg46591--63 Mrs. Maloney," Thank you, Mr. Chairman. I would like to welcome all the panelists and mention to Dr. Stiglitz that I have enjoyed your books, particularly the latest one, ``The $3 Trillion War.'' And I would like to reference your written comments where you said that America's financial markets have engaged in anticompetitive practices, especially in the area of credit cards. And you go further on to say, and I quote, ``the huge fees have helped absorb the losses from their bad lending practices, but the fact that the profits are so huge should be a signal that the market has not been working well.'' I do want to note that the Federal Reserve has also called credit practices and credit cards unfair deceptive and anticompetitive and this committee and this House passed in a bipartisan way reform legislation in this area, so we are acting in that area. You also mentioned that one of the problems is the lack of transparency. I would like to hear your ideas on a master super counterparty netting system. The idea of the system would be to provide a complete and transparent view of the entire financial system which would require every dealer to download all transactions every night, including all international. This would be in one place, an international area that would have a transparency so that we could track what is happening in the system. We know that derivatives are a huge part of it. But to date, the credit derivatives have been what we have focused on, yet they are only 10 percent of the global derivatives volume, so we may have an even larger problem that we have no idea how wide it is, and with such a super counterparty netting system, add more transparency, and help us move forward towards a better knowledge about our markets. " CHRG-111shrg52619--199 RESPONSE TO WRITTEN QUESTIONS OF SENATOR KOHL FROM DANIEL K. TARULLOQ.1. Two approaches to systemic risk seem to be identified: (1) monitoring institutions and taking steps to reduce the size/activities of institutions that approach a ``too large to fail'' or ``too systemically important to fail'' or (2) impose an additional regulator and additional rules and market discipline on institutions that are considered systemically important. Which approach do you endorse? If you support approach one how you would limit institution size and how would you identify new areas creating systemic importance? If you support approach two how would you identify systemically important institutions and what new regulations and market discipline would you recommend?A.1. As we have seen in the current financial crisis, large, complex, interconnected financial firms pose significant challenges to supervisors. In the current environment, market participants recognize that policymakers have strong incentives to prevent the failure of such firms because of the risks such a failure would pose to the financial system and the broader economy. A number of undesirable consequences can ensue: a reduction in market discipline, the encouragement of excessive risk-taking by the firm, an artificial incentive for firms to grow in size and complexity in order to be perceived as too big to fail, and an unlevel playing field with smaller firms that are not regarded as having implicit government support. Moreover, of course, government rescues of such firms can be very costly to taxpayers. The nature and scope of this problem suggests that multiple policy instruments may be necessary to contain it. Firms whose failure would pose a systemic risk should be subject to especially close supervisory oversight of their risk-taking, risk management, and financial condition, and should be held to high capital and liquidity standards. As I emphasized in my testimony, the government must ensure a robust framework--both in law and practice--for consolidated supervision of all systemically important financial firms. In addition, it is important to provide a mechanism for resolving systemically important nonbank financial firm in an orderly manner. A systemic risk authority that would be charged with assessing and, if necessary, curtailing systemic risks across the entire U.S. financial system could complement firm-specific consolidated supervision. Such an authority would focus particularly on the systemic connections and potential risks of systemically important financial institutions. Whatever the nature of reforms that are eventually adopted, it may well be necessary at some point to identify those firms and other market participants whose failure would be likely to impose systemic effects. Identifying such firms is a very complex task that would inevitably depend on the specific circumstances of a given situation and requires substantial judgment by policymakers. That being said, several key principles should guide policymaking in this area. No firm should be considered too big to fail in the sense that existing stockholders cannot lose their entire investment, existing senior management and boards of directors cannot be replaced, and over time the organization cannot be wound down or sold in an orderly way either in whole or in part, which is why we have recommended that Congress create an orderly resolution procedure for systemically important financial firms. The core concern of policymakers should be whether the failure of the firm would be likely to have contagion, or knock-on, effects on other key financial institutions and markets and ultimately on the real economy. Of course, contagion effects are typically more likely in the case of a very large institution than with a smaller institution. However, size is not the only criterion for determining whether a firm is potentially systemic. A firm may have systemic importance if it is critical to the functioning of key markets or critical payment and settlement systems.Q.2. Please identify all regulatory or legal barriers to the comprehensive sharing of information among regulators including insurance regulators, banking regulators, and investment banking regulators. Please share the steps that you are taking to improve the flow of communication among regulators within the current legislative environment.A.2. In general, there are few formal regulatory or legal barriers to sharing bank supervisory information among regulators, and such sharing is done routinely. Like other federal banking regulators, the Board's regulations generally prohibit the disclosure of confidential supervisory information (such as examination reports and ratings, and other supervisory correspondence) and other confidential information relating to supervised financial institutions without the Board's consent. See 12 C.F.R. 261, Subpart C. These regulations, however, expressly permit designated Board and Reserve Bank staff to make this information available to other Federal banking supervisors on request. 12 C.F.R. 261.20(c).. As a practical matter, federal banking regulators have access to a database that contains examination reports for regulated institutions, including commercial banks, bank holding companies, branches of foreign banks, and other entities, and can view examination material relevant to their supervisory responsibility. State banking supervisors also have access to this database for entities they regulate. State banking supervisors may also obtain other information on request if they have direct supervisory authority over the institution or if they have entered into an information sharing agreement with their regional Federal Reserve Bank and the information concerns an institution that has acquired or applied to acquire a financial institution subject to the state regulator's jurisdiction. Id. at 261.20(d). The Board has entered into specific sharing agreements with a number of state and federal regulators, including most state insurance regulators, the Securities and Exchange Commission, the Commodity Futures Trading Commission, the Office of Foreign Asset Control (OFAC), and the Financial Crimes Enforcement Network (FinCEN), authorizing sharing of information of common regulatory and supervisory interest. We frequently review these agreements to see whether it would be appropriate to broaden the scope of these agreements to permit the release of additional information without compromising the examination process. Other supervisory or regulatory bodies may request access to the Board's confidential information about a financial institution by directing a request to the Board's general counsel. Financial supervisors also may use this process to request access to information that is not covered by one of the regulatory provisions or agreements discussed above. Normally such requests are granted subject to agreement on the part of the regulatory body to maintain the confidentiality of the information, so long as the requester bas identified a legitimate basis for its interest in the information. Because the Federal Reserve is responsible for the supervision of all bank holding companies and financial holding companies on a consolidated basis, it is critical that the Federal Reserve also have timely access to the confidential supervisory information of other bank supervisors or functional regulators relating to the bank, securities, or insurance subsidiaries of such holding companies. Indeed, the Gramm-Leach-Bliley Act (GLBA) provides that the Federal Reserve must rely to the fullest extent possible on the reports of examinations prepared by the Office of the Comptroller of the Currency, the Federal Deposit Insurance Corporation, the SEC, and the state insurance authorities for the national bank, state nonmember bank, broker-dealer, and insurance company subsidiaries of a bank holding company. The GLBA also places certain limits on the Federal Reserve's ability to examine or obtain reports from functionally regulated subsidiaries of a bank holding company. Consistent with these provisions, the Federal Reserve has worked with other regulators to ensure the proper flow of information to the Federal Reserve through information sharing arrangements and other mechanisms similar to those described above. However, the restrictions in current law still can present challenges to timely and effective consolidated supervision in light of, among other things, differences in supervisory models--for example, between those favored by bank supervisors and those used by regulators of insurance and securities subsidiaries--and differences in supervisory timetables, resources, and priorities. In its review of the U.S. financial architecture, we hope that the Congress will consider revising the provisions of Gramm-Leach-Bliley Act to help ensure that consolidated supervisors have the necessary tools and authorities to monitor and address safety and soundness concerns in all parts of an organization.Q.3. What delayed the issuance of regulations under the Home Ownership Equity Protection Act for more than 10 years? Was the Federal Reserve receiving outside pressure not to write these rules? Is it necessary for Congress to implement target timelines for agencies to draft and implement rules and regulations as they pertain to consumer protections?A.3. In responding, I will briefly report the history of the Federal Reserve's rulemakings under the Home Ownership and Equity Protection Act (HOEPA). Although I did not join the Board until January 2009, I support the action taken by Chairman Bernanke and the Board in 2007 to propose stronger HOEPA rules to address practices in the subprime mortgage market. I should note, however, that in my private academic capacity I believed that the Board should have acted well before it did. HOEPA, which defines a class of high-cost mortgage loans that are subject to restrictions and special disclosures, was enacted in 1994 as an amendment to the Truth in Lending Act. In March 1995, the Federal Reserve published rules to implement HOEPA, which are contained in the Board's Regulation Z. HOEPA also gives the Board responsibility for prohibiting acts or practices in connection with mortgage loans that the Board finds to be unfair or deceptive. The statute further requires the Board to conduct public hearings periodically, to examine the home equity lending market and the adequacy of existing laws and regulations in protecting consumers, and low-income consumers in particular. Under this mandate, during the summer of 1997 the Board held a series of public hearings. In connection with the hearings, consumer representatives testified about abusive lending practices, while others testified that it was too soon after the statute's October 1995 implementation date to determine the effectiveness of the new law. The Board made no changes to the HOEPA rules resulting from the 1997 hearings. Over the next several years, the volume of home-equity lending increased significantly in the subprime mortgage market. With the increase in the number of subprime loans, there was increasing concern about a corresponding increase in the number of predatory loans. In response, during the summer of 2000 the Board held a series of public hearings focused on abusive lending practices and the need for additional rules. Those hearings were the basis for rulemaking under HOEPA that the Board initiated in December 2000 to expand HOEPA's protections. The Board issued final revisions to the HOEPA rules in December 2001. These amendments lowered HOEPA's rate trigger for first-lien mortgage loans to extend HOEPA's protections to a larger number of high-cost loans. The 2001 final rules also strengthened HOEPA's prohibition on unaffordable lending by requiring that creditors generally document and verify consumers' ability to repay a high-cost HOEPA loan. In addition, the amendments addressed concerns that high-cost HOEPA loans were ``packed'' with credit life insurance or other similar products that increased the loan's cost without commensurate benefit to consumers. The Board also used the rulemaking authority in HOEPA that authorizes the Board to prohibit practices that are unfair, deceptive, or associated with abusive lending. Specifically, to address concerns about ``loan flipping'' the Board prohibited a HOEPA lender from refinancing one of its own loans with another HOEPA loan within the first year unless the new loan is in the borrower's interest. The December 2001 final rule addressed other issues as well. As the subprime market continued to grow, concerns about ``predatory lending'' grew. During the summer of 2006, the Board conducted four public hearings throughout the country to gather information about the effectiveness of its HOEPA rules and the impact of the state predatory lending laws. By the end of 2006, it was apparent that the nation was experiencing an increase in delinquencies and defaults, particularly for subprime mortgages, in part as a result of lenders' relaxed underwriting practices, including qualifying borrowers based on discounted initial rates and the expanded use of ``stated income'' or ``no doc'' loans. In response, in March 2007, the Board and other federal financial regulatory agencies published proposed interagency guidance addressing certain risks and emerging issues relating to subprime mortgage lending practices, particularly adjustable-rate mortgages. The agencies finalized this guidance in June 2007. Also in June 2007, the Board held a fifth hearing to consider ways in which the Board might use its HOEPA rulemaking authority to further curb abuses in the home mortgage market, including the subprime sector. This became the basis for the new HOEPA rules that the Board proposed in December 2007 and finalized in July 2008. Among other things, the Board's 2008 final rules adopt the same standard for subprime mortgage loans that the statute previously required for high cost HOEPA loans--a prohibition on making loans without regard to borrowers' ability to repay the loan from income and assets other than the home's value. The July 2008 final rule also requires creditors to verify the income and assets they rely upon to determine borrowers' repayment ability for subprime loans. In addition, the final rules restrict creditors' use of prepayment penalties and require creditors to establish escrow accounts for property taxes and insurance. The rules also address deceptive mortgage advertisements, and unfair practices related to real estate appraisals and mortgage servicing. We can certainly understand the desire of Congress to provide timelines for regulation development and implementation. This could be especially important to address a crisis situation. However, in the case of statutory provisions that require consumer disclosure for implementation, we hope that any statutory timelines would account for robust consumer testing in order to make the disclosures useful and effective. Consumer testing is an iterative process, so it can take some additional time, but we have found that it results in much clearer disclosures. Additionally, interagency rulemakings are also more time consuming. While they have the potential benefit of bringing different perspectives to bear on an issue, arriving at consensus is always more time consuming than when regulations are assigned to a single rule writer. Moreover, assigning rulewriting responsibility, to multiple agencies can result in diffused accountability, with no one agency clearly responsible for outcomes. ------ FOMC20070628meeting--281 279,MR. REINHART.," The law says no later than February 20 and July 20. In practice, the Committee sometimes allows for some slippage. The last few times it has tended to be earlier than that. So that does put a T in terms of your planning horizon. You also have some flexibility about when you schedule the meetings." CHRG-111hhrg53240--85 Mr. Sherman," But you are free to find the retailer who is most bank-friendly and appoint that person, elect that person? Ms. Duke. In theory. But in practice, that is not the case. And I can actually send a breakdown of what they are. And the C directors are appointed by the Board of Governors, and again from that same group. " CHRG-111hhrg67816--89 Mr. Radanovich," Right. Yes. And I will get on to those cases that you brought in just a second. One more quick question though. Why can't the Commission use your existing authority to propose rules defining unfair acts and practices for financial services? Why can't you use what you have now? " CHRG-111shrg382--14 Mr. Sobel," Yes, sir. Senator Corker. Well, let me ask you this, just out of curiosity. Why would we talk about this theory to save the world and yet not put it in practice today in our country? I am just curious. And maybe others might want to jump in. " CHRG-111hhrg67816--108 Mr. Leibowitz," And let me just add my point to that that advance fees are prohibited under CROA. We prohibit the under the telemarketing sales rules which is an FTC rule, and in some instances, not in every, but in some instances it has really sort of helped clean up bad practices that harm consumers. " CHRG-111hhrg52406--57 Mr. Bachus," Well, other than disclosing them, though, would you stop some of those practices? Ms. Warren. The point, Congressman, as I see it, is that it is all about disclosing them. That is really the whole point here. We have now played the game over and over and over of, add 10 more paragraphs, 4 more pages, 20 more pages. That is not disclosure. " FOMC20080625meeting--94 92,MR. WARSH.," Thank you, Mr. Chairman. At this point everything has been said, but everybody hasn't said it. So let me try. [Laughter] Let me make three summary points, and then I will talk about three issues that I think are harder. First, on the economy, through late May, as the Greenbook suggests, the real economy proved more resilient and more dynamic than the consensus had anticipated. Consumer spending was moderate but positive, and the labor markets were soft, but neither was necessarily indicative of a recession through late May. Business fixed investment and corporate profits ex financials look all right. Productivity growth looks, frankly, impressive, and corporations, unlike consumers, still appear okay through the month of June--but I'm going to return to June in just a short while. In sum, my assessment of the economy reasonably approximates the average GDP from the Greenbook for 2008, but I remain considerably more cautious on the catalyst for return-to-trend growth in the forecast period of 2009 and beyond. I suspect that this is a long, slow climb with the credit channels needing to be rebuilt and that the process is still in its very early stages. Second, let me talk about the financial markets. Financial markets continue to show tenuous but real improvements in market functioning--which, as Bill Dudley suggested, is remarkable given the weakness among financial institutions themselves. Leveraged loans and high-yield markets continue to trend toward improved market functioning. Credit spreads are well off their March highs. Credit markets, in particular, are holding up well, despite the broad weakness across equities. Third, let me turn to inflation risks. Inflation risks, in my view, continue to predominate as the greater risk to the economy. There is more evidence of a global secular reversal of inflation trends, making the jobs of central bankers worldwide considerably more difficult. I remain worried about energy and food pass-through and the effect of a weakening dollar if our policy rates and those of our major trading partners are perceived to diverge. I would expect import prices, core inflation, and expectations to move up in the coming months even more than in the Greenbook, likely causing a policy response by our foreign peers. Commodity prices, again, with the exception of metals, have been moving up while global demand is falling, and markets have come to see this rise of some, if not most, commodities as essentially permanent. So at the end of the day, we have to be concerned about this period of above-acceptable inflation. It's crucial that broader prices do not start to rise at still-faster rates, and that could well happen if those making decisions about prices and pay expect higher inflation in the future. Anecdotes are not comforting, particularly on the price front. As a result, I think the trajectory of inflation is less favorable than in the Greenbook, thereby necessitating a policy response more significant than the Greenbook would suggest. Let me turn to three even harder issues. One is consumer spending. We're not done with the second quarter, and my sense of what's happened in the first three weeks of June is pretty miserable. I hate to extrapolate based on three weeks of data to the trajectory of the economy. But from a discussion with contacts from three credit card companies that constitute a little more than half of the credit card spend, I would say that the views from these guys were shocking in how bad things looked in the past three to four weeks, particularly in comparison to reasonably positive news from the previous two months. It is suggestive that June will be much weaker than May, and if I add that to the figures on autos that are coming out of the Detroit Three, those are a couple of anecdotes that make me a little hesitant to declare with an exclamation mark what an enviable second quarter we've had. I also look at equity market prices sometimes as maybe telling us something. I would say that consumer companies and retailers over the last three weeks have gotten killed. So I'm a little hesitant to suggest that the second quarter is going to be strong. Delinquencies and charge-offs have also moved meaningfully to the downside in the last three or four weeks among these credit card companies, and this weakness appears to be much more focused on the coasts than it is in the center of the country. I heard that from three of three. My own view may be influenced by my take on the fiscal stimulus--it sure doesn't appear to be helping very much. The second issue that I continue to struggle with is financial institutions. Financial institution equity prices showed significant underperformance, and some people say that is the Federal Reserve's fault. We're talking up our concerns about inflation. We're changing the Treasury curve going forward. I think that is a total red herring. The reason that financials are getting killed is an equity story. They have business models that are having a hard time delivering profits in this environment. They have had to show a very tough quarterly set of losses. I think the problems on financials have to do with financials and not with the Fed, though there is a disturbing amount of chatter in the markets that somehow we're the cause of that. I am comforted, again as Bill Dudley reminded us, that the broader market functioning has been able to withstand this dramatic financial institution weakness. Whether at some point that will give out I don't know, but I'd say that's extremely encouraging. In addition, we have to recognize that massive amounts of new capital are going to be needed for financial institutions of all sizes. Given the weak performance of virtually every financial investment from November till now, I think it is very easy to see a supply�demand problem. It is very easy to see that, with the number of banks that come to these markets, some of them at some point might not be able to find capital even at dramatically lower prices than their expectations. It is prudent for us at the Fed to think about alternative sources of more-patient institutional funding during this period. The third issue for discussion is credit availability, especially for small businesses. This strikes me as being key to the labor market situation. Credit availability for small businesses has held up better than I would have expected four or five months ago, but pockets of weakness remain, particularly among the regional banks, which are a source of concern. I guess I've become convinced that credit lines have not been tapped out. There was a theory, one that I even had some sympathy toward, that increases in C&I lending in the last few quarters were involuntary, reflecting existing credit lines that were called upon. That strikes me as being somewhat overstated. According to anecdotes and our own survey of the terms of business lending, it does suggest that capital is still available for these small businesses to provide some strength to the economy; but again, continued weakness among the regionals could call that into question. Let me turn finally, Mr. Chairman, to the projections. I have some sympathy for the view that Vice Chairman Geithner put forth. It strikes me that at this time the markets will see the benefits of changing our communication strategy as, yet again, pretty small. The costs are harder for me to be certain about. So if anyone is proposing to do this during the next six months, I would have real hesitancy about introducing this variable into our communication strategy amid our assessment of all the other challenges that we have. So I favor having a trial run come October, but I think we should revisit where we stand on the inflation front, the financial institution front, and the growth front before adding this to the mix. To the extent that we find the appropriate time to go down this path, I would favor option 3. Thank you, Mr. Chairman. " CHRG-109hhrg22160--84 Mr. Greenspan," I was about to get to that. The issue is we are going to eventually get to a clinical best practice, and it involves the whole sets of procedures that are involved, which is going to be quite different, in my judgment, from what is done today. And I think we are going to have to build up, as quickly as we can, the technology because I don't see how we can make major long-term structural decisions on Medicare of which the issue that you are raising, Congressman, is a critical one because I am fearful if we freeze in a ``solution,'' in quotes, to all of these problems, and we find that this clinical practice is changing fairly dramatically, we are going to find as we have frozen in the system which won't work. So I can't answer your question specifically, but I will tell you that there is not only that problem, but a long series of other problems, which is manifested in a huge potential expenditure outlook going forward with not only Medicare, but Medicaid, and I must say with medical expenditures generally. " CHRG-109hhrg31539--106 Mr. Bachus," And also, I would like to say that we have created 5\1/2\ million jobs, and job growth is stronger than it was under the last recovery. But let me ask you this. You have been asked for 2 days--you have heard Members of Congress, you have heard the media talking about the anemic economy and the slow economy and the slowing economy. And I think The Wall Street Journal said it best. They called it the ``Dangerfield economy, it is the economy that gets no respect.'' Bottom line: What is your view about the economy? Is it as strong as some claim? Is it as weak as others claim? Just talk to us about the economy. " CHRG-110shrg50415--85 Mr. Rokakis," Mr. Chairman, if you look at what happened in July, just look at the rules that were promulgated--prohibiting loans without regard to making good on that loan; the repayment of the loan; requiring creditors to verify income; banning prepayment penalties in the first 4 years of an ARM was involved; rules against the pressuring, against the coercion of appraisers--if those rules had been put into effect back when they went to the Fed, let's say 2001 or even 2002 or 2003, the outrageous lending practices that accelerated between 2003, 2004, 2005, and 2006 I think would have been prevented, or certainly slowed down, and I think we would be in a different position here today. " CHRG-111hhrg56766--129 Mr. Bernanke," Well, the purpose of the TALF was not really to solve the whole CRE problem. Its purpose was to try to get the commercial mortgage-backed securities market going again. I guess it's a little bit of an overstatement to say that it's going again, but we are getting some deals there and the spreads have come in and so that issue has been somewhat reduced in terms of the concern. I think the real concern at this point is that the fundamentals for hotels and office buildings and malls and so on are quite weak and that's why the loans are going bad and really the only solution there is, first, to strengthen the economy overall and, second, to help banks deal with those problems, work them out. Ms. Velazquez. Mr. Chairman, today it has been reported that 25 percent of all mortgage borrowers were underwater, 11 million families in this country. What is the Fed doing to encourage stability in the housing sector that is so tied to economic recovery in the long term? " CHRG-109shrg21981--114 Chairman Greenspan," Senator, I think it is a very difficult issue. And I think that to the extent we see that benefits are going up and wages have flattened out, relatively speaking, a goodly part of this is the fact that individuals are willing to take health benefits in lieu of wages and salaries, but only in part. So overall, there is no question that the net effect on cost to businesses is rising. My own judgment is that the Medicare problem is, of course, several multiples more difficult than is Social Security. But I am also of the belief that we probably ought not to address the medical issue quite yet, until we get much further down the road in the advance in information technology in the medical area, which a number of individuals are looking into, and indeed there are Members of this body on both sides of the aisle who are focused on this issue, and I think, to the extent that we can begin to get major advances in information technology at an encrypted individual level, I think that best clinical practice is going to change. And it is going to change because we are going to see things that we already suspect, on the basis of certain different types of surveys, namely, that there are all different types of practices for specific diseases across this country with very varying outcomes, and it is largely the unavailability of all of the information which has made the improvement in clinical practice difficult. And in my judgment, we have to get to the point where the medical profession, following from the information technology, creates a best clinical practice, at which point I think that an endeavor to address the problems that you are concerned with and, in the broader sense, the medical profession generally is concerned with, would be appropiate. If we were to do it now or even next year, I am fearful we would be restructuring an obsolete model and have to come back and undo it. So, I agree with people who are saying we should do Medicare first before Social Security because it is a much bigger problem. I agree it is a hugely much more difficult problem. But I am not sure I would agree with the issue of the sequence, wholly because of what is now occurring in medicine. Senator Dole. And let me ask you about manufacturing. As I mentioned in my opening statement, and we all know, North Carolina and a number of other States have been hit hard by the loss of manufacturing jobs since 1998. According to the Bureau of Labor Statistics, manufacturing employment has remained level in the last year. Do you see growth in manufacturing in this next year? " CHRG-111hhrg54872--31 Mr. Calhoun," Chairman Frank, Ranking Member Bachus, and members of the committee, thank you for your work over the last year as you have dealt with one of the largest financial crises our country has ever faced. Most of the witnesses today, from both panels, acknowledge that poor oversight and weak consumer protection were major causes of our present crisis. The question is how to improve them. And an appropriate test is what would have happened over the last 10 years if proposed reforms had been in place. The CFPA bill that is before this committee would have prevented the worst of what we are experiencing now. However, some of the proposals to weaken it would have exacerbated the last crisis and would make it likely that we will repeat these mistakes in the future. In other words, done wrong, we can make things even worse for consumers and the whole economy. There are four critical things we have to get right. First, we need to create an independent agency. As we have learned, if financial products are not sound, the markets built on them cannot be sound. Second, we need to cover products, not labels. We need to make sure to prevent the gaps and unlevel rules that contributed so much to the current crisis. Third, we need to be careful not to insulate abusive practices with preemption. This was done over recent years with mortgages, credit cards, and debit cards, all with disastrous results. And fourth, we need to provide effective enforcement. There has been case after case in recent years where, when standards were enacted but without enforcement, they created an illusion of protection that was worse and more dangerous than none at all. I was struck, Mr. Chairman, by your comments about the impact of Mr. Greenspan's approach at the Fed to not enact consumer protections. That takes me to what is the core issue I want to ask you to focus on, and that is the preemption that has been raised. Imagine what would have been the case if Mr. Greenspan would have had not only the authority to not act, but also the authority to wipe out all State protections and to bar all States from stepping in to protect the abuses that we saw. We should remember, it was the States who led the way in addressing the ability to repay, finding loans that were being made repeatedly to customers who had no ability to stay in those homes. It was the States who addressed broker kickbacks where the brokers received payments to steer people to higher-priced loans, even though in 2001, HUD took action to actually protect those kickbacks. So I think it is also important to know the details of the preemption in this bill. The sweeping scope of present financial preemption is a recent and isolated phenomenon, as the chairman mentioned. In 2004, the Federal banking agencies took preemption to a whole new level as they competed with each other to be attractive to the institutions they regulated, who they referred to in official documents as their customers. The bill makes a return to preemption as it was 5 years ago and it relies on you, the Congress, not agencies, to prescribe preemption. States still cannot set usury limits for mortgage loans, credit cards, or other credit under this bill as it currently reads. There are, however, proposals to greatly increase preemption beyond current levels and make all rules of the CFPA preemptive. This would wipe out State consumer protection laws and a wide array of transactions, and weaken overall consumer protection. If that had been in place over the last year, we would have faced an even greater disaster. We would have seen, again, no opportunity for States to detect problems and test solutions, and no enforcements of State civil rights laws. Finally, we need to make sure there is effective enforcement for this bill. Looking at the overdraft area, the Fed acknowledged, in 2001 and 2004, major problems with overdraft loans. It issued best practices that said you should not be applying these to debit cards. You should protect people from outrageous fees or from repeated fees. One bank submitted a request for approval of their overdraft program. The OCC refused to give that approval and the bank asked, ``Are you going to enforce these guidelines against us?'' And the OCC said, ``We will only enforce those things that are law. These are not law. Do what you will.'' Fast forward, 8 years later, $80 billion of overdraft fees later. For the American public, we now have proposals that the Fed may act. We look forward to working with the committee to establish an effective CFPA that is enforceable and efficient. Thank you, Mr. Chairman. [The prepared statement of Mr. Calhoun can be found on page 76 of the appendix.] " CHRG-110shrg50416--124 Chairman Dodd," Thank you very much. Let me ask just a couple of quick questions. Mr. Montgomery, I want to compliment you again as well. Keeping those underwriting standards may have been a painful process. Everyone was probably saying, ``Why aren't we doing more to get more of this business?'' But we are all very grateful you stuck to the principles on that. And you are rightly proud as well to have been able to launch the Hope for Homeowners plan in such a short time. That is really rather amazing going from July to October 1, and I want to commend you for it. And I hope it is just more than hope as well, but we have plan here that could really make a difference with some people. In the end, of course, the goal is to help homeowners. Please just update us on what you are doing to maximize the use of this program. What steps have you taken to sign up lenders? What steps have you taken to ensure borrowers know about the program? And what impediments do you see in the use of this program? And let me just add anecdotally, again, going back to people we are hearing from, when they make that call, the first advice is ``Call your lender.'' Now, I appreciate that, but too often what happens then is you get into that calling your lender and you end up along the lines that lawyer in Staten Island talked about, representing a number of people facing foreclosure. So would you please respond to those? " FinancialCrisisReport--227 Numerous documents show that OTS and the FDIC were, in fact, aware that WaMu was issuing high risk loans that led to poor quality securitizations: 2005 OTS email describing poor quality Long Beach mortgage backed securities: “Performance data for 2003 and 2004 vintages appear to approximate industry average while issues [of securities] prior to 2003 have horrible performance. ... [Long Beach] finished in the top 12 worst annualized [net credit losses] in 1997 and 1999 thru 2003. … At 2/05, [Long Beach] was #1 with a 12% delinquency rate. Industry was around 8.25%.” 863 2005 FDIC analysis of WaMu high risk loans: “Management acknowledges the risks posed by current market conditions and recognizes that a potential decline in housing prices is a distinct possibility. Management believes, however that the impact on [WaMu] would be manageable, since the riskiest segments of production are sold to investors, and that these investors will bear the brunt of a bursting housing bubble.” 864 2005 OTS email discussing allowing lower standards for loans held for sale: “[L]oans held for sale could be underwritten to secondary market standards …. I believe we would still find that secondary market requirements are more lax than our policy on underwriting to fully indexed rates. … [I]f you allow them [WaMu] the exception for loans held for sale … they probably do not have a ton of loans that fall far outside our policy guidance.” 865 2006 OTS email discussing Long Beach loans that had to be repurchased from buyers: “The primary reasons for the problem were … [g]eneral lower quality 2005 production due to economy and lowered standards …. The $4.749 billion in loans on [Long Beach] books at 12/31/05 are largely comprised of the same 2005 vintage production that was sold in the whole loan sales and are now subject to the increased repurchases. … Management is balancing the probability that these loans will perform worse than expected and priced for, versus the increased income they generate … in considering whether to [sell] some or all of the portfolio.” 866 862 “Securitizations of Washington Mutual and Long Beach Subprime Home Loans,” chart prepared by the Subcommittee, Hearing Exhibit 4/13-1c; 10/17/2006 “Option ARM” draft presentation to the WaMu Board of Directors, JPM_WM02549027, chart at 2, Hearing Exhibit 4/13-38. 863 4/14/2005 email from OTS examiner to colleagues, OTSWME05-0120000806, Hearing Exhibit 4/13-8a. 864 Undated draft memorandum from WaMu examination team to the FDIC Section Chief for Large Banks, FDIC- EM_00251205-10, Hearing Exhibit 4/16-51a (likely mid-2005). 865 9/16/2005 email from OTS Examiner-in-Charge at WaMu, OTSWMS05-002 0000535, Hearing Exhibit 4/16-6. 866 1/20/2006 email from Darrel Dochow to Michael Finn and others, OTSWMS06-007 0001020. 2008 OTS email after WaMu’s failure: “We were satisfied that the loans were originated for sale. SEC and FED [were] asleep at the switch with the securitization and repackaging of the cash flows, irrespective of who they were selling to.” 867 2005 WaMu audit of Loan Sales and Securitization planned no further audit for three years. In March 2007, OTS informally suggested that more frequent audits would be appropriate given the high volume and high risk nature of WaMu’s securitization activity and “data integrity issues surrounding the creation of securitization trusts, resulting in loan repurchases from those trusts.” 868 OTS was two years too late, however; the secondary market for subprime securities collapsed four months later. CHRG-110hhrg44901--57 Mr. Bernanke," Well, first of all, IndyMac did fail, and the Fed did not do anything about that. I would add to your constituents, as I mentioned earlier, that all insured deposits were available immediately and no insured depositor is going to take any loss from that. We have in this episode just been confronted with weaknesses and problems in the financial system that we didn't fully--we collectively, the regulators, the Congress, the economists did not fully anticipate. And in the interest of the broader financial system and particularly as always, always the ultimate objective is the strength of the economy and the conditions for--economic conditions for all Americans. We found weaknesses and we had to respond in crisis situations. I think that--while I certainly would defend the actions we have taken, I would much prefer in the future not to have to take such ad hoc actions and, as I described, I think to Ranking Member Bachus, the best solution is to have a set of rules that govern when a bank can be or other institution can be, you know, put through a special process. In particular, we already have such a process for depository institutions, which is a fiduciary process where the requirement is that the government resolve that bank at the least cost to the taxpayer unless a determination by a broad range of financial officials that a systemic risk exists, in which case other measures could be taken. So I think it wouldn't be appropriate for me to try to give you any guidelines right now. I think what we are doing right now is trying to do the best we can to make sure the financial markets continue to improve, and that they begin to function at a level which would be supportive of the economy. I think what is critical is as we go forward, we take stock from the lessons we have learned from this experience and try to set up a system that will be less prone to these kinds of difficult decisions that we have had to make. " CHRG-110hhrg44901--126 Mr. Bernanke," There was consumer testing, and it was precisely that consumer testing that led us to conclude that there were certain practices that could not be made adequately transparent through disclosures that did not have direct beneficial effects to consumers. That outweighed whatever problems that might arise. That was the reason that we, in some cases, chose prohibition over disclosure. " CHRG-109hhrg31539--154 Mr. Bernanke," I think it should be recognized that our budget deficit--and again, this is a practice of some standing--reflects current revenues and current spending, it doesn't reflect the unfunded obligations that are arising for future entitlement? Mr. Moore of Kansas. So that can be very misleading then, can't it? " CHRG-111hhrg56778--83 Mr. Greenlee," That's correct. And we don't just rely on what we get from the functional regulators. As the consolidated supervisor, we would have a view of all the company's major lines of businesses and its risk management practices. We are aware of broader things going on in the marketplace. We pull all that together to make the assessments of the risk in the organization. " CHRG-111hhrg52397--187 Mr. Johnson," Well, I think what is interesting is the good work that is being done in the credit default swap market as the regulators have nudged participants to clean up the area and to try and reduce systemic risk. Some of the best practices, and it has almost become a model for what we could do in other areas as we move forward. " CHRG-111shrg50814--187 Mr. Bernanke," I think there are a couple of issues, practical issues, that people need to pay attention to. One is just the great technical difficulty of shutting down an enormous holding company with many components, an international presence. Senator Shelby. We understand that. " FOMC20080430meeting--282 280,MR. PLOSSER.," Yes, just an implementation question. One thing you talked about was in periods of stress, the way we've conducted policy intraday, you have had firmness in the funds rate in the morning and then weakness in the afternoon causing some intraday volatility. The difficulty of hitting the target was partly the fact that we were entering the market only once a day, in the morning, and you had to see through that. With all these other strategies, as they are implemented in other countries, are the central banks doing the same thing? Are they entering the market only once a day, or do they come in several times a day? I just wondered if there are differences in their approaches as to how often they interact in the marketplace. " FinancialCrisisReport--568 Mr. Tourre: Yes. 2545 ACA has since filed a civil lawsuit against Goldman asserting that Goldman did not inform ACA that “Paulson intended to take an enormous short position” in Abacus and is seeking to recover $30 million in compensatory damages and $90 million in punitive damages for fraudulent inducement, fraudulent concealment, and unjust enrichment. 2546 Regardless of the communications between Goldman and ACA, it is clear that the Abacus marketing material and offering documents provided by Goldman to investors contained no mention of Paulson’s short position in the CDO nor the significant role it played in the selection of the CDO’s reference assets. This was confirmed by Mr. Tourre at the Subcommittee hearing: Senator Levin: And was it reflected in the Goldman Sachs security offering to investors that Paulson had been part of the selection process? Was that represented in that document? Mr. Tourre: Paulson was not disclosed in the Abacus 07 AC-1 transaction, Mr. Chairman. Senator Levin: It was not? Mr. Tourre: No, it was not. 2547 Still another troubling omission was Goldman’s failure to advise potential Abacus investors that the firm’s own economic interests were aligned with those of the Paulson hedge fund. As part of the Abacus CDO arrangement, Paulson agreed to pay Goldman a higher fee if Goldman could provide Paulson with CDS contracts containing premium payments below a certain level. 2548 The 2545 2546 Id. at 86. ACA Financial Guaranty Corp. v. Goldman Sachs & Co. , Index No. 650027/2011 (N.Y. Sup.), Complaint (January 6, 2011), at 1, 23 (hereinafter “ACA Complaint against Goldman Sachs). 2547 2548 April 27, 2010 Subcommittee Hearing at 86. See 3/12/2007 Goldman memorandum to Mortgage Capital Committee, “ABACUS Transaction sponsored by ACA,” GS MBS-E-002406025, Hearing Exhibit 4/27-118 ( “Goldman will receive an upfront premium from Paulson for distributing risk at or within specified strike spreads.” “If Goldman succeeds in placing a given Targeted Tranche inside the related Strike Spread, Goldman will receive from Paulson a fee on the notional amount of such Targeted Tranche distributed. Such fee will have a floor component (the ‘Minimum Fee Rate ’) and an upside sharing component, under which Goldman will share with Paulson any execution delivered at levels tighter than the Strike Spreads.”). See also 1/18/2007 email from Fabrice Tourre to David Lehman and others, GS MBS-E-002483446 (detailing the additional fees Goldman could earn by executing trades within the strike spread of each tranche); 3/14/2007 email from Paolo Pellegrini to Sihan Shu with “ACA ABACUS Paulson Fee Illustration ” spreadsheet attached (the spreadsheet provides details of the incentive-based fees paid to Goldman, including for Goldman ’s pricing of spreads), PAULSON-ABACUS 0250401. Mr. Pellegrini told the SEC that Goldman and Paulson had discussions regarding Goldman ’s compensation, resulting in “a formula that tied their compensation to sort of kind of the spread that they sort of presented to or that they would present to us.” SEC deposition of Paolo Pellegrini (12/3/2008), PSI-Paulson-04 (Pellegrini Depo)-0001, at 118-19. Mr. Tourre described the compensation agreement in an email to Mr. Sparks, writing that if Goldman could place super senior risk inside a certain spread, Paulson would pay Goldman an upfront fee and periodic fees reflecting the money Goldman saved Paulson. 9/8/2006 email from Fabrice Tourre to Dan Sparks, GS MBS-E-009516671. Mr. Tourre told the SEC that Paulson was problem with the fee incentive offer was that, while lower premiums would result in lower costs to Paulson, it would also result in lower premium payments to the CDO, directly reducing the amount of cash available to the long investors. The Paulson-Goldman compensation arrangement, thus, created a direct conflict of interest between Goldman and the investors to whom it was selling the Abacus securities. FOMC20061212meeting--105 103,MR. MISHKIN.," Thanks, Mr. Chairman. I see the economy evolving very much along the lines of the past couple of Greenbooks, particularly the ones since I’ve been here. The staff is to be very highly commended: They pointed out that outcomes were going to be weaker than other forecasters thought, and they really did get it right. Now, I have promised Dave that I wouldn’t jump on him when they get it wrong, and today I’ll be nice in the other direction. I think their forecast has been very useful in terms of the numbers. In fact, I think we’re seeing the economy evolve very much along the lines that we discussed at the past couple of meetings. There really is not all that much new. I think there’s a smidgen more weakness on the real side, but it doesn’t alter my basic view that the economy is evolving along the lines of having slightly below potential GDP growth. I don’t see any indications that we will have big spillovers into other sectors from weak housing and motor vehicles. In that sense, there’s a slight concern about a little weakness, but the right word is I guess a “smidgen,” not a whole lot. I see that inflation pressures are also very similar to what they were at the time of our last meeting. Inflation is likely to decelerate to somewhere around 2½ percent in the core CPI and 2 percent in the core PCE. Part of the reason I believe those numbers is that the nature of the output paths we’ve talked about is consistent with them, but I also think that we have anchored inflation expectations around those levels. I don’t like to use the word “persistence” the way other people do. I think of mean reversion to expected inflation—and very likely that’s where inflation will be heading, given the paths that we see in terms of the economy and the forecast from the Greenbook. I see the risks to forecast inflation as fairly balanced. The good news is that compensation is not as scary as it was. But the bad news is that the labor markets are very tight, and we’re just not quite sure what the implications of that are going to be. So my view is that we have a bit greater uncertainty, not a whole lot, so that we need to be very vigilant on inflation because it is too high, labor markets are tight, and there is still some question about how quick the mean reversion to expected inflation will be. We also need to be vigilant about real output. There is a bit more certain information coming in, so I think we have to watch both inflation and output. The last thing to mention is the yield curve. I did some of the research on yield curves in recessions, and I do not think that the yield curve is providing much information at this time, exactly for the reasons that Governor Kroszner and others have discussed. I think there are special reasons that the term premium is extremely low. There is always that nice little table of the yield curve and recession probabilities, but you notice that I haven’t mentioned it, and I’m not going to mention it in the future. [Laughter] Thank you very much." CHRG-111shrg55278--31 Mr. Tarullo," Senator, could I just--just slightly amend or add to what I said. It is important to look to see what those rules are that prevail. The rules on leverage, the rules on capital, the rules on liquidity are themselves supposed to be based upon concepts of risk, and I believe they are based upon concepts of risk, which should contain these kinds of risks I mentioned. I think that if you set the rules properly, you have gotten a fair way down the line to containing risks within those institutions. What I was saying before about the backup supervisory examination authority is there can still be practices that arise that somehow are evading the rules or are not falling under the rules, and then you need to determine whether it is an unsafe and unsound practice and make a judgment about that. So, I do not think anybody should promise to you that as soon as any firm starts doing anything dangerous that some regulator is going to see it and be able to stop it. It is going to have to evolve over time. If the rules are set right, you should be containing a good bit of that to begin with. " FOMC20080109confcall--16 14,MR. STOCKTON.," I believe in nonlinear dynamics. [Laughter] I think I have even experienced them, and probably you have as well on occasion, in terms of the difficulty that we have in forecasting recessions. Our forecast isn't just some sort of ""push a button on a linear model and here is the result."" But I do think the current situation illustrates to me why it is, in fact, so hard for us and why we don't forecast recessions very often. As I indicated, I think there is a configuration of a number of indicators that make it easy for me to imagine you looking back on next June and saying, ""Indeed, what you saw back there in December--in terms of the jump in the unemployment rate, the drop in the manufacturing ISM, and the uptick in initial claims-- were all precursors of a recession."" The point of my remarks is that I am pretty darn worried about that possibility. But it is hard at this point to make that call--we are coming off the data in the fourth quarter, which have exceeded our expectations considerably. As I noted, not all the things that you might expect to be highly sensitive to a business cycle downturn, such as motor vehicle sales, have moved in that direction. I know this is unfortunate, and we really cannot be as helpful to you as I would like. We are saying, in effect, ""Yes, we'll call the recession when we see the weak spending data."" But the weak spending data will already be lagged one or two months, and that is the reason that we will be looking back, if we're lucky to be able to do it in March, saying, ""The spending data indicate that a recession may have started in December."" The current forecast is our best judgment. But I think it wouldn't take much more in the way of negative news for us at this point to regime-shift, as you said, into recession mode. We are not quite there yet, but we are certainly worried about that possibility at this point. " CHRG-111shrg54789--177 FINANCIAL PROTECTION AGENCY It has become clear that a major cause of the most calamitous worldwide recession since the Great Depression was the simple failure of Federal regulators to stop abusive lending, particularly unsustainable home mortgage lending. Such action would not only have protected many families from serious financial harm but would likely have stopped or slowed the chain of events that has led to the current economic crisis. The idea of a Federal consumer protection agency focused on credit and payment products has gained broad and high-profile support because it targets the most significant underlying causes of the massive regulatory failures that occurred. First, Federal agencies did not make protecting consumers their top priority and, in fact, seemed to compete against each other to keep standards low, ignoring many festering problems that grew worse over time. If agencies did act to protect consumers (and they often did not), the process was cumbersome and time-consuming. As a result, agencies did not act to stop some abusive lending practices until it was too late. Finally, regulators were not truly independent of the influence of the financial institutions they regulated. Meanwhile, despite an unprecedented Government intervention in the financial sector, the passage of mortgage reform legislation in the House of Representatives and the enactment of a landmark law to prevent abusive credit card lending, problems with the sustainability of home mortgage and consumer loans keep getting worse. With an estimated 2 million households having already lost their homes to foreclosure because of the inability to repay unsound loans, Credit Suisse now predicts that foreclosures will exceed 8 million through 2012. \27\ The amount of revolving debt, most of which is credit card debt, is approaching $1 trillion. \28\ Based on the losses that credit card issuers are now reporting, delinquencies and defaults are expected to peak at their highest levels ever within the next year. \29\ One in two consumers who get payday loans default within the first year, and consumers who receive these loans are twice as likely to enter bankruptcy within 2 years as those who seek and are denied them. \30\ Overall, personal bankruptcies have increased sharply, up by one-third in the last year. \31\--------------------------------------------------------------------------- \27\ ``Foreclosures Could Top 8 million: Credit Suisse,'' 9 December 2008, MarketWatch, available at http://www.marketwatch.com/story/more-than-8-million-homes-face-foreclosure-in-next-4-years (last visited 21 June 2009). \28\ See the Federal Reserve statistical release G19, Consumer Credit, available at http://www.federalreserve.gov/releases/g19/ \29\ ``Fitch Inc. said it continues to see signs that the credit crunch will escalate into next year, and it said card chargeoffs may approach 10 percent by this time next year.'' ``Fitch Sees Chargeoffs Nearing 10 percent,'' Dow Jones, May 5, 2009. \30\ Paige Marta Skiba and Jeremy Tobacman, ``Payday Loans, Uncertainty, and Discounting: Explaining Patterns of Borrowing, Repayment, and Default,'' August 21, 2008. http://www.law.vanderbilt.edu/faculty/faculty-personal-sites/paige-skiba/publication/download.aspx?id=1636 and Paige Marta Skiba and Jeremy Tobacman, ``Do Payday Loans Cause Bankruptcy?'' October 10, 2008 http://www.law.vanderbilt.edu/faculty/faculty-personal-sites/paige-skiba/publication/download.aspx?id=2221 (last visited 21 June 2009). \31\ ``Bankruptcy Filings Continue to Rise'' Administrative Office of the U.S. Courts, news release, 8 June 2009, available at http://www.uscourts.gov/Press_Releases/2009/BankruptcyFilingsMar2009.cfm (last visited 21 June 2009).--------------------------------------------------------------------------- The failure of Federal banking agencies to stem subprime mortgage lending abuses is fairly well known. They did not use the regulatory authority granted to them to stop unfair and deceptive lending practices before the mortgage foreclosure crisis spun out of control. In fact, it wasn't until July of 2008 that these rules were finalized, close to a decade after analysts and experts started warning that predatory subprime mortgage lending would lead to a foreclosure epidemic. Less well known are Federal regulatory failures that have contributed to the extension of unsustainable consumer loans, such as credit card, overdraft and payday loans, which are now imposing a crushing financial burden on many families. As with problems in the mortgage lending market, failures to rein in abusive types of consumer loans were in areas where Federal regulators had existing authority to act, and either chose not to do so or acted too late to stem serious problems in the credit markets. Combining safety and soundness supervision--with its focus on bank profitability--in the same institution as consumer protection magnified an ideological predisposition or antiregulatory bias by Federal officials that led to unwillingness to rein in abusive lending before it triggered the housing and economic crises. Though we now know that consumer protection leads to effective safety and soundness, structural flaws in the Federal regulatory system compromised the independence of banking regulators, encouraged them to overlook, ignore, and minimize their mission to protect consumers. This created a dynamic in which regulatory agencies competed against each other to weaken standards and ultimately led to an oversight process that was cumbersome and ineffectual. These structural weaknesses threatened to undermine even the most diligent policies and intentions. They complicated enforcement and vitiated regulatory responsibility to the ultimate detriment of consumers. These structural flaws include: a narrow focus on ``safety and soundness'' regulation to the exclusion of consumer protection; the huge conflict-of-interest that some agencies have because they rely heavily on financial assessments on regulated institutions that can choose to pay another agency to regulate them; the balkanization of regulatory authority between agencies that often results in either very weak or extraordinarily sluggish regulation (or both); and a regulatory process that lacks transparency and accountability. Taken together, these flaws severely compromised the regulatory process and made it far less likely that agency leaders would either act to protect consumers or succeed in doing so.SECTION 2. CORRECTING REGULATORY SHORTCOMINGS BY CREATING A CONSUMER FOMC20081216meeting--230 228,MR. FISHER.," Mr. Chairman, thank you. President Rosengren talked about micro behavior, and at the beginning, First Vice President Cumming talked about the hunkering-down mentality. I have been focused on the microeconomic behavioral responses to our current situation. As one of my CEO contacts outside my region said, we are basically all, in his words, ""chasing the anvil down the stairs,"" and that is that the behavioral responses of both businesses and consumers are driving us into a slow-growth cul-de-sac and a deflationary trap. One CEO I talked with was quite pleased that he could borrow $40 million over the weekend for a total of $250. That is great from a commercial paper standpoint; he is an A1/P1 issuer. However, were he to go to the longer-term debt markets, it would cost him 7� percent. So they can finance their daily operations easily. But in terms of their long-term planning, they and others are responding--and I see this uniformly across my contacts--out of concern about the high cost of debt and the spreads over Treasuries, by doing what any businesswoman or businessman would do. They are planning on less cap-ex, and they are cutting back on their plans for acquisitions of the weak, which they would like to take advantage of under the current circumstances. They are also responding to the situation by cutting back on head count. So, Chris, there is very much a hunkering-down mentality, not just in my District but across the country. That leads to further economic weakness--that plus the fact that they are chary about issuing and paying for things with shares in a very weak market. I am hearing more and more worries about their pension liabilities and how they are going to be able to finance those. Obviously this is leading to the kind of economic behavior that none of us would like to see. On the consumer side, you see a similar behavioral pattern. It seems that after Black Friday, according to my sources, there was weaker behavior than one had expected. The spending pulse data that I get from one of the large credit card companies reflect what one would expect under these circumstances--that is, a shift to nonbranded products, smaller purchases of items, a rotation out of credit cards to debit cards and cash payments according to the pay cycle, and overall an expectation, on both the business and the consumer side, that things will get cheaper if they wait longer and they postpone either their cap-ex or their consumer purchases. The one ray of sunshine that I was able to find is that one large law firm, Cravath, has announced that it is not increasing its billing rates in 2009, [laughter] and other law firms are actually planning to respond by cutting their billing rates. One woman whom I know summarized it this way: ""This is the divorce from hell. My net worth has been cut in half, but I am still stuck with my husband."" [Laughter] " CHRG-111shrg57319--8 Mr. Melby," Mr. Chairman and Members of the Subcommittee, good morning. My name is Randy Melby. I joined WaMu in June 2004 and became general auditor in December 2004. I have close to 30 years of bank experience with 27 of those years as a professional internal auditor for Norwest, who later acquired Wells Fargo, and 2 years leading a large commercial loan operations division for Wells Fargo, along with my current position as chief risk officer for BankUnited in Miami Lakes, Florida. I am also a certified internal auditor.--------------------------------------------------------------------------- \1\ The prepared statement of Mr. Melby appears in the Appendix on page 146.--------------------------------------------------------------------------- As general auditor for WaMu, I reported directly to the chairman of the Audit Committee of the corporate board of directors and administratively to the chief risk officer who reported directly to the CEO. I was not a member of the executive committee, which was comprised of the CEO's direct reports and select direct reports of the president and COO. My primary role as general auditor was to provide an independent, objective assessment of WaMu's system of internal control and underlying business processes. We conducted our work in accordance with the Institute of Internal Auditors' Standards for the Professional Practice of Internal Auditing and Code of Ethics and employed the Committee of Sponsoring Organizations of the Treadway Commission, or more commonly referred to as COSO, for defining, evaluating, testing, and reporting on WaMu's policies, processes, and information systems. My primary objectives were twofold: One, to assist the board, management, and employees in the effective discharge of their responsibilities by providing analysis, testing, recommendations, advice, and information concerning the adequacy and effectiveness of WaMu's internal control structure related to safeguarding of assets, compliance with applicable laws and regulations, and achievement of management's operational objectives; and, two, to promote effective business processes to internal control at a reasonable cost. The board, management, and employees of WaMu were accountable and responsible for establishing both an adequate and effective internal control environment and for balancing risk and reward in determining and executing business strategies. In other words, internal audit does not set or determine business strategies. We audit those processes established to execute against business strategies determined by both the board and management. As defined by COSO, internal control is a process effected by the board, management, and employees designed to provide reasonable assurance regarding the achievement of objectives related to the effectiveness and efficiency of operations, reliability of financial reporting, and compliance with applicable laws and regulations. I was hired by the Audit Committee to assist the board, management, and employees strengthen WaMu's overall system of internal control by improving and upgrading its internal audit function. When I joined WaMu in 2004, the company was at the tail end of a string of significant acquisitions that resulted in, among other things, multiple and disparate systems and a manually intensive business process environment. And the Internal Audit Department was very traditional and in need of being elevated to the next level of professionalism, credibility, and to be positioned as a forerunner in effecting change and delivering strategic and value-added internal audit services. For example, in 2005, we turned over close to 50 percent of the audit staff, or approximately 40 to 45 people. Most of this turnover was by design, and we began upgrading the overall quality and experience of the audit team. Turnover was cut in half to 24 percent in 2006 and improved to below 20 percent in 2008, which is in line with other large financial services' internal audit departments. In addition, 2005 was a year where we focused on our Internal Audit Department infrastructure by initiating an audit process improvement project, enhanced our professional practices group, developed internal metrics and MIS, started performing cross-organizational audits, and improved overall Audit Committee reporting. In 2006, I hired a deputy general auditor, an IT audit director, a professional practices audit director, and an audit director to oversee and redesign our audit approach for assessing credit risk. All came from outside of WaMu and reported directly to me and came with over 75 combined years of internal audit experience. These changes were significant, specifically as it relates to credit risk. Corporate Credit Review was positioned within WaMu as an independent function that was separate from internal audit. This group was responsible for providing an independent assessment of WaMu's overall credit risk and credit quality and reported up through the enterprise chief risk officer. These changes were designed to provide enhanced audit coverage of the credit review function. We redesigned our audit processes. The company acquired Providian Card Services, and we integrated the Providian audit team into our Audit Department, approximately 30 professional internal auditors, and we continued performing more risk-based and strategic audits. Last, we received an external review, which is required by the Institute of Internal Auditors' Standards for the Professional Practice of Internal Auditing, and received the highest rating assigned. In 2007, we continued hiring external talent to keep pace with the rapid changes occurring within WaMu. We achieved our full staffing plan for the first time since I joined the company, which allowed us to reduce our reliance on external co-source resources. We enhanced the overall quality of our ongoing risk assessments with the focus on emerging risks, and Corporate Fraud Investigations was merged and integrated into the Audit Department, and I hired an Investigations Director from the outside who reported directly to me. In 2008, we continued enhancing the quality of our assurance work. We enhanced our continuous risk assessment process with a focus on enterprise-wide risk assessments, and we continued performing high-risk, cross-organizational audits. Last, during my tenure as General Auditor, Internal Audit consistently reported to executive management and the Audit Committee those areas of the company that required significant improvement as well as those areas that were well controlled. I look forward to answering any of your questions to the best of my ability. Thank you. Senator Levin. Thank you very much. We are going to have an opening round, which is a 20-minute opening round, so that each of us will take up to that. In our subsequent rounds, we may have a little shorter period, but we will start with that approach. First, let me start with questions about Long Beach Mortgage. This was WaMu's primary subprime lender. Let me start with you, Mr. Vanasek. Did Long Beach have an effective risk management regime when you arrived at WaMu? " fcic_final_report_full--71 Indeed, the regulators, including the Fed, would fail to identify excessive risks and unsound practices building up in nonbank subsidiaries of financial holding compa- nies such as Citigroup and Wachovia.  The convergence of banks and securities firms also undermined the supportive relationship between banking and securities markets that Fed Chairman Greenspan had considered a source of stability. He compared it to a “spare tire”: if large commer- cial banks ran into trouble, their large customers could borrow from investment banks and others in the capital markets; if those markets froze, banks could lend us- ing their deposits. After , securitized mortgage lending provided another source of credit to home buyers and other borrowers that softened a steep decline in lending by thrifts and banks. The system’s resilience following the crisis in Asian financial markets in the late s further proved his point, Greenspan said.  The new regime encouraged growth and consolidation within and across bank- ing, securities, and insurance. The bank-centered financial holding companies such as Citigroup, JP Morgan, and Bank of America could compete directly with the “big five” investment banks—Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers, and Bear Stearns—in securitization, stock and bond underwriting, loan syndication, and trading in over-the-counter (OTC) derivatives. The biggest bank holding companies became major players in investment banking. The strategies of the largest commercial banks and their holding companies came to more closely re- semble the strategies of investment banks. Each had advantages: commercial banks enjoyed greater access to insured deposits, and the investment banks enjoyed less regulation. Both prospered from the late s until the outbreak of the financial cri- sis in . However, Greenspan’s “spare tire” that had helped make the system less vulnerable would be gone when the financial crisis emerged—all the wheels of the system would be spinning on the same axle. LONG TERM CAPITAL MANAGEMENT: “THAT ’S WHAT HISTORY HAD PROVED TO THEM ” In August , Russia defaulted on part of its national debt, panicking markets. Rus- sia announced it would restructure its debt and postpone some payments. In the af- termath, investors dumped higher-risk securities, including those having nothing to do with Russia, and fled to the safety of U.S. Treasury bills and FDIC-insured de- posits. In response, the Federal Reserve cut short-term interest rates three times in seven weeks.  With the commercial paper market in turmoil, it was up to the com- mercial banks to take up the slack by lending to corporations that could not roll over their short-term paper. Banks loaned  billion in September and October of —about . times the usual amount  —and helped prevent a serious disruption from becoming much worse. The economy avoided a slump. Not so for Long-Term Capital Management, a large U.S. hedge fund. LTCM had devastating losses on its  billion portfolio of high-risk debt securities, including the junk bonds and emerging market debt that investors were dumping.  To buy these securities, the firm had borrowed  for every  of investors’ equity;  lenders included Merrill Lynch, JP Morgan, Morgan Stanley, Lehman Brothers, Goldman Sachs, and Chase Manhattan. The previous four years, LTCM’s leveraging strategy had produced magnificent returns: ., ., ., and ., while the S&P  yielded an average .  CHRG-110hhrg44901--105 Mr. Royce," Thank you, Mr. Chairman. Chairman Bernanke, for a better part of a decade there has been a push to improve what is a very weak regulator in OHFEO over Fannie and Freddie. And I remember the week after you took your position we talked about this issue. We were in agreement. Here on this committee I have raised this issue countless times. In 2003, I introduced the first legislation which sought to bring Fannie and Freddie and the Federal Home Loan Bank System under one strong regulator within the Federal Government. Back in 2005, I introduced an amendment on the House Floor to give the new regulator the authority to review and adjust the GSEs' retained portfolios in order to mitigate against systemic risks. This is the same thing we are trying to do now with an independent regulator. And we are now witnessing what the current weak regulator, without the ability to mitigate against systemic risk, means for these two institutions and our broader capital markets. I will just mention that the majority of my colleagues voted against that amendment on the Floor of the House. But as we go forward with an episode here that could have been prevented long ago had your counsel or the counsel of those of us pushing this had been taken, we move closer now to passing legislation to strengthen the regulator for Fannie and Freddie. And I must again express my sincerest opposition and frankly my amazement to the inclusion of a roughly $600 million affordable housing fund and a $300 billion bailout for lenders and speculators that has been put in the bill. And I said this since its inception, this affordable housing fund is straight out of Central Planning 101. It should not be accepted by my colleagues. It should not be accepted by this Administration. And much of this money, pushed for by certain NGOs, will most likely end up in the pockets of a group of radical activist organizations with history of both voter fraud and anti-free market advocacy nationwide. So even if the money is used to promote affordable housing, because it is fungible, the American taxpayers will be indirectly subsidizing the most egregious actions taken by certain radical groups. So unfortunately, the safeguards in the bill meant to prevent abuses are far from sufficient. As a recent Wall Street Journal editorial noted, if later investigations prove the taxpayer funds were misused, the bill provides that recipients can simply return the amount of the grant with no further financial penalty. And Chairman Bernanke, I know you are not an advocate for this fund. So I will spare you a line of questioning to address that part of the issue, but I would like to get your thoughts on an additional issue, and that has to be on stability in the economy. As we watch our capital markets, as we watch this economy struggle, I believe there is plenty Congress could do to help in the recovery. And I think if we are able, I believe we should provide certainty to the environment in which our companies operate. And part of that certainty, if we go back to a speech that you gave as Chairman of the Council of Economic Advisors, you mentioned the 2001 tax cuts. And you said, additional tax legislation passed in 2002 and 2003 provided incentives for businesses to expand their capital investments and reduce the cost of capital by lowering tax rates on dividends and capital gains. Well, with those cuts looking to expire in 2010, it would seem critical to give the markets the certainty necessary to recover fully in the coming months. So I would ask, Chairman Bernanke, do you still agree with your previous assessment of the impact of the 2002 and 2003 cuts on the economy? And what would be the effects of an increase in the capital gains and dividends rate of 20 percent or higher as being discussed, what would that effect be on our already weak capital markets, especially considering the much lower rates that exist around the world? That would be my question to you now. " FOMC20070321meeting--83 81,MR. LACKER.," Thank you, Mr. Chairman. Overall, economic activity in the Fifth District expanded modestly in recent weeks, though performance across sectors remains uneven. Growth is centered in the services sector, where moderately positive readings continue. Real activity has recovered somewhat in recent weeks, and big-ticket sales have posted modest gains after two months of quite weak readings. In manufacturing, our survey respondents continue to report a downward drift in activity. They remain optimistic about their future prospects, however, though many comment on generally weak current demand. Labor markets remain tight in most jurisdictions, with the standard reports of spot shortages of skilled workers, but wage pressures are reported to be moderate. We continue to hear of some reasonably firm housing activity in a number of District localities. Home prices remain generally flat, though builders are offering more incentives to buyers. Inflation pressures appear to have moderated in March according to our latest survey, but manufacturers and service providers expect price pressures to increase modestly over the next six months. On the national level, risks seem to have risen lately, but my sense is that prospects are still reasonably sound. Subprime mortgages, obviously, have dominated the financial news in recent weeks. Concerns about the welfare of families suffering foreclosure are quite natural, and anecdotes about outright fraud suggest some criminality. But my overall sense of what’s going on is that an industry of originators and investors simply misjudged subprime mortgage default frequencies. Realization of that risk seems to be playing out in a fairly orderly way so far. Mortgage-backed securities have lost value as risk spreads have widened, and there have been insolvencies among firms that specialized in this sector. The updating of risk estimates in light of recent experience will lead to higher borrowing costs in the affected market segments, and at the margin this increase could shift some households from homeownership to renting. But in my judgment, that isn’t likely to affect the net demand for housing units. Notably, we have not seen broader risks to credit availability in other markets or to the financial safety net. Perhaps the greatest economic risk posed by recent subprime developments is legislation that impedes the availability of credit or that provides financial support ex-post that was unanticipated ex-ante but affects private decisionmaking henceforth, somewhat like ad hoc disaster relief. Housing construction continues to contract, of course, and inventories remain elevated. The choppy winter data make it hard to gauge the descent, but overall home sales seem to be holding steady, and we haven’t heard anything locally that suggests a renewed contraction in demand. So the housing outlook hasn’t changed much for me. However, the recent weakness in business investment has been disappointing. One would expect soft patches related to housing, autos, and the new truck regulations, but the broader sluggishness is a bit at odds with the generally favorable fundamentals. I still expect this investment to pick up ultimately, although I have to admit that the recent data have left me a bit less certain, especially about when. The outlook for consumer spending remains fairly healthy, though. Real disposable income growth has been powered by continuing gains in employment and firmer wage growth. So all in all, I still think the current episode of below-trend growth is fundamentally a transitory phenomenon that will most likely be behind us by the end of the year, although the recent weakness in business investment suggests more downside risk than before. Core inflation continues to firm, and it now seems clear that the fourth quarter’s energy- induced lull is over. We have yet to see much sign of the long-awaited easing in resource utilization. It’s not obvious that we will be getting any help from labor costs any time soon, and inflation expectations remain centered at or above 2 percent. So to me, the prospects for moderation in inflation remain tenuous. I continue to believe that, by summer, growth concerns are likely to be behind us, and we will want to act to reduce inflation, which we recognize is higher than we want. Thank you." FOMC20061212meeting--110 108,MR. MADIGAN.," No, they really don’t. The three-factor term structure model doesn’t provide a breakdown; it doesn’t allow us to distinguish between changes in risk perceptions and risk appetite. So there’s no evidence from that score. You may be seeing some reflection of what’s shown in the bottom left-hand panel with that pronounced downward skew to interest rates. If investors believe that bonds could prove to be a particularly good investment, given the possibility of economic weakness, they may actually demand a lower term premium because of the covariances that you referenced. But I think we need to do more work on that before we push hard on that analysis." FinancialCrisisReport--340 Backed Securities Corporation Home Equity Loan Trust, as a “crap deal”; and describing ACE 2006 HE2 M7, a subprime RMBS securitization issued by ACE Securities Corp., as: “[D]eal is a pig!” 1287 (3/1/2007) When asked about these emails, Mr. Lippmann told the Subcommittee that he generally thought all assets in CDOs were weak, and that his descriptions were often a form of posturing while negotiating prices with his clients. In a number of cases, however, Mr. Lippmann was assisting his clients in devising short strategies or communicating with Deutsche Bank colleagues, rather than negotiating with clients over prices. As will be seen later in this Report, some of the RMBS securities he criticized were, at virtually the same time, being included by his trading desk in Gemstone 7, which was later sold by Deutsche Bank’s CDO Group. In addition to disparaging individual RMBS securities, Mr. Lippmann expressed repeated negative views about the CDO market as a whole. At times during 2006 and 2007, he referred to CDO underwriting activity by investment banks as the workings of a “CDO machine” or “ponzi scheme.” 1288 In June 2006, for example, a year before CDO credit ratings began to be downgraded en masse, Mr. Lippmann sent an email to a hedge fund trader warning about the state of the CDO market: “[S]tuff is flat b/c [because] the cdo machine has not slowed but I am fielding 2-4 new guys a day that are kicking the tires so we probably don’t go tighter.” 1289 A few months later, in August 2006, Mr. Lippmann wrote about the coming market crash: “I don’t care what some trained seal bull market research person says this stuff has a real chance of massively blowing up.” 1290 When asked about his comments, Mr. Lippmann told the Subcommittee that the CDO market was not really a ponzi scheme, because people did receive an investment return, and asserted that he had used the term because he was “grasping at things” to prove he was right in his short position. 1291 Mr. Lippmann also told the Subcommittee that while he knew that the major credit rating agencies had given AAA ratings to an unusually large number of RMBS and CDO securities and most people believed in the ratings, he did not. He also told the 1285 12/4/2006 email from Greg Lippmann to Mark Lee at Contrarian Capital, DBSI_PSI_EMAIL01866336. The acronyms in the email refer to the following lenders: Bear Stearns Asset Backed Securities (“bsabs”), Option One Mortgage Loan Trust (“omlt”), and Ameriquest Mortgage Securities, Inc. (“amsi”). 1286 12/8/2006 email from Greg Lippmann to Peter Faulkner at PSAM LLC, DBSI_PSI_EMAIL01882188. 1287 3/1/2007 email from Greg Lippmann to Joris Hoedemaekers at Oasis Capital UK, DBSI_PSI_EMAIL02033845. 1288 In the 1920s, Charles Ponzi defrauded thousands of investors in a speculation scheme that “involves the payment of purported returns to existing investors from funds contributed by new investors.” “Ponzi Schemes – Frequently Asked Questions,” SEC, http://www.sec.gov/answers/ponzi.htm. 1289 6/8/2006 email from Greg Lippmann to Bradley Wickens at Spinnaker Capital, DBSI_PSI_EMAIL01282551. 1290 8/29/2006 email from Greg Lippmann to Bradley Wickens at Spinnaker Capital, DBSI_PSI_EMAIL01628496. 1291 Subcommittee interview of Greg Lippmann (10/18/2010). CHRG-111shrg50815--30 Mr. Plunkett," Thank you, Chairman Dodd, members of the Committee. I am Travis Plunkett, the Legislative Director at the Consumer Federation of America. I am testifying today on behalf of CFA and five other national consumer organizations. I appreciate the opportunity to offer our analysis of the very serious national consequences that unfair and deceptive credit card practices are having on many families in this recession as well as what this Committee can do to stop these traps and tricks. American families cannot become the engine of economic recovery if they are burdened by high credit card debt that can further escalate at a creditor's whim. I would like to summarize five points that I will leave with the Committee and then come back at the end of my testimony and provide a little detail on each point. First, the number of families in trouble with their credit card loans is approaching historic highs, as Senator Dodd said. Based on loss trends the card issuers are reporting, 2009 could be one of the worst years on record for credit card consumers. Second point, credit card issuers share a great deal of responsibility for putting so many Americans in such a vulnerable financial position through their reckless extension of credit over a number of years and use of abusive and unjustified pricing practices, which seem to be accelerating at this time when consumers can least afford it. Third, the need for quick action to end abusive lending practices is more urgent than ever now because taxpayers are propping up major credit card issuers through several enormously expensive programs. If the government is going to attempt to spur credit card issuers to offer more credit, it must ensure that the loans they are offering now are fair and sustainable. Fourth, the recent credit card rule finalized by the Federal regulators is a good first step in curbing abusive practices. It does have significant gaps, though, and as we have heard, it doesn't take effect until July of 2010. Fifth, Senator Dodd's comprehensive Credit Card Act fills in many of these gaps, as do a number of other legislative proposals that have been offered by members of this Committee. It will make the credit card marketplace fairer, more competitive, and more transparent. So let us talk a little detail here. On loss trends, Senator Dodd went through some of the most worrisome factors. One thing to watch is something industry insiders look at a lot. It is called the payoff rate. This is the amount of money that credit card consumers pay on their credit card bill every month and it has just dropped at the end of last year precipitously for credit cards. It is now at one of the lowest levels ever reported, showing that cardholders are having a harder time affording their bills and that the amount of money they can pay every month is dropping. Charge-offs and delinquencies--charge-offs is the amount of money proportionate to how much is loaned that credit card issuers write off as uncollectible--it is looking like they may approach the highest levels ever by the end of this year, and they are already quite high and have shot up very fast. Personal bankruptcy is up by about a third. On the responsibility that issuers have for this problem, just so you don't think this is last year's news or old news, let me just cite a few recent problems with some of the pricing practices you have heard about. They involve issuers adding new fees, increasing the amount of fees that they are charging, using harmful rather than responsible methods to lower credit lines, and a number of other abusive practices. Citigroup last fall back-pedaled on its promise to note increase interest rates any-time for any-reason, and then increased interest rates on a large part of their portfolio. Chase, as we have heard, has suddenly started charging people $120 a year for their accounts. These are cardholders who were promised a fixed rate for the life of their balance. Bank of America has used a variety of questionable methods for cardholders who appear to have done nothing wrong to violate their agreement, citing risk-based pricing and not providing clear information to these cardholders about the problem. Capital One and a number of other issuers over the last year, year and a half, have used very vague clauses in the cardholder agreements that allow them to increase interest rates for large parts of their portfolio for so-called market conditions. Let me be clear. Issuers do have the right to try and limit their losses in a recession, but these kinds of arbitrary and unjustified practices for cardholders who thought they were playing by the rules are very, very harmful. On the need for quick action because of government support, a couple of days ago, Treasury Secretary Geithner announced the expansion of a program that is supposed to provide taxpayer dollars to support securitization of credit card loans. They want more credit card lending. We have urged the Secretary to establish minimum fair practices standards for credit cards now so that our tax money isn't supporting unfair loans. On the Federal Reserve and regulator credit card rule, several positive aspects that we have heard about to the rule related to double-cycle billing, restrictions on increasing interest rates on existing balances, payment allocation. There are gaps, though. Fees are not addressed at all. Credit extension is not addressed at all. Bringing down rates if cardholders say they have a problem, then they pay on time for, say, 6 months, not addressed. And as we have heard, it doesn't take effect for a long time. The Credit Card Act and a number of other bills introduced in the Senate address many of these gaps. No any-time, any-reason repricing. That is the excuse Chase used. Limiting unjustified penalty fees by requiring that fees be reasonably related to the cost issuers incur, a very important part of the Credit Card Act. Limiting aggressive marketing and irresponsible lending to young consumers and lowering rates if consumers perform well after a problem occurs. Let me just close by saying that we have heard a lot about fears that fair regulation of the credit card market will lead to less credit, will lead to people who need it not having access to credit, especially lower-income or minority consumers. I always get a little worried because this context, or the context for this discussion is to ignore what has happened through essentially self-regulation of the market. I mean, where are we now? Issuers have been able to write their own rules for a very long time and they are cutting back on credit, especially to more vulnerable borrowers, especially to lower-income and minority borrowers. Plus, we have to deal with the kind of uncompetitive, not transparent marketplace we have heard about. So it sounds like the worst of all possible worlds to me, and that is why we support Senator Dodd's bill and fair regulation of the marketplace. " FinancialCrisisReport--185 In June 2007, for example, OTS examiners completed a review critical of WaMu procedures to oversee the loans it purchased from third party mortgage brokers. 678 From 2003 to 2007, 48 to 70% of WaMu’s loans were purchased from third parties. 679 An OTS memorandum noted that Washington Mutual had only 14 full-time employees overseeing more than 34,000 third party brokers submitting loans to the bank for approval. OTS also criticized the scorecard used to rate those brokers which, among other problems, did not include the rate at which significant lending or documentation deficiencies were attributed to the broker, the rate at which its loans were denied or produced unsaleable loans, or an indication of whether the broker was included in industry watchlists for misconduct. After describing these and other problems, rather than lower WaMu’s safety and soundness scores for its poor oversight, however, the OTS memorandum made only the following observation: “Given the . . . increase in fraud, early payment defaults, first payment defaults, subprime delinquencies, etc., management should re- assess the adequacy of staffing.” 680 WaMu management agreed with the finding, but provided no corrective action plan, stating only that “[s]taffing needs are evaluated continually and adjusted as necessary.” 681 In the September 2007 annual ROE, OTS wrote: “Risk management practices in the HLG (Home Loans Group) during most of the review period were inadequate …. We believe that there were sufficient negative credit trends that should have elicited more aggressive action by management with respect to limiting credit exposure. In particular, as previously noted, the risk misrepresentation in stated income loans has been generally reported for some time. This information should have led management to better assess the prudence of stated income lending and curtail riskier products well before we indicated during this examination that we would limit the Bank’s ability to continue such lending.” 682 The ROE also faulted management and Board inaction: “Board oversight and management’s performance was less than satisfactory. … Contributing factors should have been more proactively managed by the Board and management. The most significant of these factors include Matters Requiring Board 678 6/7/2007 OTS Asset Quality Memo 11, “Broker Credit Administration,” Hedger_Ann-00027930_001, Hearing Exhibit 4/16-10. 679 Prepared statement of Treasury IG Thorson, April 16, 2010 Subcommittee Hearing, at 5. 680 6/7/2007 OTS Asset Quality Memo 11, “Broker Credit Administration,” Hedger_Ann-00027930_001, Hearing Exhibit 4/16-10. 681 Id. at 011. 682 9/18/2007 OTS Report of Examination, at OTSWMEF-0000046681, Hearing Exhibit 4/16-94 [Sealed Exhibit]. FinancialCrisisReport--128 Mr. Chen, in turn, forwarded the email to the head of WaMu’s Capital Markets Division, David Beck. Mr. Chen’s introductory comments indicated that the research had been performed in response to a question from WaMu Home Loans President David Schneider and was intended to identify criteria for the loans driving delinquencies in the Option ARM portfolio: “This answers partially [David] Schneider’s questions on break down of the option arm delinquencies. The details (1PPD tab) shows Low fico, low doc, and newer vintages are where most of the delinquency comes from, not a surprise.” 460 On the same day, February 14, Mr. Beck forwarded the entire email chain to David Schneider and WaMu Home Loans Risk Officer Cheryl Feltgen, adding his own view: “Please review. The performance of newly minted option arm loans is causing us problems. Cheryl can validate but my view is our alt a (high margin) option arms [are] not performing well. We should address selling 1Q [first quarter] as soon as we can before we loose [sic] the oppty. We should have a figure out how to get this feedback to underwriting and fulfillment.” 461 Mr. Beck’s message indicated that recently issued Option ARM loans were not performing well, and suggested selling them before the bank lost the opportunity. WaMu would lose the opportunity to sell those loans if, for example, they went delinquent, or if the market realized what WaMu analysts had already determined about their likelihood of going delinquent. Mr. Beck’s email proposed selling the loans during the first quarter of the year, already six weeks underway, and “as soon as we can.” Four days later, on Sunday, February 18, Mr. Schneider replied to the email chain by requesting Ms. Feltgen’s thoughts. Later that day, Ms. Feltgen responded with additional analysis and an offer to help further analyze the Option ARM delinquencies: “The results described below are similar to what my team has been observing. California, Option ARMs, large loan size ($1 to $2.5 million) have been the fastest increasing delinquency rates in the SFR [Single Family Residence] portfolio. Although the low FICO loans have … higher absolute delinquency rates, the higher FICOs have been increasing at a faster pace than the low FICOs. Our California concentration is getting close to 50% and many submarkets within California actually have declining house prices according to the most recent OFHEO [Office of Federal Housing Enterprise Oversight] data from third quarter of 2006. There is a meltdown in the subprime market which is creating a ‘flight to quality’. I was talking to Robert Williams just after his 460 Id. 461 Id. return from the Asia trip where he and Alan Magleby talked to potential investors for upcoming covered bond deals backed by our mortgages. There is still strong interest around the world in USA residential mortgages. Gain on sale margins for Option ARMs are attractive. This seems to me to be a great time to sell as many Option ARMs as we possibly can. Kerry Killinger was certainly encouraging us to think seriously about it at the MBR [ Monthly Business Review] last week. What can I do to help? David, would your team like any help on determining the impact of selling certain groupings of Option FinancialCrisisReport--119 According to a 2007 WaMu presentation at a securities investor meeting in New York, in 2004, WaMu issued $37.2 billion in RMBS securitizations and was the sixth largest RMBS issuer in the United States. 420 In 2005, it doubled its production, issuing $73.8 billion in securitizations, and became the third largest issuer. In 2006, it issued $72.8 billion and was the second largest issuer, behind Countrywide. 421 WaMu and Long Beach’s securitizations produced only RMBS securities. Although WaMu considered issuing CDO securities as well, it never did so. 422 From 2004 to 2006, WaMu and Long Beach securitized dozens of pools of prime, subprime, Alt A, second lien, home equity, and Option ARM loans. 423 WaMu and Long Beach also sold “scratch and dent” pools of nonperforming loans, including nonperforming primary mortgages, second lien, and Option ARMs. 424 At first, Washington Mutual worked with Wall Street firms to securitize its home loans, but later built up its own securitization arm, Washington Mutual Capital Corporation (WCC), which gradually took over the securitization of both WaMu and Long Beach loans. WCC was a private Washington State corporation that WaMu acquired from another bank in 2001, and renamed. 425 WCC became a wholly owned subsidiary of Washington Mutual Bank. In July 2002, WaMu announced that WCC would act as an institutional broker-dealer handling RMBS securities and would work with Wall Street investment banks to market and sell WaMu and Long Beach RMBS securities. 426 WCC was initially based in Seattle, and by 2003, had between 30 and 40 employees. 427 In 2004, due to increasing securitizations, WaMu decided to move the headquarters of WCC to Manhattan. 428 In 2004, for the first time, WCC acted as the lead manager of a WaMu securitization. That same year, WCC initiated a “conduit program” to buy Alt A and subprime loans in bulk for securitization. 429 WCC issued its first Alt A securitization in 2005, and its first subprime securitization in 2006. 430 It also conducted whole loan sales and credit card 420 See 6/11/2007 chart entitled, “Rate of Growth Exceeds the Industry,” JPM_WM03409860, Hearing Exhibit 4/13- 47c. 421 Id. WaMu attributed its rapid rise in the issuer rankings over the three-year period to its establishment of a Conduit Program, which began buying loans in bulk in 2004. Id. 422 See 12/15/2006 Enterprise Risk Management Committee, JPM_WM02656967. See also 10/25/2006 Asset- Liability Management Committee Meeting Agenda, JPM_WM02406624. 423 See 6/2008 “WaMu Wholesale Specialty Lending Securitization Performance Summary,” JPM_WM02678980, Hearing Exhibits 4/13-45 and 46; 6/11/2007 chart entitled, “WaMu Capital Corp Sole/Lead Underwriter,” JPM_WM03409861, Hearing Exhibit 4/13-47c. 424 See, e.g., undated “List of WaMu-Goldman Loans Sales and Securitizations,” Hearing Exhibit 4/13-47b; 2/2007 internal WaMu email chain, JPM_WM00652762. 425 See 6/11/2007 chart entitled, “Capital Markets Division Growth,” JPM_WM03409858, Hearing Exhibit 4/13- 47c. 426 Id. 427 Subcommittee interview of David Beck (3/2/2010). 428 Id. 429 See 6/11/2007 chart entitled, “Capital Markets Division Growth,” JPM_WM03409858, Hearing Exhibit 4/13- 47c. 430 Id. securitizations. 431 At its peak, right before the collapse of the subprime securitization market, FOMC20050503meeting--105 103,MS. BIES.," Thank you, Mr. Chairman. I guess I’m going to repeat a lot of the things that others have said, but I think I will end up in a somewhat different place than some of you around the table in that I’m much more concerned about the risks of inflation than I am about those for the real economy. If we look at the first-quarter data, and more particularly the information that has come out in the last several weeks, we can really see that the quarter started out very strong and that the more recent data showed some weakness. First-quarter GDP growth at 3.1 percent was much weaker than most folks, myself included, expected. But if one looks at the components of the underlying data, May 3, 2005 67 of 116 surge in imports—and in government spending. In fact, private domestic final sales were really quite good in the quarter, growing by my rough estimate at somewhere in the high 3 percent range. So how do we deal with that? Well, to the extent that the weakness is imports and is coming from strong consumer and business spending, that’s a good sign. So, while I want to get some more data on what is happening in the real economy, I’m not as pessimistic as some of you. Monetary policy is still accommodative, if one looks at the liquidity in the banking system. And while the weaker economic data caused some reaction in financial markets, overall the conditions are very supportive of business expansion and consumer borrowing. Corporate profits for the first quarter, which are still coming in, seem to show continued strength, and first-quarter earnings growth now looks as if it will be in double digits for the twelfth straight quarter. To me the other remarkable development in the markets is what has happened in reaction to news about compliance with Sarbanes-Oxley. This is the first year-end reporting. Most companies are on a calendar year-end, and a record number of companies have announced that they cannot report in the regular time frame and are doing late filings. Normally, one would expect this to create a disruption in the market, but the market has been very discerning in the way it has taken the news. Many companies that have reported have had to disclose weaknesses in their internal controls around financial reporting. And based just on the anecdotal evidence, the market seems to be behaving very prudently in that it is distinguishing between companies where the reported weaknesses are isolated in one small area and those where the control weaknesses are more pervasive. So, it appears that the sunshine associated with these disclosures is being handled well in the marketplace. We’ll see what happens as we go along and those firms that have still to disclose their Sarbanes-Oxley reports do so. I was a little concerned that we might see more volatility in the May 3, 2005 68 of 116 Let me turn now to the inflation issue, which does have me more concerned. If we look at the lagging indicators, inflation numbers over the last 12 months are still in the mid-1 percent range, depending on what measure we look at. But one of the things we need to realize is that in the first part of last year inflation rates were very, very low. If I look instead at inflation measures in the first quarter compared to the fourth quarter, I get very much concerned about the trend we’re seeing. If I throw out all of the volatile energy and food components, the way we typically do, and look at core measures, core CPI has risen by 1.3 percentage points to 3.3 percent in the last three months. Core PCE is up a full point to 2.6 percent. As to where we see prices rising, the big turnaround, as some of you have indicated, has been in the goods sector of the market. Prices for services continue to be rising by a bit above 2 percent, but goods prices have gone from declining at an almost 3 percent pace at the beginning of last year to being about unchanged now. That is affecting the aggregate numbers and is something we need to watch. The employment cost index in the first quarter did show a slight slowing to 0.7 percent from 0.8 percent in the fourth quarter. But as David remarked, this is due to the slowdown in pension funding that occurred in the first quarter. A recent survey of corporate CFOs shows that their number one concern continues to be health care costs. And as they look to pay for the cost of labor going forward, many of them are trying to hold down wage increases because of the significant rise they’re seeing in health care costs. Where this will lead in terms of future hiring is a concern. It may impact the real economy, because if employment growth continues at the more subdued pace of the last month, it could affect consumption and the real final sales that are giving me confidence in the real sector. As for the balance of risks, I agree with the comments President Yellen made; I believe the risks of inflation are May 3, 2005 69 of 116" CHRG-111hhrg55809--163 The Chairman," Would the gentleman yield to me then his remaining time? I just want to make a couple of points. First, Mr. Bernanke, you correctly, I think, talked about banning some products, but I think we ought to expand on the rationale. For instance, you talk about no-doc loans. My own view is we do not ban things totally, primarily for consumer protection. I am in favor of letting people be stupid in a number of other areas. The problem is that, in some of these areas, there is a spill-over to the system, that the problem with no-doc loans was not simply an individual within that position, but those accumulate into a systemic position. So I think, as we talk about whether or not you prohibit certain practices, the argument for doing that gets stronger when there is a systemic overlap. Is that an accurate assessment? " FinancialCrisisReport--79 After a short hiatus, WaMu allowed Long Beach to resume securitizing subprime loans in 2004. 216 An internal WaMu memorandum, later prepared by a WaMu risk officer who had been asked to review Long Beach in 2004, recalled significant problems: “You’ve asked for a chronological recap of ERM [Enterprise Risk Management] market risk involvement with Longbeach and the sub prime conduit. … [In] 2004: I conducted an informal but fairly intensive market risk audit of Longbeach …. The climate was very adversarial. … We found a total mess.” 217 A November 2004 email exchange between two WaMu risk officers provides a sense that poor quality loans were still a problem. The first WaMu risk officer wrote: “Just a heads-up that you may be getting some outreach from Carroll Moseley (or perhaps someone higher up in the chain) at Long Beach regarding their interest in exploring the transfer of … a small amount (maybe $10-20mm in UPB [unpaid principal balance]) of Piggieback ‘seconds’ (our favorite toxic combo of low FICO borrower and HLTV loan) from HFS [hold for sale portfolio] to HFI [hold for investment portfolio]. “As Carroll described the situation, these are of such dubious credit quality that they can’t possibly be sold for anything close to their ‘value’ if we held on to them. … I urged him to reach out to you directly on these questions. (E.g., it’s entirely possible we might want to make a business decision to keep a small amount of this crap on our books if it was already written down to near zero, but we would want all parties to be clear that no precedent was being set for the product as a whole, etc., etc.).” 218 The second risk officer sent the email to the head of Long Beach, with the comment, “I think it would be prudent for us to just sell all of these loans.” 2005 Early Payment Defaults. Early in 2005, a number of Long Beach loans experienced “early payment defaults,” meaning that the borrower failed to make a payment on the loan within three months of the loan being sold to investors. That a loan would default so soon after origination typically indicates that there was a problem in the underwriting process. Investors who bought EPD loans often demanded that Long Beach repurchase them, invoking the representations and warranties clause in the loan sales agreements. 216 Subcommittee interview of Fay Chapman (2/9/2010). See also 12/21/2005 OTS memorandum, “Long Beach Mortgage Corporation (LBMC),” OTSWMS06-007 0001010, Hearing Exhibit 4/16-31 (“In 2003, adverse internal reviews of LBMC operations led to a decision to temporarily cease securitization activity. WMU’s Legal Department then led a special review of all loans in LBMC’s pipeline and held-for-sale warehouse in order to ensure file documentation adequately supported securitization representations and warranties and that WMI was not exposed to a potentially significant contingent liability. Securitization activity was reinstated in early 2004 after the Legal Department concluded there was not a significant liability issue.”). 217 Undated memorandum from Dave Griffith to Michelle McCarthy, “Sub Prime Chronology,” likely prepared in early 2007, JPM_WM02095572. 218 11/24/2004 email from Michael Smith to Mark Hillis and others, “LBMC Transfer of Piggiebacks from HFS to HFI,” JPM_WM01407692. CHRG-111hhrg52261--33 Mr. Hirschmann," We have not yet seen the details, but we do think that consumer protection should be an important part of the overall regulatory reform; and so we welcome alternatives, particularly alternatives that build on the current structure that requires better coordination among existing regulators, that provide for better disclosure to consumers and tougher enforcement against predatory practices. " CHRG-111hhrg54867--58 Secretary Geithner," Congressman, I understand what you are doing. It is a reasonable proposition, the approach you are trying to take. But let's do the basic imperative. If you allow institutions that are essentially doing what banks do to compete with banks with no adult supervision, no constraints, and are free to engage in unfair practices, then you will recreate again-- " CHRG-111hhrg56767--91 Mr. Feinberg," Goldman is not one of the companies that falls under my mandatory jurisdiction. Unlike the others, the other seven, now five, I have no mandatory jurisdiction over Goldman. There is a provision in the law that requires me to seek information about Goldman's pay practices, which we will do, and we will examine that data. We have no mandatory jurisdiction to set compensation at Goldman. " CHRG-111shrg55117--93 Mr. Bernanke," We are going to ban the practice of tying the compensation to the type of mortgage, to having prepayment penalties, for example. Senator Merkley. So in this situation, a broker would get the same compensation if they are doing a plain vanilla 30-year, fixed-rate mortgage as they would if they were doing something that provided very high interest rates? " CHRG-111shrg61651--32 Chairman Dodd," Gerry, in asking you to respond to the same question, tell us here what the impact would be on Goldman in terms of revenue and profits. Would it put a prohibition on hedge fund activity, private equity activity? As a practical matter, what happens at Goldman if we have an ironclad rule? " FOMC20070918meeting--172 170,CHAIRMAN BERNANKE.," My sense of the table is, then, that we will just begin the practice at the next meeting of voting on the entire statement. That, of course, raises the possibility for dissent based on the statement. We have to use good judgment on that particular decision. If there is dissent on the statement, Scott, it would be explained in the minutes?" CHRG-111hhrg53240--139 Mr. Carr," Congressman, if I could just say for 5 seconds, I think the absence of conflict would be a failure of mission, which is exactly what we have right now. One would expect that given the types of deceptive and exploited practices happening, you would be having lots of conflicts for the last decade. The absence is a problem. " CHRG-110hhrg46593--340 Mr. Feldstein," Certain features of it Congress would have to override the existing contracts and existing State rules. Again, I am not a lawyer, I don't know how broad that would have to be. Somehow I don't think these are major changes in real estate law. But, for example, if an individual now pays down a piece of his mortgage, the typical practice is that reduces the principal but not the monthly payment, so they end up paying off their mortgage sooner. Well, my 20 percent mortgage replacement loan is intended to reduce their mortgage payments by 20 percent. So the legislation would have to provide for that. " CHRG-110hhrg44903--177 Mr. Geithner," I haven't looked at that specific proposal, but I want to underscore the point that the Federal Reserve Board did put out for public comment some pretty comprehensive changes to underwriting standards last week, I believe. And I think they would go some direction to meeting many of the concerns you laid out. The challenge, of course, is to make sure that they are evenly enforced. And you want to really make sure you are careful not to make sure that working family you described is unable to borrow, to meet the needs of health care or to finance education or to help create a business. And finally getting that balance right is important. I don't think we have that balance right today. I don't think anybody can say that. And it is going to require things like what the Federal Reserve Board laid out last week as well as a broader improvement in the sophistication and quality of supervision oversight and enforcement of the full range of institutions that are engaged in making those kind of loans. Ms. Waters. Thank you. If I may, there is just one other question that I have. I have gotten a partial answer from some of the staff members back here. I had an opportunity to meet with minority bankers. Some of them were from the Gulf Coast area, New Orleans in particular, who had experienced considerable destruction during Hurricane Katrina. And they were complaining about not getting a lot of support, a lot of help from anybody. Of course, they brought up Bear Stearns, look at what happens when Bear Stearns gets in trouble, but nobody is there for us. I don't know a lot about the use of the Federal Reserve discount window. Is this available to these bankers? " CHRG-109shrg30354--120 Chairman Bernanke," In the short-run, Senator, we are trying to maintain some continuity with previous practice so as not to confuse people who are paying attention to the Fed too much. But what we are doing, as was revealed in the minutes, we have set up a small committee which is going to help the entire FOMC think through our entire range of communications, all aspects, including the minutes, including the statements, and try to develop a better, more explicit, and more useful form of communication. And I will certainly keep Congressional leaders apprised of this. And if anything happens that is a departure from past practice, I will certainly let you know about it and get your input. Senator Bunning. Last but not least, one thing different in your time as Fed Chairman than when Chairman Greenspan, is the amount of attention the public is paying to statements from other Fed Members. There was even a Bloomberg article yesterday about that. Do you have any problem with other Fed Members speaking out with different points of view? Do you think that is good for the markets and the economy? " CHRG-111hhrg48868--676 Mr. Scott," Thank you very much. Mr. Liddy, over here. How are you? Welcome. First of all, I want to say you're in a tough spot. We understand that and I share your concern that whatever we do, it is very important for us to understand that the American taxpayers now have $173 billion invested at AIG. We have another $30 billion on its way. That's over $200 billion. And if we are going to get a return on that and get our money paid back and be able to restructure this company, it is going to take talented, hard-working, good people at AIG to do this. So we are aware of this and we are all very sensitive to it. But, Mr. Liddy, we are in effect at war. Our economy is almost in the tank. We get a ray of hope with the stock market here and there. We had a new Administration coming in. We had hopes soaring, but this happened. And what we have here with the action with AIG and these bonuses is sort of like a stone in America's shoe, a stone that makes it difficult for us to walk this journey, let alone run it where we have to go. And the American people are demanding that we get this stone out of this shoe, so we need to hurry up and get this bonus issue off the table. And so I applaud you in coming forward in your initial statement of saying what you're doing for that, but getting half of the money back is not the answer. The answer is getting all this money back, because there is strong evidence as you have seen from the testimony here that we are coming at that money, because the American people want us to come at it. We should not have to fight this through the courts. We should not have to harangue the Tax Code in such a way. There's also thoughts of fraudulent and criminal activity. We don't need to go down that road, so I hope that you will amend your efforts to demand, as to now see the person who is now in charge to say on my watch I don't need this hanging over us. We have too much to do to be sidetracked by this, and with the Senate offering bills along that line, with the House coming forward with efforts, and you heard the chairman of the committee and the different concerns. The American people need this. We need to win this round and get this money back. I want to ask you a couple of points along this line. The first point I want to ask you is would you do that, first of all. Would you amend and ask for all of this money to come back? " FOMC20070321meeting--179 177,MR. KOHN.," I think there was back in 2001, after we cut rates, but I’m not sure. Overall my concern about cutting things off after “quarters” or “gains in income” is that such a statement would be kind of weak. We say that indicators have been mixed and adjustment in the housing sector is ongoing, but there’s an act of faith here. Somehow not giving some rationale for the moderate growth in income ahead weakens the statement. The income phrase always struck me as endogenous: “We think that growth is going to be moderate and that income will go up with growth.” But I can see the worries about the mention of financial conditions. Most people around the table mentioned that concern." FOMC20060328meeting--233 231,MR. HOENIG.," Thank you, Mr. Chairman. I have a slightly different view. I would go with A. I wouldn’t dissent over it if I were a voting member, but I would push very hard for signaling that we are just about at the end. And here is a bit of my reasoning. I think we are at or in the area of equilibrium in terms of the fed funds rate. Perhaps we’re even at the upper end. I know we can’t observe what the equilibrium rate is, but then we can’t observe the NAIRU either, and we tend to put a lot of weight on that. If we believe our projections—the Greenbook or our own projections—I suggest we are moving back toward trend, even without further actions. Then I think we are where we need to be. If we believe the Greenbook that we need to raise the rate and then come back down, then we are about where we need to be. So I think that’s important to keep in mind. Also, probably most in this room have said at one time or another that monetary policy acts with a lag, but we never believe it. And here we are, we’ve tightened for how long? We recently tightened again. We are at a point at which we say there aren’t really inflationary pressures, and yet we have tightened up. The outlook is that we would move to trend, and yet we haven’t had the full effects of our recent tightenings. The fourth quarter was weak but for transitory reasons; and the first quarter bump-up was a bounceback for the weak fourth quarter, and we’re heading toward trend. I think we are where we need to be, and we need to be patient about that. And about whether we move again—we ought to have our language say that we are not moving but that we may if the data come in stronger than we anticipated and than our own projections suggest they would. So here we are anxious again about it. The economy is strong. We’ve heard it’s strong. And yet we don’t believe that it will taper off, so we’ve got to do something about it. And that is our history—always going too far. I think that’s what we’re in danger of. Whether we go to 4¾ percent today is not the issue. The issue is that we are about where we should be, and if we’re going to signal something, that’s what we should be signaling to the market." CHRG-111shrg57319--535 Mr. Rotella," Senator, as I said in my opening statement, shortly after arriving at Washington Mutual and having been an observer from JP Morgan Chase, I was aware of the fact that the company had an extreme concentration in real estate loans as a thrift. It had a concentration in Florida and in California, 60 percent of its mortgage assets. As I said earlier, it was going through explosive growth, particularly in higher-risk lending, and the operating infrastructure was quite weak. That combined with the view that the housing market was softening led a group of us to begin a process of diversifying the company and de-emphasizing the mortgage business, which over time we hoped would lead us to a company that was concentrated less in real estate and had other asset classes. Senator Coburn. So in your testimony, on the one hand you say that you were simply carrying out the chairman and CEO's strategies as far as the high-risk category; but on the other hand, you are saying it was your decision to decrease the high-risk lending. Which is it? " CHRG-111hhrg48674--317 Mr. Castle," Thank you. What criteria are you looking at to determine the effectiveness of the various programs, not only your regular lending to the banks, but to the other institutions, the AIGs and Bear Stearnses? I mean, do you look at just the capitalization and liquidity, or are you looking at what they are doing with it and how they are conforming to their normal lending practices or whatever? What criteria do you look at? " FOMC20071211meeting--84 82,MR. ROSENGREN.," Thank you, Mr. Chairman. I think I took the same pessimism pill as President Yellen this morning. The Greenbook makes very somber reading, and I would make several observations about the forecast it provides. First, Greenbook forecasts of two successive quarters of growth below 1 percent are quite rare, and often in the past have occurred shortly before or during recessions. Second, the 70 percent confidence interval for the Greenbook projection of GDP, using historical forecast errors, has a negative lower bound. Third, I would note that when the unemployment rate rises at least ½ percent, it tends to rise much further than just ½ percent. That is, historically, when we have unemployment rates rise ½ percent, we have subsequently found ourselves in a recession. These observations indicate that, while a recession is not forecast in the Greenbook—as David has been careful to state—the probability of a recession is clearly elevated. At our last meeting, the housing market was very soft, but weakness in other components was not yet reflected in the data. But now we have some evidence that consumption and investment may also be slowing, and residential investment may be even weaker than we thought. While incoming data have generally been weak, some higher-frequency data, like the recent labor report, might be consistent with a stronger outlook than the Greenbook forecast. However, I am concerned that housing prices may actually fall more than assumed in the Greenbook, potentially resulting in consequences that are difficult to forecast with models using only postwar data. I am also sympathetic to the view that disruptions in financial flows have the potential to result in significantly more weakness than would result from an econometric model that does not capture significant liquidity disruptions, in part because the occurrence of such events is quite rare. Added to these concerns is the current state of financial markets both here and abroad. The elevated rates for term lending, even over relatively short maturities, indicates significant risk aversion by market participants. Financial institutions with very low probabilities of default, as measured by credit default swap rates, are nonetheless having difficulty securing term lending over year-end. Bank supervisors of large financial institutions are beginning to report correlations in nonperforming experiences of auto, credit card, and mortgage loans. Geographic regions hard hit by mortgage defaults are also experiencing rising default rates in other types of loans. Portfolios that are not highly correlated during good times can become highly correlated during bad times, and the initial trends being reported in bank supervision are not encouraging. I would also highlight this as one of the instances in which bank supervision is providing some very relevant input into thinking about the macroeconomy. Finally, I would highlight several institutional concerns that could have broader implications. First, financial guarantors, as was highlighted earlier, have credit default swap rates inconsistent with their AAA rating. Significant downgrades would further depress CDOs but also disrupt the municipal bond market and force some banks to fulfill agreements to purchase securities that do not maintain at least an AA rating. Second, there is the potential for significant further announcements of downgrades of assets related to SIVs and CDOs. Money market funds are currently experiencing inflows. However, those flows could quickly reverse if investors lose confidence in their ability to redeem money market funds at par. Third, I would note that for securities like lower-grade bonds that have not previously shown elevated risk premiums, those premiums are now becoming quite elevated, providing evidence that what was initially a liquidity concern is now becoming a more widespread and generalized concern about the state of the economy. With core inflation a little below 2 percent, and future reductions in labor market pressures likely, we have the flexibility to respond aggressively to slowing economic growth and the ongoing financial turmoil. This seems to be the appropriate time to take significant further action, knowing that, should the economy perform much better than we currently anticipate, we could be equally nimble in raising rates as appropriate." FinancialCrisisInquiry--80 VICE CHAIRMAN THOMAS: Is each one unique? Or can you run to a standardized structure on those, quote-unquote, “problems?” It’s something about who gets what when and how? MACK: Well, it’s a combination. One of my colleagues used the—the word earlier “bespoke.” Some of these products are—are tailored just for a specific problem, but others are generic and can be used across many different fields of investing. VICE CHAIRMAN THOMAS: And bespoke always costs more than the general. Thank you, Mr. Chairman. CHAIRMAN ANGELIDES: Thank you. Mr. Hennessey? HENNESSEY: Thank you, Mr. Chairman. I want to focus on the too big to fail question and just a—a comment on—on the selection of the panelists. I just—I think it’s interesting that we’re talking about risk management with the four firms that survived, whether that was because of your risk management practices. But I’m much more interested in hearing about risk management practices at Lehman and Bear Stearns and Fannie Mae and Freddie Mac, the firms that actually failed to manage their risks and—and went under. FOMC20070807meeting--51 49,MR. WILCOX.," It relies on a variety of considerations, but ultimately I would say it relies on inflation performance. One way that we have of assessing whether our gauges of resource utilization are moving off track is to look back and see whether our inflation models that incorporate those measures of resource utilization are overpredicting or underpredicting. It’s an imperfect mechanism, to be sure, because the impulse from resource utilization to inflation is very weak; therefore, an error in estimation on our part of the pressures on resource utilization would show up in a discrepancy in the inflation projection that could easily be lost in the noise. But that’s probably the main approach that we take to attempting to gauge ultimately whether or not we’re off base. In putting together our assessment of the output gap, we also attempt to maintain some alignment of that measure with the gap between the unemployment rate and the natural rate or the NAIRU. Our analysis of the NAIRU factors in as well a more fundamental inspection of things like demographic influences, including disability rates and the age composition of the population. So there is an effort to bring to bear an independent analysis of some of the economic determinants that might be moving the NAIRU up or down." fcic_final_report_full--233 Contrary to this view, two Fed economists determined that lenders actually made few subprime loans to meet their CRA requirements. Analyzing a database of nearly  million loans originated in , they found that only a small percentage of all higher-cost loans as defined by the Home Mortgage Disclosure Act had any connec- tion to the CRA. These higher-cost loans serve as a rough proxy for subprime mort- gages. Specifically, the study found that only  of such higher-cost loans were made to low- or moderate-income borrowers or in low- or moderate-income neighbor- hoods by banks and thrifts (and their subsidiaries and affiliates) covered by the CRA. The other  of higher-cost loans either were made by CRA-covered institutions that did not receive CRA credit for these loans or were made by lenders not covered by the CRA. Using other data sources, these economists also found that CRA-related subprime loans appeared to perform better than other subprime loans. “Taken to- gether, the available evidence seems to run counter to the contention that the CRA contributed in any substantive way to the current crisis,” they wrote.  Subsequent research has come to similar conclusions. For example, two econo- mists at the San Francisco Fed, using a different methodology and analyzing data on the California mortgage market, found that only  of loans made by CRA-covered lenders were located in low- and moderate-income census tracts versus over  for independent mortgage companies not covered by the CRA. Further, fewer than  of the loans made by CRA lenders in low-income communities were higher priced, even at the peak of the market. In contrast, about one-half of the loans originated by independent mortgage companies in these communities were higher priced. And af- ter accounting for characteristics of the loans and the borrowers, such as income and credit score, the authors found that loans made by CRA-covered lenders in the low- and moderate-income areas they serve were half as likely to default as similar loans made by independent mortgage companies, which are not subject to CRA and are subject to less regulatory oversight in general. “While certainly not conclusive, this suggests that the CRA, and particularly its emphasis on loans made within a lender’s assessment area, helped to ensure responsible lending, even during a period of over- all declines in underwriting standards,” they concluded.  Overall, in , , and , CRA-covered banks and thrifts accounted for at least  of all mortgage lending but only between  and  of higher-priced mortgages. Independent mortgage companies originated less than one-third of all mortgages but about one-half of all higher-priced mortgages.  Finally, lending by nonbank affiliates of CRA-covered depository institutions is counted toward CRA performance at the discretion of the bank or thrift. These affiliates accounted for an- other roughly  of mortgage lending but about  of high-price lending. Bank of America provided the FCIC with performance data on its CRA-qualify- ing portfolio, which represented only  of the bank’s mortgage portfolio.  In the end of the first quarter of ,  of the bank’s  billion portfolio of residential mortgages was nonperforming:  of the  billion CRA-qualifying portfolio was nonperforming at that date. John Reed, a former CEO of Citigroup, when asked whether he thought govern- ment policies such as the CRA played a role in the crisis, said that he didn’t believe banks would originate “a bad mortgage because they thought the government policy allowed it” unless the bank could sell off the mortgage to Fannie or Freddie, which had their own obligations in this arena. He said, “It’s hard for me to answer. If the rea- son the regulators didn’t jump up and down and yell at the low-doc, no-doc sub- prime mortgage was because they felt that they, Congress had sort of pushed in that direction, then I would say yes.”  “You know, CRA could be a pain in the neck,” the banker Lewis Ranieri told the FCIC. “But you know what? It always, in my view, it always did much more good than it did anything. You know, we did a lot. CRA made a big difference in communi- ties. . . . You were really putting money in the communities in ways that really stabi- lized the communities and made a difference.” But lenders including Countrywide used pro-homeownership policies as a “smokescreen” to do away with underwriting standards such as requiring down payments, he said. “The danger is that it gives air cover to all of this kind of madness that had nothing to do with the housing goal.”  FOMC20081216meeting--514 512,MR. PARKINSON.," We've heard from practically everyone that's not within the class of consumer ABS and SBA loans. We have heard from the commercial real estate people and from the auto dealers about their floor plan loans; we have heard from the banks that would like to get the motorcycles and leases. But also corporate loans--the CLO (collateralized loan obligation) market also is shut down. So there is no question. Again, we're in a hard place because, if we weren't constrained in part by the TARP capital and our concerns about our balance sheet, we would maybe be able to have a much broader program in which we didn't have to make these kinds of decisions. But given that there's only $20 billion of TARP capital and we're willing at this point to go only to $200 billion, you can't really say we'll take all these different asset classes. " CHRG-111hhrg56847--261 Chairman Spratt," The gentleman yields back. Mr. Chairman, thank you very, very much for finding the time to testify and for your full and forthright answers. Those members who did not have an opportunity to submit questions may submit questions for the record if there is no objection. There is none. So ordered. Thank you once again for coming. We very much appreciate your testimony and your service to our country. [Questions submitted and their responses follow:] Questions Submitted for the Record to Chairman BernankeCongressman Aderholt 1. On April 1, the Federal Reserve began requiring escrow accounts to be established for first-lien higher-priced mortgage loans. Many community banks protested this requirement since they do not have the resources to create these escrow accounts. Since the rule went into effect, many community banks, including one in my district, have stopped offering these mortgages. Is the Federal Reserve reviewing this policy and how it affects community banks? Do you foresee the Federal Reserve exempting community banks from this regulation in the near future? 2. I hear stories from community bankers in my district about overzealous regulators going so far as to demand changes on individual $8,000 car loans. Do you believe that some of this over regulation could hinder our economic recovery more than help it? Will increased regulations in the financial reform legislation in Congress decrease the availability of credit to consumers, especially from small banks? 3. During the hearing, you stated that some banks are taking second looks at loan applications to ensure consumers get the credit they deserve. In discussion with small bankers in my district, I have learned that many community banks are taking second, third and fourth looks. While it is good that they are reviewing these applications, it is slowing down access to credit. The fact is that many of these banks are afraid to lend money. What is the Federal Reserve doing to give community banks more confidence in lending and free up credit for consumers?Congresswoman Kaptur 1. Mr. Chairman, what role, if any, should the Federal Reserve System play in working to solve the housing crisis continues to ravage our nation's communities? 2. Mr. Chairman, the Treasury is pouring money into Fannie and Freddie, keeping it afloat to support the current structure of housing finance. What should be done to stop us from dumping money into Fannie and Freddie to cover the losses of bad paper dumped into both institutions by big banks at profits and to return our housing finance system to a prudent lending, sound system that supports homeownership and affordable housing? 3. Mr. Chairman, in the House bill on financial regulatory reform, we created the Consumer Financial Protection Agency. In the Senate bill, a bureau was created within the Federal Reserve System, underneath the Board of Governors. The conference is using the Senate bill as the base bill for discussion. Therefore, Mr. Chairman, do you feel that the Federal Reserve should have any responsibility for consumer protection? Do you feel that this fits in with the roles of the Federal Reserve System, which is to formulate the nation's monetary policy, supervise and regulate banks, and provide a variety of financial services to depository financial institutions and the federal government? Please including any related information to support your responses. Responses to Mr. Aderholt's Questions From Chairman Bernanke 1. On April 1, the Federal Reserve began requiring escrow accounts to be established for first-lien higher-priced mortgage loans. Many community banks protested this requirement since they do not have the resources to create these escrow accounts. Since the rule went into effect, many community banks, including one in my district, have stopped offering these mortgages. Is the Federal Reserve reviewing this policy and how it affects community banks? Do you foresee the Federal Reserve exempting community banks from this regulation in the near future? As you note, the Board's rules for higher-priced mortgage loans require that creditors establish escrow accounts for taxes and insurance. The Board issued these rules in July 2008 using its authority under the Home Ownership and Equity Protection Act to prohibit unfair practices in connection with mortgage loans. Compliance with the rule did not become mandatory until this year because the Board recognized that some lenders would need time to develop the capacity to escrow. As background, the Board adopted the escrow requirement to address specific concerns. The Board found that lenders generally did not establish escrow accounts for consumers with higher-priced loans. The Board was concerned that when there is no escrow account, lenders might disclose a monthly payment that includes only principal and interest. As a result, consumers might mistakenly base their borrowing decision on an unrealistically low assessment of their total mortgage-related obligations. The Board was also concerned that consumers not experienced at handling taxes and insurance on their own might fail to pay those items on a timely basis. Nonetheless, we do appreciate the concerns you have raised about the cost of establishing escrow accounts, and whether the cost may be prohibitive for lenders that make a small number of loans and hold them in portfolio. In fact, community banks also have raised these concerns with the Board directly during the past several months. As a result, we have been discussing with their representatives the potential impact of the escrow rule. Please be assured that the Board is monitoring implementation of the new escrow rule by small lending institutions and the availability of credit in the communities they serve. If it is determined that the costs of the rule outweigh the benefits, we will explore alternatives that do not adversely affect consumer protection. 2. I hear stories from community bankers in my district about overzealous regulators going so far as to demand changes on individual $8,000 car loans. Do you believe that some of this over regulation could hinder our economic recovery more than help it? Will increased regulations in the financial reform legislation in Congress decrease the availability of credit to consumers, especially from small banks? In retrospect, loan underwriting standards became too loose during the run up to the recent financial crisis. Accordingly, some tightening of underwriting standards from the practices that prevailed just a few years ago was needed. However, as your question suggests, there is a risk that over-correction by banks and supervisors could unnecessarily constrain credit. To address this risk, the Federal Reserve and the other banking agencies have repeatedly instructed their examiners to take a measured and balanced approach to reviews of banking organizations and to encourage efforts by these institutions to work constructively with existing borrowers that are experiencing financial difficulties. Examples of such guidance include the November 12, 2008 Interagency Statement on Meeting the Needs of Creditworthy Borrowers and an October 30, 2009 interagency statement designed to encourage prudent workouts of commercial real estate loans and facilitate a balanced approach by field staff to evaluating commercial real estate credits (SR 09-7). More recently, on February 5, the Federal Reserve and other regulatory agencies issued a joint statement on lending to creditworthy small businesses. This statement is intended to help to ensure that supervisory policies and actions are not inadvertently limiting access to credit. If bankers in your district believe that Federal Reserve examiners have taken an inappropriately strict approach on a supervisory matter, they should discuss their views with bank supervision management at their local Reserve Bank or raise their specific concerns with the Federal Reserve's ombudsman (see details on the Board's website at http://www.federalreserve.gov/aboutthefed/ombudsman.htm). Regulation imposes costs on small banks and can affect their capacity and willingness to lend. However, on balance, it is likely that the benefits of implementing reforms to prevent a future financial crisis outweigh the costs of these changes. Indeed, a repeat of the recent crisis in all likelihood would be far more costly to community banks and consumers seeking credit than the costs of the proposed financial reform package. 3. During the hearing, you stated that some banks are taking second looks at loan applications to ensure consumers get the credit they deserve. In discussion with small bankers in my district, I have learned that many community banks are taking second, third and fourth looks. While it is good that they are reviewing these applications, it is slowing down access to credit. The fact is that many of these banks are afraid to lend money. What is the Federal Reserve doing to give community banks more confidence in lending and free up credit for consumers? As discussed above, the Federal Reserve has developed guidance for its examiners to ensure that they are taking a measured approach to evaluating lending activities at small banks. In addition, the Federal Reserve has supplemented these issuances with training programs for examiners and outreach to the banking industry to underscore the importance of the guidance and ensure its full implementation. Also, in an effort to better understand small business lending trends, the Federal Reserve System this month is completing a series of more than 40 meetings across the country to gather information that will help the Federal Reserve and others better respond to the credit needs of small businesses. As part of this series, the Federal Reserve Bank of Atlanta hosted five small business roundtable discussions at locations across its district during the spring and summer. Emerging themes, best practices, and common challenges identified by the meeting series were discussed and shared at a conference held at the Federal Reserve Board in Washington in early July. Responses to Ms. Kaptur's Questions From Chairman Bernanke [Whereupon, at 12:20 p.m., the committee was adjourned.] " FOMC20061025meeting--160 158,MR. KOHN.," Thank you, Mr. Chairman. I support keeping rates unchanged and alternative B. I think that rate, at least for now, seems consistent with growth of the economy just a tad below the growth of its potential and a gradual decline in inflation. Incoming data will tell us if we’re wrong on that, but right now that looks like our best bet to accomplish the objectives I think the Committee ought to be accomplishing. I agree that the pace and the extent of disinflation are great uncertainties here. President Poole has made a valuable contribution here about the loss function relative to the policy path. A failure to reverse the earlier increase in inflation is the main risk to good economic performance that we face. Therefore, we need to see a downward path of inflation. I think our minutes and our speeches have made it pretty clear that that’s what the Committee means by inflation risks remaining. I think the public understands that. President Poole has made a valuable distinction between the loss function and the economic outlook and what that implies for interest rates, but I don’t agree with his conclusion. After all, the Greenbook forecast has essentially a flat federal funds rate and a very, very gradual decline in inflation barely along the path that most Committee members could tolerate. If our loss function is asymmetrical relative to that, it’s more likely that interest rates would have to rise than to fall relative to the Greenbook path. Moreover, many members of the Committee seem to have a stronger path for output, and maybe even inflation going forward, than is embedded in the Greenbook. So the wording about additional firming that may be needed, the asymmetrical wording of a risk assessment, is the appropriate representation of how this Committee is looking at the potential future path of interest rates given both the loss function and the Committee’s outlook for growth and inflation. I do have some comments on the language. In section 2, I like the addition of the forward-looking language and, unlike President Fisher, the use of “moderate.” It seems to me that the word “moderate” is fairly ambiguous, but it does suggest that we don’t expect a great deal of weakness going forward or a great deal of strength. I think that’s about where the Committee is—growth close to, maybe a bit below, the growth of potential, and the word “moderate” conveys the sense that the Committee wasn’t looking for something really weak or something really strong going forward. So I think that was a valuable addition. Like you, President Fisher, I did wonder about the specific reference to the third quarter and how that would play out. Governor Kroszner actually brought this to my attention on Friday. The advantage of the reference to the third quarter is that, by our acknowledging a weak third quarter, the markets might not react as strongly to a print that begins with the number 1 as they would if we didn’t acknowledge that. There are also a couple of disadvantages. The third quarter could come in much closer to 2½ percent. There are a lot of assumptions built into that number. We could be wrong. But even more important, from my perspective, an awful lot of the weakness in the third quarter is in net exports and inventory change. The underlying feel to the third quarter and final demand aren’t really all that different from the second quarter. So emphasizing the weakness in the third quarter in our language may not give a good sense of what we think the underlying situation was. Alternative language might be a more general sentence saying that “economic growth has slowed over the course of the year, partly reflecting a cooling of the housing market.” That more general sentence about “over the course of the year” probably reflects better where the Committee is. I could live with the third-quarter language that’s in there now, but I would have a slight preference for the other one. In section 3, I actually have a slight preference for the wording under alternative A. I’ve always been a little uncomfortable with relating the outlook for inflation to the level of energy prices. The last major increase in energy prices was last spring, and I think they’ve been kind of level since April or May and actually have come down. Some of the commentary after our last announcement pointed out the contradiction in which we have energy prices both pushing up inflation and pulling it down in the future. So my slight preference, again, would be for the wording of alternative A, which says that the high level of resource utilization has the potential to sustain pressures. It doesn’t reference the high level of prices of energy and other commodities. In section 4, the risk assessment, looking at the language that Vincent put on the table yesterday, I think the first sentence of that does a better job of enunciating what the Committee has been thinking about—that the reduction of inflation is what we’re looking at. But I’m hesitant to change the risk assessment language. I think that people do understand what we mean by our risk assessment language now. I am concerned that changing it would provoke a reaction, and I’m not confident that I know what the reaction would be. So my preference, again, is to stick with the current risk assessment language that’s in alternative B. Thank you, Mr. Chairman." FOMC20070807meeting--89 87,MR. ROSENGREN.," The Boston staff forecast is broadly consistent with the Greenbook forecast, with export-led growth being significantly offset by weakness in residential investment, resulting in a gradual increase in the unemployment rate and core PCE inflation settling around 2 percent. The Boston staff forecast is somewhat more optimistic on residential investment but also has somewhat higher potential than the Greenbook forecast. My own view is that residential investment is likely to be as weak as in the Greenbook forecast but that potential may be closer to Boston’s estimate. Taken together, weak residential investment and somewhat stronger productivity, along with the possibility that construction employment will be more depressed going forward, may result in more of an upward drift in unemployment, helping to reduce some of the concerns with labor market pressures on inflation. However, given the similarities in the forecasts, well within standard errors, at this time it is probably more important to highlight the risks to the forecast. It is notable that the rather benign outlook of the forecasters is in marked contrast to the angst I hear when talking to asset and hedge fund managers in Boston. The angst is new and reflects heightened concerns with the financial ramifications stemming from subprime mortgages. Recent developments in residential markets are of potential concern. They have been raised by many around the table. Over the past several years, large homebuilders have been able to increase their market share. Given the use of subcontractors and with little obvious economies of scale, the primary advantage of large homebuilders would seem to be access to external finance, which allows them to purchase large tracts of land. When housing and land prices were rising, particularly in fast growing areas of the country, this access provided a significant advantage over the small builders that could not tie up significant resources in land. However, what provided a competitive advantage in the first half of this decade now places a significant strain on large homebuilders. A large investment in land whose price is falling is aggravating the problem these builders have with unsold inventory and depressed prices for new homes. Not surprisingly, the largest homebuilders, which account for nearly a quarter of homes sold, have equity prices trading lower than at any time in the past year, and recent earnings announcements have highlighted significant write-downs in land values. The low equity prices of homebuilders seem broadly consistent with residential investment remaining quite weak well into 2008. Financial market disruptions are likely to be a further impediment to the housing market and potentially provide a channel for problems to extend beyond residential investment. A number of financial instruments, such as the 2/28 and 3/27 mortgages that were widely used last year, are no longer readily available. Furthermore, the originate-to-distribute model has been disrupted by the heightened uncertainty surrounding CDOs and CLOs that we heard about earlier this morning. There seem to be two significant developments. First, the liquidity of these instruments has declined, making valuation assessment difficult. As lenders have made margin calls, forced liquidation of collateral in illiquid markets has further depressed the market. While of concern, I would hope that this is only a short-run effect. The second development of concern is that many investors have been relying on rating agencies to evaluate credit risk but the underlying credit risk is relatively opaque and the correlations between tranches may not have been fully appreciated. If investors have lost confidence in the rating agencies to accurately assess credit risk for structured products, the market could be impeded until confidence is restored. Since similar structures are used for financial instruments besides mortgages, getting secondary market financing for a broader range of financing needs could be difficult, and external financing for some borrowers could be affected. This has been reflected in the widening spreads for riskier corporate bonds, where the spreads have widened from unusually low levels and are still relatively narrow compared with earlier periods of significant financial disruption. While recent problems are not compelling enough for me to have a significant disagreement with the forecast presented in the Greenbook, the risks surrounding that forecast on the downside have increased. I remain concerned that higher oil prices, a falling dollar, and tight labor markets pose upward risks to the forecast of inflation, but recent events have significantly raised my estimate of the risk of a slower economy than I would have predicted a few weeks ago." fcic_final_report_full--35 At Citigroup, meanwhile, Richard Bowen, a veteran banker in the consumer lend- ing group, received a promotion in early  when he was named business chief underwriter. He would go on to oversee loan quality for over  billion a year of mortgages underwritten and purchased by CitiFinancial. These mortgages were sold to Fannie Mae, Freddie Mac, and others. In June , Bowen discovered that as much as  of the loans that Citi was buying were defective. They did not meet Citi- group’s loan guidelines and thus endangered the company—if the borrowers were to default on their loans, the investors could force Citi to buy them back. Bowen told the Commission that he tried to alert top managers at the firm by “email, weekly reports, committee presentations, and discussions”; but though they expressed concern, it “never translated into any action.” Instead, he said, “there was a considerable push to build volumes, to increase market share.” Indeed, Bowen recalled, Citi began to loosen its own standards during these years up to : specifically, it started to pur- chase stated-income loans. “So we joined the other lemmings headed for the cliff,” he said in an interview with the FCIC.  He finally took his warnings to the highest level he could reach—Robert Rubin, the chairman of the Executive Committee of the Board of Directors and a former U.S. treasury secretary in the Clinton administration, and three other bank officials. He sent Rubin and the others a memo with the words “URGENT—READ IMMEDI- ATELY” in the subject line. Sharing his concerns, he stressed to top managers that Citi faced billions of dollars in losses if investors were to demand that Citi repurchase the defective loans.  Rubin told the Commission in a public hearing in April  that Citibank han- dled the Bowen matter promptly and effectively. “I do recollect this and that either I or somebody else, and I truly do not remember who, but either I or somebody else sent it to the appropriate people, and I do know factually that that was acted on promptly and actions were taken in response to it.”  According to Citigroup, the bank undertook an investigation in response to Bowen’s claims and the system of un- derwriting reviews was revised.  Bowen told the Commission that after he alerted management by sending emails, he went from supervising  people to supervising only , his bonus was reduced, and he was downgraded in his performance review.  Some industry veterans took their concerns directly to government officials. J. Kyle Bass, a Dallas-based hedge fund manager and a former Bear Stearns executive, testified to the FCIC that he told the Federal Reserve that he believed the housing se- curitization market to be on a shaky foundation. “Their answer at the time was, and this was also the thought that was—that was homogeneous throughout Wall Street’s analysts—was home prices always track income growth and jobs growth. And they showed me income growth on one chart and jobs growth on another, and said, ‘We don’t see what you’re talking about because incomes are still growing and jobs are still growing.’ And I said, well, you obviously don’t realize where the dog is and where the tail is, and what’s moving what.”  CHRG-111hhrg48867--174 Mr. Bartlett," Dr. Price, I would share the one that we have come up with, and this is about our 18th draft: ``Systemic risk is an activity or a practice that crosses financial markets or financial services firms and which, if left unaddressed, would have a significant material and adverse effect on financial services firms, markets, or the U.S. economy.'' " CHRG-111hhrg48868--693 Mr. Liddy," Oh, sure. You know, I would report it first to our general counsel and to our board and audit committee, and our partners at the Federal Reserve, absolutely. We are trying to establish a new AIG, one that is transparent, one that shares information. It's hard to do. That has not been our practice in the past, but that would be reported and I wouldn't be shy about taking the lead on that. " CHRG-111shrg53176--118 Mr. Ketchum," Chairman Dodd, Ranking Member Shelby, and Members of the Committee, I am Richard Ketchum, Chairman and CEO of the Financial Industry Regulatory Authority, or FINRA. On behalf of FINRA, I would like to thank you for the opportunity to testify, and I commend you, Mr. Chairman, for having today's hearing on the critically important topic of reforming our regulatory structure for financial services. As someone who has spent the great majority of my career as a regulator, dedicated to protecting investors and improving market integrity, I am deeply troubled by our system's recent failures. The credit crisis and scandals of the last year have painfully demonstrated how the gaps in our current fragmented regulatory system can allow significant activity and misconduct to occur outside the view and reach of regulators. FINRA shares this Committee's commitment to identifying these gaps and weaknesses and improving the system for investors. Let me briefly talk about FINRA and our regulatory role. FINRA regulates the practices of nearly 4,900 securities firms and more than 650,000 registered securities representatives. As an independent regulatory organization, FINRA provides the first line of oversight for broker-dealers. FINRA augments and deepens the reach of the Federal securities laws with detailed and enforceable ethical rules and a host of comprehensive regulatory oversight programs. We have a robust and comprehensive examination program with dedicated resources of more than 1,000 employees. FINRA has the ability to bring enforcement actions against firms and their employees who violate the rules. Mr. Chairman, as I said earlier, the topic of today's hearing is critical. The failures that have rocked our financial system have laid bare the regulatory gaps that must be fixed if investors are to have the confidence to re-enter the markets. Our current system of financial regulation leads to an environment where investors are left without consistent and effective protections when dealing with financial professionals. At the very least, our system should require that every person who provides financial advice and sells a financial product be licensed and tested for competence, that advertising for products not be misleading; that every product marketed to an investor is appropriate for that particular investor; and that comprehensive disclosure exists for services and products. I would like to highlight the regulatory gap that, in our view, is among the most glaring examples of what needs to be addressed--the disparity between oversight regimes for broker-dealers and investment advisers. The lack of a comprehensive, investor-level examination program for investment advisers impacts the level of protection for every person that entrusts funds to an adviser. In fact, the Madoff Ponzi scheme highlighted what can happen when a regulator like FINRA has only free rein to see one side of the business. Let me be clear. I mention this example not because FINRA is sanguine with its role in the Madoff tragedy. Any regulator who had any responsibility for oversight for Madoff must accept accountability and search diligently for lessons learned. But the way to identify fraud, just as with sales practice abuse, is not through the fog of jurisdictional restrictions. Fragmented regulation provides opportunities to those who would cynically game the system to do so at great harm to investors, and it must be changed. The regulatory regime for investment advisers should be expanded to include an additional component of oversight by an independent regulatory organization, similar to that which exists for broker-dealers. The SEC and State securities regulators play vital roles in overseeing both broker-dealers and investment advisers, and they should continue to do so. But it is clear that dedicating more resources to regular and vigorous examination and day-to-day oversight of investment advisers could improve investor protection for their customers, just as it has for customers of broker-dealers. Broker-dealers are subject to rules established and enforced by FINRA that pertain to safety of customer cash and assets, advertising, sales practices, limitations on compensation, and financial responsibility. FINRA ensures firms are following the rules with a comprehensive exam and enforcement regime. Simply put, FINRA believes that the kind of additional protections provided to investors through its model are essential. Does that mean FINRA should be given that role for investment advisers? That question must ultimately be answered by Congress and the SEC, but we do believe FINRA is uniquely positioned from a regulatory standpoint to build an oversight program quickly and efficiently. In FINRA's view, the best oversight system for investment advisers would be one that is tailored to fit their services and role in the market, starting with the requirements that are currently in place for advisory activity. Simply exporting in wholesale fashion the broker-dealer rulebook or current governance would not make sense. We stand ready to work with Congress and the SEC to find solutions that fill the gaps in our current regulatory system and create a regulatory environment that works properly for all investors. Thank you, Mr. Chairman. I would be happy to answer any questions. " FOMC20071211meeting--62 60,MR. STOCKTON.," I don’t think you’d need to look much farther than the horizon that we’re showing here to see that, in the context of the staff’s view about activity, that path for the fed funds rate would probably not be sustainable because in some sense our IS curve is considerably stronger than the market’s currently. If it makes you feel a little better, we are planning on incorporating the extended forecast into the Greenbook next time, and we want to take these alternative scenarios and push them out because we recognize that one of the weaknesses in the relatively short period that we have here is that much of the interesting action in these often takes place just beyond the time frame that we’re showing. So I think that will help." FinancialCrisisInquiry--226 ROSEN: I—I think the dot com bubble—the—the main problem there was again, I think related to the underwriting of unprofitable companies. It used to be you had to have, you know, a year of profit under your belt before you could go public. That was the Wall Street standard. They enforced it. Then that all changed. So it’s really the same thing. The lowering of standards, because you could get it done, and there were investors to buy it. This housing problem is much more serious though, because it is such a large sector as Mark said -- $11 trillion. It’s—every financial institution has this. It is larger than the public debt that we have, you know? And that’s why it’s so important, and so why the bubble is so much bigger. I would say the dot com bubble set up this bubble though. Because to clean up the last bubble, the Fed kept at rates too low too long. Their idea of not trying to do something about the bubble is either regulatory or through policy I think is—really is the core of the problem. Monetary policy is poorly—was poorly done under the last chairman. THOMPSON: So you would give monetary policy a shot in the eye for its... ROSEN: Oh I think... THOMPSON: ... role here? ROSEN: ... there’s no question about it that they set this one up, and used the wrong words. Matter of fact in 2007 the chairman who I respect a lot did say that it is demographic demand that was causing the housing market. I wrote a paper that he had read that said it wasn’t true. It was the credit bubble. But based—these demographic demand, all these other things which just the data don’t support it. fcic_final_report_full--285 On February , , PwC auditors met with Robert Willumstad, the chairman of AIG’s board of directors. They informed him that the “negative basis adjustment” used to reach the . billion estimate disclosed on the December  investor call had been improper and unsupported, and was a sign that “controls over the AIG Finan- cial Products super senior credit default swap portfolio valuation process and over- sight thereof were not effective.” PwC concluded that “this deficiency was a material weakness as of December , .”  In other words, PwC would have to announce that the numbers AIG had already publicly reported were wrong. Why the auditors waited so long to make this pronouncement is unclear, particularly given that PwC had known about the adjustment in November. In the meeting with Willumstad, the auditors were broadly critical of Sullivan; Bensinger, whom they deemed unable to compensate for Sullivan’s weaknesses; and Lewis, who might not have “the skill sets” to run an enterprise-wide risk manage- ment department. The auditors concluded that “a lack of leadership, unwillingness to make difficult decisions regarding [Financial Products] in the past and inexperience in dealing with these complex matters” had contributed to the problems.  Despite PwC’s findings, Sullivan received  million over four years in compensation from AIG, including a severance package of  million. When asked about these figures at a FCIC hearing, he said, “I have no knowledge or recollection of those numbers whatsoever, sir. . . . I certainly don’t recall earning that amount of money, sir.”  The following day, PwC met with the entire AIG Audit Committee and repeated the analysis presented to Willumstad. The auditors said they could complete AIG’s audit, but only if Cassano “did not interfere in the process.” Retaining Cassano was a “management judgment, but the culture needed to change at FP.”  On February , AIG disclosed in an SEC filing that its auditor had identified the material weakness, acknowledging that it had reduced its December valuation loss estimates by . bil- lion—that is, the difference between the estimates of . billion and . billion— because of the unsupportable negative basis adjustment. The rating agencies responded immediately. Moody’s and S&P announced down- grades, and Fitch placed AIG on “Ratings Watch Negative,” suggesting that a future downgrade was possible. AIG’s stock declined  for the day, closing at .. At the end of February, Goldman held  billion in cash collateral, was demand- ing an additional . billion, and had upped to . billion its CDS protection against an AIG failure. On February , AIG disappointed Wall Street again—this time with dismal fourth-quarter and fiscal year  earnings. The company re- ported a net loss of . billion, largely due to . billion in valuation losses re- lated to the super-senior CDO credit default swap exposure and more than . billion in losses relating to the securities-lending business’s mortgage-backed pur- chases. Along with the losses, Sullivan announced Cassano’s retirement, but the news wasn’t all bad for the former Financial Products chief: He made more than  mil- lion from the time he joined AIG Financial Products in January of  until his re- tirement in , including a  million-a-month consulting agreement after his retirement.  CHRG-111shrg52619--15 Mr. Dugan," Thank you, Chairman Dodd, Ranking Member Shelby, and Members of the Committee. The financial crisis has raised legitimate questions about whether we need to restructure and reform our financial regulatory system, and I welcome the opportunity to testify on this important subject on behalf of the OCC. Let me summarize the five key recommendations from my written statement which address issues raised in the Committee's letter of invitation. First, we support the establishment of a systemic risk regulator, which probably should be the Federal Reserve Board. In many ways, the Board already serves this role with respect to systemically important banks, but no agency has had similar authority with respect to systemically important financial institutions that are not banks, which created real problems in the last several years as risk increased in many such institutions. It makes sense to provide one agency with authority and accountability for identifying and addressing such risks across the financial system. This authority should be crafted carefully, however, to address the very real concerns of the Board taking on too many functions to do all of them well, while at the same time concentrating too much authority in a single Government agency. Second, we support the establishment of a regime to stabilize resolve and wind down systemically significant firms that are not banks. The lack of such a regime this past year proved to be an enormous problem in dealing with distressed and failing institutions such as Bear Stearns, Lehman Brothers, and AIG. The new regime should provide tools that are similar to those the FDIC currently has for resolving banks, as well as provide a significant funding source, if needed, to facilitate orderly dispositions, such as a significant line of credit from the Treasury. In view of the systemic nature of such resolutions and the likely need for Government funding, the systemic risk regulator and the Treasury Department should be responsible for this new authority. Third, if the Committee decides to move forward with reducing the number of bank regulators--and that would, of course, shorten this hearing--we have two general recommendations. The first may not surprise you. We believe strongly that you should preserve the role of a dedicated prudential banking supervisor that has no job other than bank supervision. Dedicated supervision produces no confusion about the supervisor's goals or mission, no potential conflict with competing objectives; responsibility and accountability are well defined; and the result is a strong culture that fosters the development of the type of seasoned supervisors that we need. But my second recommendation here may sound a little strange coming from the OCC given our normal turf wars. Congress, I believe, should preserve a supervisory role for the Federal Reserve Board, given its substantial experience with respect to capital markets, payment systems, and the discount window. Fourth, Congress should establish a system of national standards that are uniformly implemented for mortgage regulation. While there were problems with mortgage underwriting standards at all mortgage providers, including national banks, they were least pronounced at regulated banks, whether State or nationally chartered. But they were extremely severe at the nonbank mortgage companies and mortgage brokers regulated exclusively by the States, accounting for a disproportionate share of foreclosures. Let me emphasize that this was not the result of national bank preemption, which in no way impeded States from regulating these providers. National mortgage standards with comparable implementation by Federal and State regulators would address this regulatory gap and ensure better mortgages for all consumers. Finally, the OCC believes the best way to implement consumer protection regulation of banks, the best way to protect consumers is to do so through prudential supervision. Supervisors' continual presence in banks through the examination process creates especially effective incentives for consumer protection compliance, as well as allowing examiners to detect compliance failures much earlier than would otherwise be the case. They also have strong enforcement powers and exceptional leverage over bank management to achieve corrective action. That is, when examiners detect consumer compliance weaknesses or failures, they have a broad range of corrective tools from informal comments to formal enforcement action, and banks have strong incentives to move back into compliance as expeditiously as possible. Finally, because examiners are continually exposed to the practical effects of implementing consumer protection rules for bank customers, the prudential supervisory agency is in the best position to formulate and refine consumer protection regulation for banks. Proposals to remove consumer protection regulation and supervision from prudential supervisors, instead consolidating such authority in a new Federal agency, would lose these very real benefits, we believe. If Congress believes that the consumer protection regime needs to be strengthened, the best answer is not to create a new agency that would have none of the benefits of the prudential supervisor. Instead, we believe the better approach is for Congress to reinforce the agency's consumer protection mission and direct them to toughen the applicable standards and close any gaps in regulatory coverage. The OCC and the other prudential bank supervisors will rigorously apply any new standards, and consumers will be better protected. Thank you very much. I would be happy to answer questions. " CHRG-111shrg52619--173 PREPARED STATEMENT OF SCOTT M. POLAKOFF Acting Director, Office of Thrift Supervision March 19, 2009Introduction Good morning Chairman Dodd, Ranking Member Shelby, and Members of the Committee. Thank you for inviting me to testify on behalf of the Office of Thrift Supervision (OTS) on Modernizing Bank Supervision and Regulation. It has been pointed out many times that our current system of financial supervision is a patchwork with pieces that date to the Civil War. If we were to start from scratch, no one would advocate establishing a system like the one we have cobbled together over the last century and a half. The complexity of our financial markets has in some cases reached mind-boggling proportions. To effectively address the risks in today's financial marketplace, we need a modern, sophisticated system of regulation and supervision that applies evenly across the financial services landscape. The economic crisis gripping this nation and much of the rest of the world reinforces the theme that the time is right for an in-depth, careful review and meaningful, fundamental change. Any restructuring should take into account the lessons learned from this crisis. Of course, the notion of regulatory reform is not new. When financial crisis strikes, it is natural to look for the root causes and logical fixes, asking whether the nation's regulatory framework allowed problems to occur, either because of gaps in oversight, a lack of vigilance, or overlaps in responsibilities that bred a lack of accountability. Since last year, a new round of studies, reports and recommendations have entered the public arena. In one particularly notable study in January 2009--Financial Regulation: A Framework for Crafting and Assessing Proposals to Modernize the Outdated U. S. Financial Regulatory System--the Government Accountability Office (GAO) listed four broad goals of financial regulation: Ensure adequate consumer protections, Ensure integrity and fairness of markets, Monitor the safety and soundness of institutions, and Ensure the stability of the overall financial system. The OTS recommendations discussed in this testimony align with those goals. Although a review of the current financial services regulatory framework is a necessary exercise, the OTS recommendations do not represent a realignment of the current regulatory system. Rather, these recommendations represent a fresh start, using a clean slate. They present the OTS vision for the way financial services regulation in this country should be. Although they seek to remedy some of the problems of the past, they do not simply rearrange the current regulatory boxes. What we are proposing is fundamental change that would affect virtually all of the current federal financial regulators. It is also important to note that these are high-level recommendations. Before adoption and implementation, many details would need to be worked out and many questions would need to be answered. To provide all of those details and answer all of those questions would require reams beyond the pages of this testimony. The remaining sections of the OTS testimony begin by describing the problems that led to the current economic crisis. We also cite some of the important lessons learned from the OTS's perspective. The testimony then outlines several principles for a new regulatory framework before describing the heart of the OTS proposal for reform.What Went Wrong? The problems at the root of the financial crisis fall into two groups, nonstructural and structural. The nonstructural problems relate to lessons learned from the current economic crisis that have been, or can be, addressed without changes to the regulatory structure. The structural problems relate to gaps in regulatory coverage for some financial firms, financial workers and financial products.Nonstructural Problems In assessing what went wrong, it is important to note that several key issues relate to such things as concentration risks, extraordinary liquidity pressures, weak risk management practices, the influence of unregulated entities and product markets, and an over-reliance on models that relied on insufficient data and faulty assumptions. All of the regulators, including the OTS, were slow to foresee the effects these risks could have on the institutions we regulate. Where we have the authority, we have taken steps to deal with these issues. For example, federal regulators were slow to appreciate the severity of the problems arising from the increased use of mortgage brokers and other unregulated entities in providing consumer financial services. As the originate-to-distribute model became more prevalent, the resulting increase in competition changed the way all mortgage lenders underwrote loans, and assigned and priced risk. During the then booming economic environment, competition to originate new loans was fierce between insured institutions and less well regulated entities. Once these loans were originated, the majority of them were removed from bank balance sheets and sold into the securitization market. These events seeded many residential mortgage-backed securities with loans that were not underwritten adequately and that would cause significant problems later when home values fell, mortgages became delinquent and the true value of the securities became increasingly suspect. Part of this problem stemmed from a structural issue described in the next section--inadequate and uneven regulation of mortgage companies and brokers--but some banks and thrifts that had to compete with these companies also started making loans that were focused on the rising value of the underlying collateral, rather than the borrower's ability to repay. By the time the federal bank regulators issued the nontraditional mortgage guidance in September 2006, reminding insured depository institutions to consider borrowers' ability to repay when underwriting adjustable-rate loans, numerous loans had been made that could not withstand a severe downturn in real estate values and payment shock from changes in adjustable rates. When the secondary market stopped buying these loans in the fall of 2007, too many banks and thrifts were warehousing loans intended for sale that ultimately could not be sold. Until this time, bank examiners had historically looked at internal controls, underwriting practices and serviced loan portfolio performance as barometers of safety and soundness. In September 2008, the OTS issued guidance to the industry reiterating OTS policy that for all loans originated for sale or held in portfolio, savings associations must use prudent underwriting and documentation standards. The guidance emphasized that the OTS expects loans originated for sale to be underwritten to comply with the institution's approved loan policy, as well as all existing regulations and supervisory guidance governing the documentation and underwriting of residential mortgages. Once loans intended for sale were forced to be kept in the institutions' portfolios, it reinforced the supervisory concern that concentrations and liquidity of assets, whether geographically or by loan type, can pose major risks. One lesson from these events is that regulators should consider promulgating requirements that are counter-cyclical, such as conducting stress tests and lowering loan-to-value ratios during economic upswings. Similarly, in difficult economic times, when house prices are not appreciating, regulators could permit loan-to-value (LTV) ratios to rise. Other examples include increasing capital and allowance for loan and lease losses in times of prosperity, when resources are readily available. Another important nonstructural problem that is recognizable in hindsight and remains a concern today is the magnitude of the liquidity risk facing financial institutions and how that risk is addressed. As the economic crisis hit banks and thrifts, some institutions failed and consumers whose confidence was already shaken were overtaken in some cases by panic about the safety of their savings in insured accounts at banks and thrifts. This lack of consumer confidence resulted in large and sudden deposit drains at some institutions that had serious consequences. The federal government has taken several important steps to address liquidity risk in recent months, including an increase in the insured threshold for bank and thrift deposits. Another lesson learned is that a lack of transparency for consumer products and complex instruments contributed to the crisis. For consumers, the full terms and details of mortgage products need to be understandable. For investors, the underlying details of their investments must be clear, readily available and accurately evaluated. Transparency of disclosures and agreements should be addressed. Some of the blame for the economic crisis has been attributed to the use of ``mark-to-market'' accounting under the argument that this accounting model contributes to a downward spiral in asset prices. The theory is that as financial institutions write down assets to current market values in an illiquid market, those losses reduce regulatory capital. To eliminate their exposure to further write-downs, institutions sell assets into stressed, illiquid markets, triggering a cycle of additional sales at depressed prices. This in turn results in further write-downs by institutions holding similar assets. The OTS believes that refining this type of accounting is better than suspending it. Changes in accounting standards can address the concerns of those who say fair value accounting should continue and those calling for its suspension. These examples illustrate that nonstructural problems, such as weak underwriting, lack of transparency, accounting issues and an over-reliance on performance rather than fundamentals, all contributed to the current crisis.Structural Problems The crisis has also demonstrated that gaps in regulation and supervision that exist in the mortgage market have had a negative impact on the world of traditional and complex financial products. In recent years, the lack of consistent regulation and supervision in the mortgage lending area has become increasingly apparent. Independent mortgage banking companies are state-chartered and regulated. Currently, there are state-by-state variations in the authorities of supervising agencies, in the level of supervision by the states and in the licensing processes that are used. State regulation of mortgage banking companies is inconsistent and varies on a number of factors, including where the authority for chartering and oversight of the companies resides in the state regulatory structure. The supervision of mortgage brokers is even less consistent across the states. In response to calls for more stringent oversight of mortgage lenders and brokers, a number of states have debated and even enacted licensing requirements for mortgage originators. Last summer, a system requiring the licensing of mortgage originators in all states was enacted into federal law. The S.A.F.E. Mortgage Licensing Act in last year's Housing and Economic Recovery Act is a good first step. However, licensing does not go far enough. There continues to be significant variation in the oversight of these individuals and enforcement against the bad actors. As the OTS has advocated for some time, one of the paramount goals of any new framework should be to ensure that similar bank or bank-like products, services and activities are scrutinized in the same way, whether they are offered by a chartered depository institution, or an unregulated financial services provider. The product should receive the same review, oversight and scrutiny regardless of the entity offering the product. Consumers do not understand--nor should they need to understand--distinctions between the types of lenders offering to provide them with a mortgage. They deserve the same service, care and protection from any lender. The ``shadow bank system,'' where bank or bank-like products are offered by nonbanks using different standards, should be subject to as rigorous supervision as banks. Closing this gap would support the goals cited in the GAO report. Another structural problem relates to unregulated financial products and the confluence of market factors that exposed the true risk of credit default swaps (CDS) and other derivative products. CDS are unregulated financial products that lack a prudential derivatives regulator or standard market regulation, and pose serious challenges for risk management. Shortcomings in data and in modeling certain derivative products camouflaged some of those risks. There frequently is heavy reliance on rating agencies and in-house models to assess the risks associated with these extremely complicated and unregulated products. In hindsight, the banking industry, the rating agencies and prudential supervisors, including OTS, relied too heavily on stress parameters that were based on insufficient historical data. This led to an underestimation of the economic shock that hit the financial sector, misjudgment of stress test parameters and an overly optimistic view of model output. We have also learned there is a need for consistency and transparency in over-the-counter (OTC) CDS contracts. The complexity of CDS contracts masked risks and weaknesses. The OTS believes standardization and simplification of these products would provide more transparency to market participants and regulators. We believe many of these OTC contracts should be subject to exchange-traded oversight, with daily margining required. This kind of standardization and exchange-traded oversight can be accomplished when a single regulator is evaluating these products. Congress should consider legislation to bring such OTC derivative products under appropriate regulatory oversight. One final issue on the structural side relates to the problem of regulating institutions that are considered to be too big and interconnected to fail, manage, resolve, or even formally deem as problem institutions when they encounter serious trouble. We will discuss the pressing need for a systemic risk regulator with the authority and resources adequate to the meet this enormous challenge later in this testimony. The array of lessons learned from the crisis will be debated for years. One simple lesson is that all financial products and services should be regulated in the same manner regardless of the issuer. Another lesson is that some institutions have grown so large and become so essential to the economic well-being of the nation that they must be regulated in a new way.Guiding Principles for Modernizing Bank Supervision and Regulation The discussion on how to modernize bank supervision and regulation should begin with basic principles to apply to a bank supervision and consumer protection structure. Safety and soundness and consumer protection are fundamental elements of any regulatory regime. Here are recommendations for four other guiding principles: 1. Dual banking system and federal insurance regulator--The system should contain federal and state charters for banks, as well as the option of federal and state charters for insurance companies. The states have provided a charter option for banks and thrifts that have not wanted to have a national charter. A number of innovations have resulted from the kind of focused product development that can occur on a local level. Banks would be able to choose whether to hold a federal charter or state charter. For large insurance companies, a federal insurance regulator would be available to provide more comprehensive, coordinated and effective oversight than a collection of individual state insurance regulators. 2. Choice of charter, not of regulator--A depository institution should be able to choose between state or federal banking charters, but if it selects a federal charter, its charter type and regulator should be determined by its operating strategy and business model. In other words, there would be an option to choose a business plan and resulting charter, but that decision would then dictate which regulator would supervise the institution. 3. Organizational and ownership options--Financial institutions should be able to choose the organizational and ownership form that best suits their needs. Mutual, public or private stock and subchapter S options should continue to be available. 4. Self-sustaining regulators--Each regulator should be able to sustain itself financially through assessments. Funding the agencies differently could expose bank supervisory decisions to political pressures, or create conflicts of interest within the entity controlling the purse strings. An agency that supervises financial institutions must control its funding to make resources available quickly to respond to supervision and enforcement needs. For example, when the economy declines, the safety-and-soundness ratings of institutions generally drop and enforcement actions rise. These changes require additional resources and often an increase in hiring to handle the larger workload. 5. Consistency--Each federal regulator should have the same enforcement tools and the authority to use those tools in the same manner. Every entity offering financial products should also be subject to the same set of laws and regulations.Federal Bank Regulation The OTS proposes two federal bank regulators, one for banks predominately focused on consumer-and-community banking products, including lending, and the other for banks primarily focused on commercial products and services. The business models of a commercial bank and a consumer-and-community bank are fundamentally different enough to warrant these two distinct federal banking charters. The consumer-and-community bank regulator would supervise depository institutions of all sizes and other companies that are predominately engaged in providing financial products and services to consumers and communities. Establishing such a regulator would address the gaps in regulatory oversight that led to a shadow banking system of unevenly regulated mortgage companies, brokers and consumer lenders that were significant causes of the current crisis. The consumer-and-community bank regulator would also be the primary federal regulator of all state-chartered banks with a consumer-and-community business model. The regulator would work with state regulators to collaborate on examinations of state-chartered banks, perhaps on an alternating cycle for annual state and federal examinations. State-chartered banks would pay a prorated federal assessment to cover the costs of this oversight. In addition to safety and soundness oversight, the consumer-and-community bank regulator would be responsible for developing and implementing all consumer protection requirements and regulations. These regulations and requirements would be applicable to all entities that offer lending products and services to consumers and communities. The same standards would apply for all of these entities, whether a state-licensed mortgage company, a state bank or a federally insured depository institution. Noncompliance would be addressed through uniform enforcement applied to all appropriate entities. The current crisis has highlighted consumer protection as an area where reform is needed. Mortgage brokers and others who interact with consumers should meet eligibility requirements that reinforce the importance of their jobs and the level of trust consumers place in them. Although the recently enacted licensing requirements are a good first step, limitations on who may have a license are also necessary. Historically, federal consumer protection policy has been based on the premise that if consumers are provided with enough information, they will be able to choose products and services that meet their needs. Although timely and effective disclosure remains necessary, disclosure alone may not be sufficient to protect consumers against abuses. This is particularly true as products and services, including mortgages, have become more complex. The second federal bank regulator--the commercial bank regulator--would charter and supervise banks and other entities that primarily provide products and services to corporations and companies. The commercial bank regulator would have the expertise to supervise banks and other entities predominately involved in commercial transactions and offering complex products. This regulator would develop and implement the regulations necessary to supervise these entities. The commercial bank regulator would supervise issuers of derivative products. Nonbank providers of the same products and services would be subject to the same rules and regulations. The commercial bank regulator would not only have the tools necessary to understand and supervise the complex products already mentioned, but would also possess the expertise to evaluate the safety and soundness of loans that are based on suchthings as income streams and occupancy rates, which are typical of loans for projects such as shopping centers and commercial buildings. The commercial bank regulator would also be the primary federal supervisor of state-chartered banks with a commercial business model, coordinating with the states on supervision and imposing federal assessments just as the consumer-and-communityregulator would. Because most depositories today are engaged in some of each of these business lines, the predominant business focus of the institution would govern which regulator would be the primary federal regulator. In determining the federal supervisor, a percentage of assets test could apply. If the operations of the institution or entity changed for a significant period of time, the primary federal regulator would change. More discussion and analysis would be needed to determine where to draw the line between institutions qualifying as commercial banks and institutions qualifying as consumer and community banks.Holding Company Regulation The functional regulator of the largest entity within a diversified financial company would be the holding company regulator. The holding company regulator would have authority to monitor the activities of all affiliates, to exercise enforcement authority and to impose information-sharing arrangements between entities in the holding company structure and their functional regulators. To the extent necessary for the safety and soundness of the depository subsidiary or the holding company, the regulator would have the authority to impose capital requirements, restrict activities, issue source-of support requirements and otherwise regulate the operations of the holding company and the affiliates.Systemic Risk Regulation The establishment of a systemic risk regulator is an essential outcome of any initiative to modernize bank supervision and regulation. OTS endorses the establishment of a systemic risk regulator with broad authority to monitor and exercise supervision over any company whose actions or failure could pose a risk to financial stability. 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 inbanking, securities and insurance. For systemically important institutions, the systemic risk regulator would supplement, not supplant, the holding company regulator and the primary federal bank supervisor. A systemic regulator would have the authority and resources to supervise institutions and companies during a crisis situation. The regulator should have ready access to funding sources that would provide the capability to resolve problems at these institutions, including providing liquidity when needed. Given the events of the past year, it is essential that such a regulator have the ability to act as a receiver and to provide an orderly resolution to companies. Efficiently resolving a systemically important institution in a measured, well-managed manner is an important element in restructuring the regulatory framework. A lesson learned from recent events is that the failure or unwinding of systemically important companies has a far reaching impact on the economy, not just on financial services. The continued ability of banks and other entities in the United States to compete in today's global financial services marketplace is critical. The systemic risk regulator would be charged with coordinating the supervision of conglomerates that have international operations. Safety and soundness standards, including capital adequacy and other factors, should be as comparable as possible for entities that have multinational businesses. Although the systemic risk regulator would not have supervisory authority over nonsystemically important banks, the systemic regulator would need access to data regarding the health and activities of these institutions for purposes of monitoring trendsand other matters.Conclusion Thank you again, Mr. Chairman, Ranking Member Shelby, and Members of the Committee, for the opportunity to testify on behalf of the OTS on Modernizing Bank Supervision and Regulation. We look forward to continuing to work with the members of this Committee and others to fashion a system of financial services regulation that better serves all Americans and helps to ensure the necessary clarity and stability for this nation's economy. ______ fcic_final_report_full--364 COMMISSION CONCLUSIONS ON CHAPTER 19 The Commission concludes AIG failed and was rescued by the government prima- rily because its enormous sales of credit default swaps were made without putting up initial collateral, setting aside capital reserves, or hedging its exposure—a pro- found failure in corporate governance, particularly its risk management practices. AIG’s failure was possible because of the sweeping deregulation of over-the- counter (OTC) derivatives, including credit default swaps, which effectively elim- inated federal and state regulation of these products, including capital and margin requirements that would have lessened the likelihood of AIG’s failure. The OTC derivatives market’s lack of transparency and of effective price discovery exacer- bated the collateral disputes of AIG and Goldman Sachs and similar disputes be- tween other derivatives counterparties. AIG engaged in regulatory arbitrage by setting up a major business in this unregulated product, locating much of the business in London, and selecting a weak federal regulator, the Office of Thrift Supervision (OTS). The OTS failed to effectively exercise its authority over AIG and its affiliates: it lacked the capability to supervise an institution of the size and complexity of AIG, did not recognize the risks inherent in AIG’s sales of credit default swaps, and did not understand its responsibility to oversee the entire company, including AIG Financial Products. Furthermore, because of the deregulation of OTC derivatives, state insurance supervisors were barred from regulating AIG’s sale of credit de- fault swaps even though they were similar in effect to insurance contracts. If they had been regulated as insurance contracts, AIG would have been required to maintain adequate capital reserves, would not have been able to enter into con- tracts requiring the posting of collateral, and would not have been able to provide default protection to speculators; thus AIG would have been prevented from act- ing in such a risky manner. AIG was so interconnected with many large commercial banks, investment banks, and other financial institutions through counterparty credit relationships on credit default swaps and other activities such as securities lending that its po- tential failure created systemic risk. The government concluded AIG was too big to fail and committed more than  billion to its rescue. Without the bailout, AIG’s default and collapse could have brought down its counterparties, causing cascading losses and collapses throughout the financial system. CHRG-111hhrg48867--190 Mr. Wallison," That is the thing that bothers me more than anything else, and worries me. And that is just from what I have experienced with watching Fannie Mae and Freddie Mac. When the government chooses a winner, when the government chooses an institution that it is going to treat specially, different from any other institution, then the market looks at that and decides, quite practically, that I will be taking less risk if I make loans to such a company. And when that happens, those companies then become much tougher competitors for everybody else in the industry. The result will be a collapse of the very competitive financial system we have today and the consolidation of that system into a few very large companies that have been chosen by the government--whether they are banks, securities firms, insurance companies, hedge funds, or anything else. " CHRG-111shrg57320--378 Mr. Corston," As has been discussed earlier, with the optionality in their payment structure in their assets, they are extremely hard to value. That makes it very difficult for us as an insurer to deal with, but it also makes it very difficult for investors to value the company and put capital in. So the type of business they were involved in made it very difficult for them to go out, and raise capital, one, and then, two, when the liquidity became squeezed, the assets, again, with the asset quality deterioration, they could not fund themselves. Senator Levin. OK. Take a look finally--and I think this will be my last question--at Exhibit 1b. This is a chart that we have used to show some of the high-risk lending practices that were going on not just in Washington Mutual but a lot of other lenders across the country, and bank regulators allowed these unsafe, unsound mortgage practices to go on. Now, Exhibit 1b\1\ is in your book. You will not be able to read that unless you have phenomenal eyes, which probably you do given your occupation. At least you used to.--------------------------------------------------------------------------- \1\ See Exhibit No. 1b, which appears in the Appendix on page 198.--------------------------------------------------------------------------- " FinancialCrisisInquiry--61 HOLTZ-EAKIN: So you have, at this moment, stress tests that look at commercial real estate and the concerns that are out there now in picking up your exposures? MOYNIHAN: Yes, we have. As you said earlier, the work that was done last year about this time to put in a stress test and things like that brought firm-wide stress tests, but we’ve always had a view of commercial real estate really through with the hard knocks taken and the late ‘80’s and stuff to be very diligent about what could happen, too. I don’t think the consumer side had ever seen this kind of recession, and that led us down a path that we’ve learned from. HOLTZ-EAKIN: A lot of this revolves around housing, and I want to pick up on something in your testimony, Mr. Blankfein, where you said—if I have this right—that almost all of the losses that financial institutions sustained over the course of the crisis thus far have revolved around bad lending practices, particularly, in real estate. Can you tell us exactly what those bad lending practices are off the top of your head? What are the list of things that were bad? BLANKFEIN: FinancialCrisisInquiry--64 But I would say I would be more complacent when I saw something had AAA than if it had a AA or a AA then had a single A. So to that extent, I also must have been deferring to a rating agency. HOLTZ-EAKIN: And to close my time, I’d like to just ask Mr. Dimon to go back to the mortgage underwriting and your observations on how many—how so many bad mortgages could be written in the United States and the decline in lending standards . DIMON: Right. So it’s really not a mystery, and it’s kind of surprising. High LTV—a long time ago you did 80 percent loan to value loans. With proper appraisals it went to 85 percent, 90, 95, 100, even higher than that. Second is in the old days you had to verify your income, show a tax return or a pay stub and make sure the income was there. And there was more and more reliance on FICO scores and people saying, “I earned this.” The third is that it went lower and lower on credit. So call it subprime, Alt-A, but basically as these things were taking place, they were more—more on credit. And you never saw losses in these new products, because home prices were going up, people were making money. And—and in addition to this, I think it’s also true there were some bad products and some bad actors and excess speculation. HOLTZ-EAKIN: Can you talk specifically about the bad products and bad actors? DIMON: Well, I think as it turned out, you know, option ARMs were not a great product. I think certain subprime, Alt-A products weren’t great products. I think there were some—there were some unscrupulous mortgage salesmen and mortgage brokers. And, you know, some people missold. And there was a lot of speculation, far too many people buying second and third homes using these things, as opposed to the place you’re going to live. fcic_final_report_full--179 DISCLOSURE AND DUE DILIGENCE: “A QUALITY CONTROL ISSUE IN THE FACTORY ” In addition to the rising fraud and egregious lending practices, lending standards de- teriorated in the final years of the bubble. After growing for years, Alt-A lending in- creased another  from  to . In particular, option ARMs grew  during that period, interest-only mortgages grew , and no-documentation or low-docu- mentation loans (measured for borrowers with fixed-rate mortgages) grew . Overall, by  no-doc or low-doc loans made up  of all mortgages originated. Many of these products would perform only if prices continued to rise and the bor- rower could refinance at a low rate.  In theory, every participant along the securitization pipeline should have had an interest in the quality of every underlying mortgage. In practice, their interests were often not aligned. Two New York Fed economists have pointed out the “seven deadly frictions” in mortgage securitization—places along the pipeline where one party knew more than the other, creating opportunities to take advantage.  For example, the lender who originated the mortgage for sale, earning a commission, knew a great deal about the loan and the borrower but had no long-term stake in whether the mortgage was paid, beyond the lender’s own business reputation. The securitizer who packaged mortgages into mortgage-backed securities, similarly, was less likely to retain a stake in those securities. In theory, the rating agencies were important watchdogs over the securitization process. They described their role as being “an umpire in the market.”  But they did not review the quality of individual mortgages in a mortgage-backed security, nor did they check to see that the mortgages were what the securitizers said they were. So the integrity of the market depended on two critical checks. First, firms pur- chasing and securitizing the mortgages would conduct due diligence reviews of the mortgage pools, either using third-party firms or doing the reviews in-house. Sec- ond, following Securities and Exchange Commission rules, parties in the securitiza- tion process were expected to disclose what they were selling to investors. Neither of these checks performed as they should have. Due diligence firms: “Waived in” As subprime mortgage securitization took off, securitizers undertook due diligence on their own or through third parties on the mortgage pools that originators were selling them. The originator and the securitizer negotiated the extent of the due dili- gence investigation. While the percentage of the pool examined could be as high as , it was often much lower; according to some observers, as the market grew and originators became more concentrated, they had more bargaining power over the mortgage purchasers, and samples were sometimes as low as  to .  Some secu- ritizers requested that the due diligence firm analyze a random sample of mortgages from the pool; others asked for a sampling of those most likely to be deficient in some way, in an effort to efficiently detect more of the problem loans. FOMC20080109confcall--32 30,MR. EVANS.," Thank you, Mr. Chairman. I would not have thought to call an intermeeting videoconference. I tend to think of the in-person meetings as those where we make the decisions and do the analysis. But since you made us think about it, I agree with your assessment of the economy. I think that things are noticeably softer. I don't think there is much accommodation in place at a funds rate of 4� percent. To influence aggregate demand noticeably we probably need accommodation on the order of what you are talking about, which is about 100 basis points from a neutral federal funds rate. That range is probably on the order of 4� to 4�, so that would put such accommodation at 3� percent. We have to recognize that monetary policy, if it is going to have any influence on aggregate demand, is going to do so with a lag. That is what all our analysis assumes and suggests, and so if we want to influence aggregate demand to limit midyear weakness, I think we need to take action sooner rather than later. In terms of the data developments that you talked about, one thing that is taking place right now is that uncertainty is being resolved. The weakness that we are seeing I am currently interpreting tentatively as sort of an unraveling of things that we haven't seen so far, not necessarily a deeper weakness. The December data have been weaker. The employment data were poor, and the unemployment rate was a lot higher. In constructing my outlook for the economy in 2008 and beyond, I had been more optimistic than many that consumer spending would hold up in part because of the positive labor market situation. Taken at face value, the December employment report puts a crack in that supporting foundation. It is now likely, it seems to me, that consumer spending will soften with these labor developments. Dave Stockton went through a bit of analysis of the indicators that might lead to a recession. President Lacker and you, Mr. Chairman, mentioned regime-switching as well. I just want to mention that in Chicago we have been publishing our Chicago Fed National Activity Index for a number of years. We started out right at the onset of the 2001 recession, as it turns out. As you know, Mr. Chairman, this index is very closely related to your data-rich environment analysis with Jean Boivin and Stock and Watson. If you do an analysis where you try to assess these regime-switching events, this indicator has done a fairly good job of picking that out when it goes below a threshold of, say, minus 0.7. That is some of the probabilistic analysis that I did with this back then. If you take some of the developments in the employment report at face value, I think that this is headed for a probability of recession this year that is higher than 50 percent. So we have to be a little concerned about that. Anyway, that is the economic situation that I worry about a good bit. What about inflation? Clearly there are risks, and the risks are evident. Core inflation rates are projected to be higher in the near term. Headline inflation has been significantly above core for long enough to make people wonder about underlying inflation, but inflation expectations have remained contained. With energy prices traversing high levels over a short time, the possibility of pass-through during a period of economic weakness cannot be dismissed. We also have to be concerned about the reputational cost of inflation going up. But, again, I agree with you, Mr. Chairman, that if we do end up with significantly weaker economic activity, it would limit the inflation risk. What is hard in this period is balancing the risks of going slowly on monetary policy if we really think that the risk of a recession is higher. I agree with what you said and Governor Mishkin's thinking about being aggressive in the near term to respond to weakening aggregate demand and then making sure that we take back any excessive accommodation at the appropriate time. I know that's hard, but I think that's what we should do. I would actually favor action today on the order of 50 basis points because I think that's about the only way to get to 3� in a quick enough period of time by our next meeting. That's what I would prefer. Anyway, those are my comments. " CHRG-110hhrg46593--320 The Chairman," No, I agree with that. And let me say this. Fortunately, you know, sometimes we get into the legal habit of we have to accept it or not accept it. The TARP is so written as to give, as we are now aware, a great deal of flexibility to the Secretary. The argument that there are this or that aspect of Sheila Bair's very creative planning--she has been a very positive force here--needs modification is simply an argument to modify it. Under the TARP, they could do that. So I take that as encouragement. And, in fact, it would be good to have two models. The HOPE for Homeowners is a principal-reduction model; the other is an interest-reduction model. And they could both be made available depending on what is appropriate, with elements of Professor Feldstein. I mean, the nice thing about the TARP, its weakness could be its strength, in that it does allow for several approaches. The gentleman from California. " CHRG-111shrg56262--5 Chairman Reed," Thank you very much. Now let me introduce our witnesses. Our first witness is Professor Patricia A. McCoy, the Director of the Insurance Law Center and the George J. and Helen M. England Professor of Law at the University of Connecticut Law School. Professor McCoy specializes in financial services law and market conduct regulation. Prior to her current role, Professor McCoy was a partner in the law firm of Mayer Brown in Washington, DC, and specialized in complex financial services and commercial litigation. Thank you, Professor McCoy. Our next witness is Mr. George P. Miller. Mr. Miller is the Executive Director of the American Securitization Forum, an association representing securitization market participants including insurers, investors, and rating agencies. Mr. Miller previously served as Deputy General Counsel of the Bond Market Association, now SIFMA, where he was responsible for securitization market advocacy initiatives. Prior to that, he was an attorney in the corporate department at Sidley, Austin, Brown & Wood, where he specialized in structured financial transactions, representing both issuers and underwriters of mortgage and asset-backed securities. Thank you, Mr. Miller. Mr. Andrew Davidson is the President of Andrew Davidson & Company, a New York firm which he founded in 1992 to specialize in the application of analytical tools to mortgage-backed securities. He is also a former managing director in charge of mortgage research at Merrill Lynch. Mr. Christopher Hoeffel is an Executive Committee member of the Commercial Mortgage Securities Association, the trade association representing the commercial real estate capital market finance industry. Mr. Hoeffel is also the Managing Director of the investment management firm Investcorp International, responsible for sourcing, structuring, financing, underwriting, and closing new debt investments for the group. Mr. Hoeffel joined Investcorp from JPMorgan Bear Stearns where he was a senior managing director and global cohead of commercial mortgages. Our final witness is Dr. William Irving, a portfolio manager for Fidelity Investments. Dr. Irving manages a number of Fidelity's funds, including its mortgage-backed security Central Fund, Government Income Fund, and Ginnie Mae Fund. Prior to joining Fidelity, Dr. Irving was a senior member of the technical staff at Alpha Tech in Burlington, Massachusetts, from 1995 to 1999 and was a member of the technical staff at MIT Lincoln Laboratory in Lexington, Massachusetts, from 1987 to 1995. Welcome, all of you. Professor McCoy, would you please begin?STATEMENT OF PATRICIA A. McCOY, GEORGE J. AND HELEN M. ENGLAND CHRG-111shrg56262--98 PREPARED STATEMENT OF WILLIAM W. IRVING Portfolio Manager, Fidelity Investments October 7, 2009 Good afternoon Chairman Reed, Ranking Member Bunning, and Members of the Subcommittee. I am Bill Irving, an employee of Fidelity Investments, \1\ where I manage a number of fixed-income portfolios and play a leading role in our investment process in residential mortgage-backed securities (RMBS). This experience has certainly shaped my perspective on the role of securitization in the financial crisis, the condition of the securitization markets today, and policy changes needed going forward. I thank you for the opportunity to share that perspective with you in this hearing. At the outset, I want to emphasize that the views I will be expressing are my own, and do not necessarily represent the views of my employer, Fidelity Investments.--------------------------------------------------------------------------- \1\ Fidelity Investments is one of the world's largest providers of financial services, with assets under Administration of $3.0 trillion, including assets under management of more than $1.4 trillion as of August 31, 2009. Fidelity offers investment management, retirement planning, brokerage, and human resources and benefits outsourcing services to over 20 million individuals and institutions as well as through 5,000 financial intermediary firms. The firm is the largest mutual fund company in the United States, the number one provider of workplace retirement savings plans, the largest mutual fund supermarket and a leading online brokerage firm. For more information about Fidelity Investments, visit Fidelity.com.---------------------------------------------------------------------------Summary I will make three main points. First, the securitized markets provide an important mechanism for bringing together investors and borrowers to provide credit to the American people for the financing of residential property, automobiles, and retail purchases. Securitization also provides a major source of funding for American businesses for commercial property, agricultural equipment, and small-business investment. My second point is that the rapid growth of the markets led to some poor securitization practices. For example, loan underwriting standards got too loose as the interests of issuers and investors became misaligned. Furthermore, liquidity was hindered by a proliferation of securities that were excessively complex and customized. My third and final point is that in spite of these demonstrated problems, the concept of asset securitization is not inherently flawed; with proper reforms to prevent weak practices, we can harness the full potential of the securitization markets to benefit the U.S. economy.Brief Review of the Financial Crisis To set context, I will begin with a brief review of the financial crisis. This view is necessarily retrospective; I do not mean to imply that investors, financial institutions or regulators understood all these dynamics at the time. In the middle of 2007, the end of the U.S. housing boom revealed serious deficiencies in the underwriting of many recently originated mortgages, including subprime loans, limited-documentation loans, and loans with exotic features like negative amortization. Many of these loans had been packaged into complex and opaque mortgage-backed securities (MBS) that were distributed around the world to investors, some of whom relied heavily on the opinion of the rating agencies and did not sufficiently appreciate the risks to which they were exposed. \2\--------------------------------------------------------------------------- \2\ At Fidelity, we consider the opinions of the rating agencies, but we also do independent credit research on each issuer or security we purchase.--------------------------------------------------------------------------- The problems of poorly understood risks in these complex securities were amplified by the leverage in the financial system. For example, in 2007, large U.S. investment banks had about $16 of net assets for each dollar of capital. \3\ Thus, a seemingly innocuous hiccup in the mortgage market in August 2007 had ripple effects that quickly led to a radical reassessment of what is an acceptable amount of leverage. What investors once deemed safe levels of capital and liquidity were suddenly considered far too thin. As a result, assets had to be sold to reduce leverage. This selling shrank the supply of new credit and raised borrowing costs. In fact, the selling of complex securities was more than the market could bear, resulting in joint problems of liquidity and solvency. Suddenly, a problem that had started on Wall Street spread to Main Street. Companies that were shut off from credit had to cancel investments, lay off employees and/or hoard cash. Many individuals who were delinquent on their mortgage could no longer sell their property at a gain or refinance; instead, they had to seek loan modifications or default.--------------------------------------------------------------------------- \3\ Source: SNL Financial, and company financials.--------------------------------------------------------------------------- This de-leveraging process created a vicious cycle. Inability to borrow created more defaults, which led to lower asset values, which caused more insolvency, which caused more de-leveraging, and so forth. Home foreclosures and credit-card delinquencies rose, and job layoffs increased, helping to create the worst recession since the Great Depression.Role Played by Asset Securitization in the Crisis Without a doubt, securitization played a role in this crisis. Most importantly, the ``originate-to-distribute'' model of credit provision seemed to spiral out of control. Under this model, intermediaries found a way to lend money profitably without worrying if the loans were paid back. The loan originator, the warehouse facilitator, the security designer, the credit rater, and the marketing and product-placement professionals all received a fee for their part in helping to create and distribute the securities. These fees were generally linked to the size of the transaction and most of them were paid up front. So long as there were willing buyers, this situation created enormous incentive to originate mortgage loans solely for the purpose of realizing that up-front intermediation profit. Common sense would suggest that securitized assets will perform better when originators, such as mortgage brokers and bankers, have an incentive to undertake careful underwriting. A recent study by the Federal Reserve Bank of Philadelphia supports this conjecture. \4\ The study found evidence that for prime mortgages, private-label securitized loans have worse credit performance than loans retained in bank portfolios. Specifically, the study found that for loans originated in 2006, the 2-year default rate on the securitized loans was on average 15 percent higher than on loans retained in bank portfolios. This observation does not necessarily mean that issuers should be required to retain a portion of their securities, but in some fashion, the interests of the issuers and the investors have to be kept aligned.--------------------------------------------------------------------------- \4\ Elul, Ronel, ``Working Paper No. 09-21 Securitization and Mortgage Default: Reputation vs. Adverse Selection'', Federal Reserve Bank of Philadelphia. September 22, 2009.--------------------------------------------------------------------------- Flawed security design also played a role in the crisis. In its simplest form, securitization involves two basic steps. First, many individual loans are bundled together into a reference pool. Second, the pool is cut up into a collection of securities, each having a distinct bundle of risks, including interest-rate risk, prepayment risk, and credit risk. For example, in a simple sequential structure, the most senior bond receives all available principal payments until it is retired; only then does the second most senior bond begin to receive principal; and so on. In the early days of securitization, the process was kept simple, and there were fewer problems. But over time, cash-flow rules grew increasingly complex and additional structuring was employed. For example, the securities from many simple structures were rebundled into a new reference pool, which could then be cut into a new set of securities. In theory, there is no limit to the amount of customization that is possible. The result was excessive complexity and customization. The complexity increased the challenge of determining relative value among securities, and the nonuniformity hurt liquidity when the financial system was stressed. One example of poor RMBS design is the proliferation of securities with complex rules on the allocation of principal between the senior and subordinate bonds. Such rules can lead to counter-intuitive outcomes in which senior bonds take write-downs while certain subordinate bonds are paid off in full. A second example of poor design is borrower ability to take out a second-lien mortgage without notifying the first-lien holder. This ability leads to a variety of thorny issues, one of which is simply the credit analysis of the borrower. If a corporation levered further, the senior unsecured debt holder would surely be notified, but that is not so in RMBS.Other Factors Contributing to the Crisis Securitization of assets played a role in the crisis, but there were several additional drivers. Low interest rates and a bubble mentality in the real estate market also contributed to the problem. Furthermore, in the case of securitized assets, there were plenty of willing buyers, many of them highly levered. In hindsight, this high demand put investors in the position of competing with each other, making it difficult for any of them to demand better underwriting, more disclosure, simpler product structures, or other favorable terms. Under-estimation of risk is always a possibility in capital markets, as the history of the stock market amply demonstrates. That possibility does not mean that capital markets, or asset securitization, should be discarded.Benefits of Asset Securitization When executed properly, there are many potential benefits of allowing financial intermediaries to sell the loans they originate into the broader capital markets via the securitization process. For one, this process provides loan originators much wider sources of funding than they could obtain through conventional sources like retail deposits. For example, I manage the Fidelity Ginnie Mae Fund, which has doubled in size in the past year to over $7 billion in assets; the MBS market effectively brings together shareholders in this Ginnie Mae Fund with individuals all over the country who want to purchase a home or refinance a mortgage. In this manner, securitization breaks down geographic barriers between lenders and borrowers, thereby improving the availability and cost of credit across regions. A second benefit of securitization is it generally provides term financing which matches assets against liabilities; this stands in contrast to the bank model, a substantial mismatch can exist between short-term retail deposits and long-term loans. Third, it expands the availability of credit across the country's socio-economic spectrum, and provides a mechanism through which higher credit risks can be mitigated with structural enhancements. Finally, it fosters competition among capital providers to ensure more efficient pricing of credit to borrowers.Current Conditions of Consumer ABS and Residential MBS Markets At present, the RMBS and ABS markets are sharply bifurcated. On one side are the sectors that have received Government support, including consumer ABS and Agency MBS (i.e., MBS guaranteed by Fannie Mae, Freddie Mac, and Ginnie Mae); these sectors are, for the most part, functioning well. On the other side are the sectors that have received little or no such support, such as the new-issue private-label RMBS market, which remains stressed, resulting in a lack of fresh mortgage capital for a large segment of the housing market.Consumer ABS The overall size of the consumer debt market is approximately $2.5 trillion; \5\ this total includes both revolving debt (i.e., credit-card loans) and nonrevolving debt (e.g., auto and student loans). Approximately 75 percent takes the form of loans on balance sheets of financial institutions, while the other 25 percent has been securitized. \6\--------------------------------------------------------------------------- \5\ Source: Federal Reserve, www.federalreserve.gov/releases/g19/current/g19.htm. \6\ Source: Federal Reserve, www.federalreserve.gov/releases/g19/current/g19.htm.--------------------------------------------------------------------------- From 2005 through the third quarter of 2008, auto and credit card ABS issuance ranged between $160 billion and $180 billion per year. \7\ However, after the collapse of Lehman Brothers in September 2008, new issuance came to a virtual halt. With the ABS market effectively shut down, lenders tightened credit standards to where only the most credit worthy borrowers had access to credit. As a result, the average interest rate on new-car loans provided by finance companies increased from 3.28 percent at end of July 2008 to 8.42 percent by the end of 2008. \8\--------------------------------------------------------------------------- \7\ Source: Bloomberg. \8\ Federal Reserve, www.federalreserve.gov/releases/g19/hist/cc_hist_tc.html.--------------------------------------------------------------------------- Issuance did not resume until March 2009 when the Term Asset-Backed Securities Loan Facility (TALF) program began. Thanks to TALF, between March and September of this year, there has been $91 billion of card and auto ABS issuance. \9\ Coincident with the resumption of a functioning auto ABS market, the new-car financing rate fell back into the 3 percent range and consumer access to auto credit has improved, although credit conditions are still more restrictive than prior to the crisis. While TALF successfully encouraged the funding of substantial volumes of credit card receivables in the ABS market, it is worth noting that credit card ABS issuance has recently been suspended due to market uncertainty regarding the future regulatory treatment of the sector.--------------------------------------------------------------------------- \9\ Source: Bloomberg.--------------------------------------------------------------------------- While interest rates on top tier New Issue ABS are no longer attractive for investors to utilize the TALF program, TALF is still serving a constructive role by allowing more difficult asset types to be financed through securitization. Examples include auto dealer floorplans, equipment loans to small businesses, retail credit cards, nonprime auto loans, and so forth.Residential MBS The overall size of the residential mortgage market is approximately $10.5 trillion, which can be decomposed into three main categories: 1. Loans on bank balance sheets: \10\ $3.5 trillion.--------------------------------------------------------------------------- \10\ Source: Federal Reserve, www.federalreserve.gov/econresdata/releases/mortoutstand/current.htm. 2. Agency MBS: \11\ $5.2 trillion.--------------------------------------------------------------------------- \11\ Source: eMBS, www.embs.com.--------------------------------------------------------------------------- a. Fannie Mae: $2.7 trillion. b. Freddie Mac: $1.8 trillion. c. Ginnie Mae: $0.7 trillion. 3. Private-Label MBS: \12\ $1.9 trillion.--------------------------------------------------------------------------- \12\ Source: Loan Performance.--------------------------------------------------------------------------- a. Prime: $0.6 trillion. b. Alt-A: $0.8 trillion. c. Subprime: $0.5 trillion. Thanks to the extraordinary Government intervention over the past year, the Agency MBS market is performing very well. This intervention had two crucial components. First, on September 7, 2008, the director of the Federal Housing Finance Agency (FHFA) placed Fannie Mae and Freddie Mac into conservatorship. This action helped reassure tens of thousands of investors in Agency unsecured debt and mortgage-backed securities that their investments were supported by the Federal Government, in spite of the sharp declines in home prices across the country. The second component of the Government intervention was the Federal Reserve's pledge to purchase $1.25 trillion of Agency MBS by the end of 2009. Year to date, as of the end of September 2009, the Fed had purchased $905 billion Agency MBS, while net supply was only $448 billion. \13\ Thus, the Fed has purchased roughly 200 percent of the year-to-date net supply. Naturally, this purchase program has reduced the spread between the yields on Agency MBS and Treasuries; we estimate the reduction to be roughly 50 basis points. As of this week, the conforming-balance \14\ 30-year fixed mortgage rate is approximately 4.85 percent, which is very close to a generational low. \15\--------------------------------------------------------------------------- \13\ Source: JPMorgan, ``Fact Sheet: Federal Reserve Agency Mortgage-Backed Securities Purchase Program''. \14\ As of 2009, for the contiguous States, the District of Columbia and Puerto Rico, the general conforming limit is $417,000; for high-cost areas, it can be as high as $729,500. \15\ Source: HSH Associates, Financial Publishers.--------------------------------------------------------------------------- In contrast, the new-issue private-label MBS market has received no Government support and is effectively shut down. From 2001 to 2006, issuance in this market had increased almost four-fold from $269 billion to $1,206 billion. \16\ But when the financial crisis hit, the issuance quickly fell to zero. Issuance in 2007, 2008 and 2009 has been $759 billion, $44 billion and $0, respectively. \17\ Virtually the only source of financing for mortgage above the conforming-loan limit (so-called ``Jumbo loans'') is a bank loan. As a result, for borrowers with high-credit quality, the Jumbo mortgage rate is about 1 percentage point higher than its conforming counterpart. \18\--------------------------------------------------------------------------- \16\ Source: Loan Performance. \17\ Source: Loan Performance. \18\ Source: HSH Associates, Financial Publishers.--------------------------------------------------------------------------- At first glance, the higher cost of Jumbo financing may not seem to be an issue that should concern policymakers, but what is bad for this part of the mortgage market may have implications for other sectors. If the cost of Jumbo financing puts downward pressure on the price of homes costing (say) $800,000, then quite likely there will be downward pressure on the price of homes costing $700,000, and so forth. Pretty soon, there is downward pressure on homes priced below the conforming limit. In my opinion, at the same time that policymakers deliberate the future of the Fannie Mae and Freddie Mac, they should consider the future of the mortgage financing in all price and credit-quality tiers.Recommended Legislative and Regulatory Changes The breakdown in the securitization process can be traced to four root causes: aggressive underwriting, overly complex securities, excessive leverage, and an over-reliance on the rating agencies by some investors. Such flaws in the process have contributed to the current financial crisis. However, when executed properly, securitization can be a very effective mechanism to channel capital into our economy to benefit the consumer and commercial sectors. Keep in mind that securitization began with the agency mortgage market, which has successfully provided affordable mortgage financing to millions of U.S. citizens for over 35 years. \19\ To ensure that the lapses of the recent past are not repeated, I recommend that regulatory and legislative efforts be concentrated in four key areas.--------------------------------------------------------------------------- \19\ Fannie Mae, Freddie Mac, and Ginnie Mae issued their first MBS in 1981, 1971, and 1970, respectively. Source: ``Fannie Mae and Freddie Mac: Analysis of Options for Revising the Housing Enterprises Long-term Structures'', GAO Report to Congressional Committees, September, 2009.--------------------------------------------------------------------------- First, promote improved disclosure to investors at the initial marketing of transactions as well as during the life of the deal. For example, originators should provide detailed disclosure on the collateral characteristics and on exceptions to stated underwriting procedures. Furthermore, there should be ample time before a deal is priced for investors to review and analyze a full prospectus, not just a term sheet. Second, strong credit underwriting standards are needed in the origination process. One way to support this goal is to discourage the up-front realization of issuers' profits. Instead, issuers' compensation should be aligned with the performance of the security over its full life. This issue is complex, and will likely require specialized rules, tailored to each market sector. Third, facilitate greater transparency of the methodology and assumptions used by the rating agencies to determine credit ratings. In particular, there should be public disclosure of the main assumptions behind rating methodologies and models. Furthermore, when those models change or errors are discovered, the market should be notified. Fourth, support simpler, more uniform capital structures in securitization deals. This goal may not readily be amenable to legislative action, but should be a focus of industry best practices. Taking such steps to correct the defects of recent securitization practices will restore much-needed confidence to this critical part of our capital markets, thereby providing improved liquidity and capital to foster continued growth in the U.S. economy. Additional Material Supplied for the Record Prepared Statement of the Mortgage Bankers Association The Mortgage Bankers Association (MBA) \1\ appreciates the opportunity to provide this statement for the record of the Senate Banking Securities, Insurance, and Investment Subcommittee hearing on the securitization of assets.--------------------------------------------------------------------------- \1\ The Mortgage Bankers Association (MBA) is the national association representing the real estate finance industry, an industry that employs more than 280,000 people in virtually every community in the country. Headquartered in Washington, DC, the association works to ensure the continued strength of the Nation's residential and commercial real estate markets; to expand homeownership and extend access to affordable housing to all Americans. MBA promotes fair and ethical lending practices and fosters professional excellence among real estate finance employees through a wide range of educational programs and a variety of publications. Its membership of over 2,400 companies includes all elements of real estate finance: mortgage companies, mortgage brokers, commercial banks, thrifts, Wall Street conduits, life insurance companies and others in the mortgage lending field. For additional information, visit MBA's Web site: www.mortgagebankers.org.--------------------------------------------------------------------------- Asset-backed securities are a fundamental component of the financial services system because they enable consumers and businesses to access funding, organize capital for new investment opportunities, and protect and hedge against risks. As policymakers evaluate securitization's role in the recent housing finance system's disruptions, MBA believes it is important to keep in mind the benefits associated with securitization when it is used prudently by market participants. Securitization describes the process in which relatively illiquid assets are packaged in a way that removes them from the institution's balance sheet and sold as more liquid securities. Securities backed by residential or commercial mortgages are an example of asset securitization. Securitization is an effective means of risk management for many institutions. For example, the accumulation of many loans in a single asset sector creates concentration risk on a financial institution's balance sheet. If that sector becomes distressed, these large concentrations could place the solvency of the financial institution at risk. However, securitization provides a remedy to avoid concentration risk by disbursing the exposure more widely across the portfolios of many investors. In this way, the exposure of any one investor is minimized. As demonstrated by the current business cycle however, if the entire system is hit by a significant systemic shock, all investors will face losses from these exposures, as diversification does not protect investors from systemic events. Securitization also enables various market sectors to create synergies by combining their particular areas of expertise. For example, community-based financial institutions are known for their proficiency in originating loans because of their relationships with local businesses and consumers, and their knowledge of local economic conditions. Securitization links these financial institutions to others that may be more adept at matching asset risks with investor appetites. As the last 2 or 3 years have demonstrated, when it is not understood, or poorly underwritten, securitization can cause meaningful harm to investors, lenders, borrowers and other segments of the financial services system. Since the economic and housing finance crisis began, investors have shunned securitization products, including mortgage-backed securities (MBS), particularly those issued by private entities. As a result, central banks and governments have taken up the slack with various programs to support securitization markets. MBA believes this has been an important, yet ultimately unsustainable, course of action. One key to the process is to create an environment where investors can accurately evaluate the risks in the various investment opportunities available to them, and have confidence that their analysis of the risk is consistent with what the underlying risk will turn out to be. No investments are risk-free. But reliable instruments allow responsible investors to evaluate whether the instrument's risk profile is within the boundaries of an investor's risk tolerance. When considering how to reestablish a safe and sound environment for securitization of real estate-related assets, MBA believes the following components must be addressed: Risk Assessment: Risk assessment is an imperfect science, but it is crucial for securitization to enable accurate, effective, and stable risk assessment. Equally important, third-party assessments of risk must be highly credible to be widely used or adopted. Aligning Risks, Rewards, and Penalties: A key consideration for the market going forward will be ensuring the alignment of risks with rewards and penalties. Loan attributes, such as whether a loan is adjustable-rate or fixed rate, or does or does not have a prepayment restriction, shift risks between the borrower and the investors. If investors or other market participants are not accountable for the risks they take on, they are prone to act irresponsibly by taking on greater risks than they otherwise would. Aligning Rewards With Long-Term Performance: Given the long-term nature of a mortgage contract, as well as the imperfect state of risk assessment, some risks inherent in a mortgage asset may not appear for some time after the asset has changed hands. It is important to consider the degree to which participants in the mortgage process can be held accountable for the long-term performance of an asset. Ensuring Capital Adequacy of Participants: Participants throughout the market need adequate levels of capital to protect against losses. Capital adequacy is keenly dependent on the assessment of risks outlined above. The greater the risks, as assessed, the greater the capital needed. In times of rapid market deterioration, when model and risk assumptions change dramatically, capital needs may change dramatically as well. If market participants that have taken on certain risks become undercapitalized, they may not be able to absorb those risks when necessary--forcing others to take on unanticipated risks and losses. Controlling Fraud Between Parties in the System: A key consideration for effective securitization is the degree to which fraud can be minimized. Key considerations include the ability to identify and prosecute fraud, and the degree to which fraud is deterred. Transparency: In order to attract investors, another key consideration for securitization is transparency. The less transparent a market is, the more poorly understood it will be by investors, and the higher will be the yield those investors demand to compensate for the uncertainty. The task of improving transparency and accountability involves both policy and operational issues. Public debate typically focuses on the policy issues--what general types of information should be disclosed, and who should share and receive this information. However, the operational issues are equally important to establishing and implementing a functional system that promotes and supports the goals of transparency and accountability. We are submitting testimony today to stress the importance to market transparency and investor confidence of better loan tracking and more accessible, complete, and reliable loan and security data across the primary and secondary mortgage markets.Loan and Security Tracking Improving transparency in the real estate finance system is considered essential to restoring investor confidence in the securitization market. Because the real estate finance system embraces multiple parties--loan originators, loan aggregators (servicers) and securitizers--we need transparency solutions that flow from and span the complete mortgage value chain. The goal, we think, is relatively easy to state: key information about mortgages, the securities built upon those mortgages, and the people and companies that create them, should all be linked and tracked over time, so our financial system is more transparent and the strengths and risks of various products can be properly assessed and appreciated. Loans need to be tracked, for example, to help identify fraud and distinguish the performance of various mortgage products and securities types. Just as the vehicle identification number, or ``VIN,'' has evolved from a simple serial number into a valuable tool for consumers, enabling a potential purchaser to research the history of any car or truck, a comprehensive mortgage/security numbering system would be the key to tracking MBS history and performance. Achieving such a goal is very doable because the essential components are already in place. With relatively minor modifications these existing systems can evolve into the tools necessary to meet the challenge of transparency and accountability. On the mortgage end of the value chain there is MERS. \2\ This national loan registry is already used by virtually all mortgage originators, aggregators, and securitizers to track individual mortgages by means of a unique, 18-digit Mortgage Identification Number, or ``MIN.'' For each registered mortgage, the MIN and the MERS database tracks information regarding the originator, the borrower, the property, the loan servicer, the investors, and any changes of ownership for the life of the loan. MERS currently tracks more than 60 million loans and is embedded in every major loan origination system, servicing system, and delivery system in the United States, so total adoption would be swift and inexpensive.--------------------------------------------------------------------------- \2\ ``MERS'' is formally known as MERSCORP, Inc., and is the owner and operator of the MERS System. MBA, along with Fannie Mae, Freddie Mac, and other industry participants, is a shareholder in MERS.--------------------------------------------------------------------------- On the securitization end of the value chain, the American Bankers Association has a product called CUSIP that generates a 9-digit identification number for most types of securities, including MBS. The CUSIP number uniquely identifies the company or issuer and the type of security instrument. Together, these two identifiers solve the loan and security tracking problem, with the MIN tracking millions of individual mortgage loans and the CUSIP tracking thousands of unique financial instruments created each year in the United States. Loan-level information for every mortgage and mortgage-backed security would be available at the touch of a button, for example, the credit rating agencies would have needed information to assess more accurately the risk of a given security and track its performance relative to other securities over time. As the Congress looks to reform the capital markets, it should require that these two complementary identification systems be linked and that they be expanded in scope to track the decisions of all market participants--originators, aggregators and securitizers. In this way, throughout the value chain, participants that contributed to the creation of high-risk mortgages and selling of high-risk securities may be identified and held accountable. With a system like this in place, the Congress, regulators and the market as a whole would have a means of distinguishing with much more precision the quality of financial products and could enforce the discipline that has not been previously possible.Data Standards The Mortgage Industry Standards Maintenance Organization, Inc. (``MISMO'') \3\ has been engaged for the past 8 years in developing electronic data standards for the commercial and residential real estate finance industries. These standards, which have been developed through a structured consensus-building process, are grounded in the following principles that we believe characterize a robust, transparent system of data reporting:--------------------------------------------------------------------------- \3\ MISMO is a wholly owned subsidiary of the Mortgage Bankers Association. First, there must be concrete definitions of the data elements that are going to be collected, and these definitions must be common across all the related products in the market. Different products (such as conforming and nonconforming loans) may require different data elements, but any data elements that are required for both products should have the same --------------------------------------------------------------------------- definitions. Second, there should be a standardized electronic reporting format by which these data elements are shared across the mortgage and security value chain and with investors. The standards should be designed so that information can freely flow across operating systems and programs with a minimum of reformatting or rekeying of data to facilitate desired analytics. Rekeying results in errors, undermining the reliability of data. MISMO's standards are written in the XML (Web based) computer language. This is the language used in the relaunch earlier this week of the Federal Register's Web site. As reported in The Washington Post on October 5, 2009, this Web site has been received with great praise for allowing researchers and other users to extract information readily from the Register for further analysis and reuse without rekeying. Mortgage and securities data transmitted using MISMO's data standards can similarly be extracted and used by investors and regulators for customized analytics. XML is also related to and compatible with the XBRL web language that the Securities and Exchange Commission (SEC) is implementing for financial reporting. Third, the definitions and the standards should be nonproprietary and available on a royalty-free basis, so that third-parties can easily access and incorporate those standards into their work, whether it be in the form of a new loan origination software package or an improved analytical tool for assessing loan and security performance or fraud detection. Fourth, to the extent that the data includes nonpublic personal information, the system must maintain the highest degree of confidentiality and protect the privacy of that information. True transparency requires that information is not only available, but also understandable and usable. The incorporation of these four principles into any new data reporting regime will help ensure that the goal of transparency and accountability is realized. We believe that the standards of MISMO and MERS satisfy these elements for the conforming mortgage market. Their relative positions in the real estate finance process provide them with unique insight and an objective perspective that we believe could be very useful to improving transparency and accountability in the nonconforming market. Increasing the quality and transparency of loan-level mortgage and MBS-related data is an essential step so that investor confidence may be restored and the risk of a similar securitization crisis of the kind we are experiencing in the future can be minimized. This objective is paramount to all market participants, and as such all participants have an interest in achieving a solution. However, because it is so critical, the ultimate solution must also be able to withstand the scrutiny of investors, Government regulators, and academics. It must be widely perceived as a fair, appropriate, and comprehensive response to the challenges at hand. In conclusion, MBA reiterates its request for Congress and other policymakers to be mindful of the important role of securitization to housing finance and the entire financial services system. As the Congress looks to reform the capital markets, we look forward to working with you to developing a framework with a solid foundation based on the key considerations outlined above." fcic_final_report_full--503 Most of what was going on here was under the radar, even for specialists in the housing finance field, but not everyone missed it. In a paper published in 2001, 94 financial analyst Josh Rosner recognized the deterioration in mortgage standards although he did not recognize how many loans were subject to this problem: Over the past decade Fannie Mae and Freddie Mac have reduced required down payments on loans that they purchase in the secondary market. Those requirements have declined from 10% to 5% to 3% and in the past few months Fannie Mae announced that it would follow Freddie Mac’s recent move into the 0% down payment mortgage market. Although they are buying low down payment loans, those loans must be insured with ‘private mortgage insurance’ (PMI). On homes with PMI, even the closing costs can now be borrowed through unsecured loans, gifts or subsidies. This means that not only can the buyer put zero dollars down to purchase a new house but also that the mortgage can finance the closing costs…. [I]t appears a large portion of the housing sector’s growth in the 1990’s came from the easing of the credit underwriting process ….The virtuous cycle of increasing homeownership due to greater leverage has the potential to become a vicious cycle of lower home prices due to an accelerating rate of foreclosures. 95 [emphasis supplied] The last increase in the AH goals occurred in 2004, when HUD raised the LMI goal to 52 percent for 2005, 53 percent for 2006, 55 percent for 2007 and 56 percent for 2008. Again, the percentage increases in the special affordable category outstripped the general LMI goal, putting added pressure on Fannie and Freddie to acquire additional risky NTMs. This category increased from 20 percent to 27 percent over the period. In the release that accompanied the increases, HUD declared: Millions of Americans with less than perfect credit or who cannot meet some of the tougher underwriting requirements of the prime market for reasons such as inadequate income documentation, limited downpayment or cash reserves, or the desire to take more cash out in a refinancing than conventional loans allow, rely on subprime lenders for access to mortgage financing. If the GSEs reach deeper into the subprime market , more borrowers will benefit from the advantages that greater stability and standardization create. 96 [emphasis supplied] Fannie did indeed reach deeper into the subprime market, confirming in a March 2003 presentation to HUD, “Higher goals force us deeper into FHA and subprime.” 97 According to HUD data, as a result of the AH goals Fannie Mae’s acquisitions of goal-qualifying loans (which were primarily subprime and Alt-A) increased (i) for very low income borrowers from 5.2 percent of their acquisitions in 1993 to 12.2 percent in 2007; (ii) for special affordable borrowers from 6.4 percent in 1993 to 15.2 percent in 2007; and (iii) for less than median income borrowers (which includes the other two categories) from 29.2 percent in 1993 to 41.5 percent in 2007. 98 94 Josh Rosner, “Housing in the New Millennium: A Home Without Equity is Just a Rental With Debt,” June, 2001, p.7, available at: http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1162456. 95 96 97 98 Id., p.29. http://fdsys.gpo.gov/fdsys/pkg/FR-2004-11-02/pdf/04-24101.pdf , p.63601. Fannie Mae, “The HUD Housing Goals”, March 2003. HUD, Offi ce of Policy Development and Research, Profiles of GSE Mortgage Purchases, 1992-2000, 2001-2004, and 2005-2007. 499 CHRG-111hhrg54867--62 Mr. Gutierrez," And when the Securities and Exchange Commission was visited by the Wall Street heads from many of the same companies you just referred to, and I think it was in 2005, and they said, listen, we really like not to leverage 5:1 and 6:1, but 30:1, how significant was the decision by the Securities and Exchange Commission to allow that practice? " CHRG-111hhrg51698--581 Mr. Boswell," Okay. Thank you very much. I guess I have a little bit of time left. CME Chairman Terry Duffy testified against the clearing provisions, stating he didn't think they would prove to be practical because over-the-counter dealers may not embrace clearing. As another exchange that also has a clearinghouse, what do you think of his views? " CHRG-110hhrg46591--347 Mr. Washburn," Could you go back over my question? Ms. Bean. Sure. Yours was on mortgage reform which eliminated risky lending practices, put liability to the securitizers so they would make sure the originators did what they were supposed to do to avoid that liability; is that a good thing, is that what we need now? Or do we need something else, because I think that bill would have addressed it. And second, if we had done it, would we have avoided some of this fallout? " CHRG-111hhrg54868--68 Mr. Dugan," Double-cycle billing was expressly permitted by regulation, by the Federal Reserve. There is no way we could have brought an action against them as an unfair and deceptive practice that the regulation permitted. Mr. Miller of North Carolina. Okay. Raising the interest rates on an existing balance. That was expressly allowed? " CHRG-111shrg57319--393 Mr. Beck," I would expect that I would be informed of this, yes. Senator Levin. I mean, this is damning stuff. You are working for a bank which according to a 25-loans test had almost half reflecting a sale after an investigation has confirmed fraud, and this review says that failure has existed for some time, that control weakness has existed for some time. Now take a look at Exhibit 40b,\1\ if you would. Senator Kaufman, any time you want to jump in here, please do.--------------------------------------------------------------------------- \1\ See Exhibit 40b, which appears in the Appendix on page 632.--------------------------------------------------------------------------- Exhibit 40b. Now, this one is going to take some difficult following because it is an email chain, so we have to start at the first email, which is on page 4--it is at the end--and work back up to page 1. But take a look on page 4. You will see there on February 14, 2007, Michael Liu writes to Mr. Elson. Mr. Elson is the Senior Vice President for Portfolio Management, and here is the subject, ``Option ARM MTA''--which is the Monthly Treasury Average--``Option ARM MTA and Option ARM MTA Delinquency.'' Notice that, delinquency. So now we have an Option ARM MTA, which is an Option ARM that has an interest rate adjusting to the monthly Treasury average, is that right? " CHRG-110hhrg44901--87 Mr. Castle," Thank you, Mr. Chairman. And Chairman Bernanke, I am going to talk about something else that you mentioned that concerns me in terms of our economic future. At the very end of your testimony, you mentioned that the Board worked with the Office of Thrift Supervision and the National Credit Union Administration to issue proposed rules under the Federal Trade Commission Act to address unfair deceptive practices for credit card accounts and overdraft protection plans. You suggested credit card issuers should alter their current practices. You also note that the Fed has received over 20,000 comments on the proposed UDAP rules. I hope the Fed will be deliberate and take time to closely scrutinize these comments. I presume you share my concern that while we want to protect consumers, we likewise want to maintain a competitive credit card market, and not further damage the standing of the financial services industry. Any comments you have beyond that I would appreciate. " CHRG-111hhrg51592--126 Mr. Dobilas," Yes, I would like to comment. You know, I would like to make a distinction, too, in saying that I only speak for CMBS. You know, when we look at a subscriber-paid model, it works very well in the surveillance arena. Now, on the new issue side though, I have to say there is a real problem with the issuer-paid model. And that really isn't a problem that can't be solved, but it's going to need a long-term approach. It's going to need somebody to set the example and show investors what subscription-paid models can do in that arena, and somebody is going to have to absorb the cost, because when you do look at these new issue deals, there's a very large cost structure involved for a rating agency when they do go in to rate a new issue security. On the CMBS side, you have to visit every property, you have to underwrite those properties, you have to travel. You know, somebody is going to have to pick up those expenses. But I do think that if investors can see the light at the end of the tunnel, they will wean themselves of, you know, the dependency on those two, you know, new issue ratings, but somebody is going to have to step in in the interim and make sure that the playing field is equal, and investors will eventually buy those analyses. Realpoint, we were looking at offering a very cost-effective-- " CHRG-111shrg56415--73 Mr. Dugan," Comptroller. That is OK. There are two very good and powerful ideas connected with the CFPA. One is to have common rules that apply to everybody, whether you are a bank or a non-bank, and to have strong authority to do that. So I think that is important. Second, I think the part of the system that had the least attention paid to it were the non-banks in terms of how rules are implemented. You don't have the comprehensive regime today. So that part, I think, can be a very good and powerful idea. The part that I have had concerns about is implementing those rules on banks and carrying them out through supervision, examination, and enforcement. I think that should stay with the bank regulators. I think that you do get a benefit from things that are interwoven together between consumer protection and safety and soundness, like underwriting standards in subprime mortgages, which are related to consumer protection issues. We see examples of it all the time, which I provided to the Committee in our last testimony. That is the part I would worry about. And then, second, the notion that the new agency should focus its implementation responsibilities on the non-banks, again, very powerful idea. Senator Schumer. Would you just--I know my time has expired, Mr. Chairman--in retrospect, do you think the regulatory agencies, not yours in particular, but including yours--have done as vigorous a job on consumer protection as they should have? " Mr. Dugan," I---- Senator Schumer. In the areas that you have jurisdiction over, not the non-banks. " FOMC20061025meeting--76 74,MS. YELLEN.," Thank you, Mr. Chairman. Five weeks have passed since our last FOMC meeting, and not surprisingly the outlook does not appear to have changed in any fundamental way. Recent data bearing on the near-term situation point to noticeably slower growth in the third quarter than we anticipated at our last meeting. However, the Greenbook has revised up its projection for growth during the current and next few quarters so that the overall effect on slack next year is roughly neutral. This forecast strikes me as plausible, but there are few data thus far to bear it out. Meanwhile, measures of consumer price inflation remain uncomfortably high, although the latest readings have been very slightly better. With regard to the pace of economic activity, there’s uncertainty in all directions. In fact, we seem to have a bimodal economy with a couple of weak sectors, and the rest of the economy doing just fine. Those two weak sectors are, of course, housing and domestic auto production. Autos seem likely to have only a short-lived effect. In the case of housing, we agree with the Greenbook assessment of housing activity and find it quite consistent with the reports of our contacts in this sector. Besides the falloff in activity, house-price increases have also slowed markedly. The Case-Shiller house-price index has been flat in recent months, and futures on this index show outright declines next year. However, equity valuations for homebuilders, as Cathy mentioned, have risen moderately in the past couple of months, following large declines over the previous year, and we interpret that as providing some indication that the expected future path of home prices has at least stopped deteriorating. Of course, housing is a relatively small sector of the economy, and its decline should be self-correcting. So the bigger danger is that weakness in house prices could spread to overall consumption through wealth effects. This development would deepen and extend economic weakness, potentially touching off a nonlinear type of downward dynamic that could trigger a recession. But so far at least, there are no signs of such spillovers. Consumption spending seems on track for healthy growth. Nonetheless, the growth estimate for the third quarter begins with a 1 and just barely. Any time a forecast is that low, it’s reasonable to consider the possibility that the economy could enter recession. So for this reason, we, like the Board’s staff, took a careful look at various approaches to assess this issue, including yield-curve-based models, past forecast errors, leading indicator models, and surveys. Our bottom line is that we agree with the basic results reported in Monday’s nonfinancial briefing. The highest probability of recession that we found, around 40 percent, was obtained from a model developed by a Board staff member. The model includes the slope of the yield curve and the level of the funds rate. An issue with this result is that long-term rates may currently be low, hence the yield curve inverted, for unusual and not very well understood reasons having to do with the risk premium. Estimates from the other approaches came in with lower probabilities. Finally, other financial developments that could presage future economic performance, like stock market movements and risk spreads, suggest some optimism on the part of financial market participants. So our sense is that, except for housing and autos, the economy appears to be doing quite well. Indeed, the recent rather sharp drop in energy prices could boost consumption spending even more than assumed in the Greenbook. While this is a possibility, it seems more likely to me that households ran down their savings to fill their gas tanks when gas prices rose and are, therefore, likely to use their recent savings at the pump to bolster their finances, at least partly. Overall, under the assumption of an unchanged funds rate, our forecast shows a beautiful soft landing, with real GDP growing at a moderately below-trend pace for a few more quarters and homing in near trend thereafter. But I must admit that we got this forecast essentially by averaging the strong and weak sides of the economy. I think that way of proceeding is reasonable, and I hope the landing happens that way. But I acknowledge there is plenty of risk. We may end up instead with either the strong or the weak side dominating the outcome. For example, if the housing market decline does not spread significantly to consumption, we could end up with a strong economy in fairly short order. However, if it does spread, the slowdown could last quite a while. Scenarios like this are nicely spelled out in the alternative simulations in the Greenbook. Which way things go is a key issue, given that we’re in the vicinity of full employment. The desired soft landing depends on growth remaining below trend long enough to offset the moderate amount of excess demand that appears to be in the economy so that inflation can trend gradually lower. The slight drop in unemployment, to 4.6 percent, in September did not help in that regard, and I should note that recent comments by our head office directors almost uniformly supported the idea that labor markets, especially for skilled workers, are tight. However, we do expect the unemployment rate to edge higher over the next year in response to sluggish growth. Our forecast for core consumer inflation comes down a bit faster than foreseen by the Greenbook. We have core PCE price inflation edging down from just under 2½ percent this year to just over 2 percent in 2007 and see a good chance that it may fall a bit below 2 percent in the following year. We see the relief on energy prices as helpful, although we keep trying to resist any temptation to overestimate the extent to which past energy price pass-through has been boosting core inflation. Inflation also may benefit from an unwinding of the earlier strong pressures on rents. Finally, as in the discussion we had earlier about the alternative Greenbook scenario, we think inflation may have become less persistent over the past decade, and this is one reason that we’re a bit more optimistic than the Greenbook about the possible degree of disinflation over the next couple of years. But on balance, I have to admit we don’t have a perfect understanding of why inflation has been so high over the past few years, and so I try to remain humble, as always, in my predictions. My bottom line is this. I see a non-negligible chance that the downside risks to the economy, emanating especially from housing, could produce a recession in coming quarters, but there’s a very good chance that the spillovers will be sufficiently modest that the economy will avoid a recession. I also see a significant chance that growth could modestly exceed potential. In that sense, the overall risks to the outlook for real GDP growth could be characterized as balanced. In addition, I see quite a bit of uncertainty about inflation going forward with the risks to my forecast probably being a bit to the high side." FinancialCrisisReport--150 The presentation goes on to explain the Retail Loan Consultant incentive plan: “Incentive Tiers reward high margin products … such as the Option ARM, Non-Prime referrals and Home Equity Loans …. WaMu also provides a 15 bps ‘kicker’ for selling 3 year prepayment penalties.” 557 In order to promote high risk, high margin products, WaMu paid its loan consultants more to sell them. WaMu divided its products into four categories: “W,” “A,” “M,” and “U.” WaMu paid the highest commissions for “W” category products, and in general, commissions decreased though the other categories. “W” products included new Option ARMs, “Non-prime” referrals, and home equity loans. “A” products included Option ARM refinancings, new hybrid ARMs, new Alt A loans, and new fixed rate loans. Like Long Beach, WaMu also created four compensation tiers with increasing commissions based on volume. The tiers were called: “Bronze,” “Silver,” “Gold,” and “Platinum.” 558 Even in 2007, WaMu’s compensation plan continued to incentivize volume and high risk mortgage products. In 2007, WaMu also adopted a plan to pay “overages,” essentially a payment to loan officers who managed to sell mortgages to clients with higher rates of interest than the clients qualified for or were called for in WaMu’s daily rate sheets. The plan stated: “Overages … [give a] Loan Consultant [the] [a]bility to increase compensation [and] [e]nhance compensation/incentive for Sales Management …. Major national competitors have a similar plan in place in the market. ” 559 Under the 2007 plan, if a loan officer sold a loan that charged a higher rate of interest than WaMu would have accepted according to its rate sheet, WaMu would split the additional profit with the loan officer. 560 This compensation practice, often referred to as awarding “yield spread premiums,” has been barred by the Dodd-Frank Act implementing financial reforms. 561 556 2007 WaMu Home Loans Product Strategy, “Strategy and Business Initiatives Update,” JPM_WM03097217, Hearing Exhibit 4/13-60a [emphasis in original]. 557 Id. 558 Id. 559 12/6/2006 WaMu Home Loan Credit Risk F2F, JPM_WM02583396-98, Hearing Exhibit 4/13-60b (The proposal to pay overages, adopted in 2007, increased compensation for loan officers who sold loans with a higher interest rate or more points than required on WaMu’s daily rate sheet.) 560 Subcommittee interview of David Schneider (2/17/2010). 561 Section 1403 of the Dodd-Frank Act (prohibiting “steering incentives”). (c) Loan Processors and Quality Assurance Controllers CHRG-111hhrg52397--100 Mrs. Biggert," Would anyone else like to--Mr. Thompson? Mr. Don Thompson. Yes, I would like to add that in addition to the measures that Bob mentioned about the customized bucket of OTC derivatives, we are broadly supportive of the steps that Chairman Gensler outlined in his recent testimony in terms of codes of business practices, increased capital requirements, strengthened anti-fraud and market manipulation, and trade reporting. So I do not think it is fair to say you would be relying entirely on the trade repositories as the only measure. I think there are a host of other measures that Chairman Gensler has thoughtfully outlined and that are broadly consistent with the Administration's proposal as well. " CHRG-111shrg52619--66 Mr. Polakoff," Senator, if I could offer some thoughts regarding AIG, as you know, September 15, 2008, with the Government's action, caused AIG to no longer be a savings and loan holding company. So 6 months have passed since that time. I can assure that if AIG was still a savings and loan holding company, we would have taken enforcement action under safety and soundness to say those bonuses were an unsafe and unsound practice and would not have allowed it. But it is not a savings and loan holding company. Senator Warner. I know the Government owns it, but even though the fact that there is a Treasury-owned trust, you say that--I know you testified here a week ago that, yes, you had oversight over AIG and maybe you have missed a bit. And now you are saying you have no regulatory ability to take any of these actions? " CHRG-111hhrg52406--56 Mr. Bachus," What are some of the most destructive high-risk practices or products that you see? Ms. Warren. Well, actually, I found it interesting that you listed those as separate entities. The real point, in my view, is when customers cannot follow what you are doing, I regard it as extremely destructive, as high-risk, when you dump 30 pages on a customer and you call that a credit card contract and when only after the customer has used the credit card, discovers terms in it when those terms are charged against the customer. I think that is extremely destructive. I think it is destructive to show up at a mortgage closing and be handed literally hundreds of pages with stickers saying, sign here, sign here, sign here, and the advice, ``you cannot read it.'' I think that is destructive. I think it is destructive when there are changes over time--when you are quoted one price on a mortgage, but when you show up after you have already sold your house and after you have already gotten all the furniture in the moving truck and are told that the interest rates will be different or that there are prepayment penalties. I think those are very destructive practices. " CHRG-111shrg53176--154 PREPARED STATEMENT OF RONALD A. STACK Chair, Municipal Securities Rulemaking Board March 26, 2009 Good morning Chairman Dodd, Ranking Member Shelby, and Members of the Committee. I am Ronald Stack, Chair of the Municipal Securities Rulemaking Board (``MSRB'' or ``Board''). I am pleased to testify today on behalf of the MSRB at the Committee's second hearing on Enhancing Investor Protection and the Regulation of the Securities Markets. Part I of my testimony provides a summary of the MSRB's structure, authority, rules, information systems, and market transparency/ surveillance activities. Part II provides background on the municipal securities market. Part III is a discussion of what the MSRB is doing now to promote transparency in the municipal marketplace. Part IV points out significant gaps in the regulation of municipal market participants and discusses the manner in which the MSRB could further assist in enhancing investor protection and the regulation of the securities market, if its jurisdiction were expanded by the Congress. Finally, Part V is an executive summary of our major recommendations.I. Background on the MSRB's Structure, Authority, Rules, Information Systems, and Market Transparency/ Surveillance ActivitiesA. MSRB Structure The MSRB is a self-regulatory organization (``SRO'') established by the Congress in the Securities Acts Amendments of 1975 to develop rules for brokers, dealers, and banks (collectively ``dealers'') engaged in underwriting, trading, and selling municipal securities. In furtherance of our investor protection mandate, the Board also operates information systems designed to promote transaction price transparency and access to municipal securities issuer disclosure documents. The MSRB stands as a unique SRO for a variety of reasons. The MSRB was the first SRO specifically established by Congress. Also unique is the fact that the legislation, codified in section 15B of the Securities Exchange Act (``Exchange Act''), dictates that the MSRB Board shall be composed of members who are equally divided among public members (individuals not associated with any dealer), individuals who are associated with and representative of banks that deal in municipal securities (``bank dealers''), and individuals who are associated with and representative of securities firms. \1\ At least one public member serving on the Board must represent investors and at least one must represent issuers of municipal securities. Further, the MSRB was created as a product-specific regulator, unlike most other securities regulatory bodies. Members of the MSRB meet throughout the year to make policy decisions, approve rulemaking, enhance information systems and review developments in the municipal securities market. Day-to-day operations of the MSRB are handled by a full-time independent, professional staff. The operations of the Board are funded through assessments made on dealers, including fees for underwritings and transactions. \2\--------------------------------------------------------------------------- \1\ Under MSRB Rule A-3, the Board is composed of 15 member positions, with five positions each for public, bank dealer, and securities firm members. \2\ These fees are set forth in MSRB Rules A-12 through A-14.---------------------------------------------------------------------------B. MSRB Authority The substantive areas of the MSRB's rulemaking authority are described in Section 15B(b)(2) of the Exchange Act, which lists several specific purposes to be accomplished by Board rulemaking with respect to the municipal securities activities of dealers in connection with their transactions in and provides a broad directive for rulemaking designed to: prevent fraudulent and manipulative acts and practices, to promote just and equitable principles of trade, to foster cooperation and coordination with persons engaged in regulating, clearing, settling and processing information with respect to and facilitating transactions in municipal securities, to remove impediments to and perfect the mechanism of a free and open market and, in general, to protect investors and the public interest. Like other SROs, the MSRB must file its proposed rule changes with the Securities and Exchange Commission (``SEC'') for approval prior to effectiveness. Although the MSRB was created to write rules that govern dealer conduct in the municipal securities market, the Exchange Act directs that inspection of dealers for compliance with, and the enforcement of, MSRB rules be carried out by other agencies. For securities firms, the Financial Industry Regulatory Authority (``FINRA''), along with the SEC, performs these functions. For bank dealers, the appropriate federal banking authorities, in coordination with the SEC, have this responsibility. \3\ The MSRB works cooperatively with these regulators and maintains frequent communication to ensure that: (1) the MSRB's rules and priorities are known to examining officials; (2) general trends and developments in the market discovered by field personnel are made known to the MSRB; and (3) any potential rule violations are immediately reported to the enforcement agencies.--------------------------------------------------------------------------- \3\ These federal banking authorities consist of the Board of Governors of the Federal Reserve System, the Federal Deposit Insurance Corporation, and the U.S. Treasury Department through its Office of the Comptroller of the Currency and Office of Thrift Supervision, depending upon the specific bank dealer.--------------------------------------------------------------------------- While Section 15B of the Exchange Act provides the MSRB with authority to write rules governing the activities of dealers in connection with their transactions in municipal securities, it does not provide the MSRB with authority to write rules governing the activities of other participants in the municipal finance market such as issuers and their agents (e.g., independent financial advisors, swap advisors, guaranteed investment contract brokers, trustees, bond counsel, etc.). Municipal securities also are exempt from the registration and prospectus delivery requirements of the Securities Act of 1933 and are exempt from the registration and reporting requirements of the Exchange Act. In adopting Section 15B of the Exchange Act, Congress provided in subsection (d) specific provisions that restrict the MSRB and the SEC from regulating the disclosure practices of issuers in certain ways. Paragraph (1) of subsection (d) prohibits the MSRB (and the SEC) from writing rules that directly or indirectly (i.e., through dealer regulation) impose a pre-sale filing requirement for issues of municipal securities. Paragraph (2) of subsection (d) prohibits the MSRB (but not the SEC) from adopting rules that directly or indirectly require issuers to produce documents or information for delivery to purchasers or to the MSRB. Paragraph (2), however, specifically allows the MSRB to adopt requirements relating to such disclosure documents or information as might be available from ``a source other than such issuer.'' The provisions of subsection (d) commonly are known as the ``Tower Amendment.''C. MSRB Rules Overview The MSRB has adopted a substantial body of rules regulating dealer conduct that reflect the special characteristics of the municipal securities market and its unique regulatory needs These rules require dealers to observe the highest professional standards in their activities and relationships with customers. MSRB rules take into account the fact that rules for dealers in the municipal market--where issuers have significant discretion and nondealer market professionals are unregulated--must sometimes be crafted in ways that differ from rules for dealers in the corporate securities market, where bond issuers and other market participants are subject to regulation. MSRB rules represent a balance between broad, ``principles-based'' rules and specific prescriptive rules, depending on the nature of the specific subject of regulation. MSRB rules can generally be categorized as (1) fair practice rules (e.g., requirements for dealers to provide affirmative disclosures of material facts to investors; to ensure the suitability of dealer recommendations of municipal securities transactions; to price transactions fairly; to avoid conflicts of interest; and to publish fair and accurate advertisements and price quotations); (2) uniform practice rules (e.g., rules to ensure that standard procedures are followed in underwriting, clearing, confirming, and settling transactions in municipal securities; helping to ensure the efficiency of market operations while accommodating the differences between municipal securities and other debt instruments); (3) professional qualification rules (e.g., requirements for dealer personnel to pass tests demonstrating competency; continuing education requirement); (4) operational standards (e.g., rules regarding recordkeeping; supervision of professionals); and (5) marketplace disclosure rules (e.g., rules requiring dealer real-time reporting of trade prices; underwriter filing of issuer disclosure documents; and dealer disclosure of political contributions to the MSRB for public dissemination). These rules significantly exceed the general antifraud principles that are embodied in the federal securities laws. Maintaining municipal market integrity is an exceptionally high priority for the MSRB as it seeks to foster a fair and efficient municipal securities market through dealer regulation. The MSRB engages in an on-going review of its rules and market practices to ensure that the Board's overriding goal of protecting investors and maintaining market integrity is not compromised by emerging practices. As an example, the MSRB implemented rules to remove the conflict of interest that can arise when political contributions may be used by dealers to obtain municipal securities business. We also seek to coordinate our rules with FINRA rules in cases where similar requirements make sense. The MSRB also reminds dealers of its rules in times of market stress when the pace of events might cause some to lose sight of their significance. For example, during 2008, as bond insurer ratings were reduced frequently and significantly, we reminded dealers of their disclosure obligations concerning credit enhancement. \4\ We also issued an interpretive notice on transactions in auction rate securities that reminded dealers of their obligation to recommend investments that are suitable to their customers \5\ and provided guidance on reporting dealer buybacks of auction rate securities. \6\ When many issuers rushed to convert their high yielding auction rate securities to variable rate demand obligations, we reminded dealers of restrictions on underpricing of credit and tying the provision of letters of credit to the provision of underwriting services. \7\--------------------------------------------------------------------------- \4\ MSRB Notice 2008-04 on Bond Insurance Ratings (January 22, 2008). \5\ MSRB Notice 2008-09 on Application of MSRB Rules to Transactions in Auction Rate Securities (February 19, 2008). \6\ MSRB Notice 2008-36 on Transactions Reporting of Dealer Buybacks of Auction Rate Securities: Rule G-14 (September 2, 2008). \7\ MSRB Notice 2008-34 on Bank Tying Arrangements, Underpricing of Credit and Rule G-17 on Fair Dealing (August 14, 2008).---------------------------------------------------------------------------D. Information Systems and Market Transparency/Surveillance In furtherance of our investor protection mandate, the MSRB also operates information systems to improve the availability of information in the market about municipal issues. These systems ensure that investors have information necessary to make investment decisions, that dealers can comply with MSRB rules, and that the inspection and enforcement agencies have the necessary tools to do their work. Since 1990, the Municipal Securities Information Library (``MSIL'') system has collected issuer primary market disclosure documents (i.e., official statements and advanced refunding documents) from underwriters and made them available to the market and the general public. The MSIL system also accepts and disseminates certain secondary market information provided by municipal issuers and trustees pursuant to SEC Rule 15c2-12. In order to further increase the accessibility of municipal market information by retail investors, the MSRB has developed a free, centralized database, named the Electronic Municipal Market Access system or EMMA, which is discussed further below and which will shortly replace the MSIL system. In 2005, the MSRB implemented a facility for real-time transaction reporting and price dissemination of transactions in municipal securities (the ``Real-Time Transaction Reporting System'' or ``RTRS''). \8\ RTRS serves the dual role of providing transaction price transparency to the marketplace, as well as supporting market surveillance by the enforcement agencies. Surveillance data is made available to regulators with authority to enforce MSRB rules, including FINRA and the SEC. The market surveillance function of the MSRB's transaction reporting system provides enforcement agencies with a powerful tool in enforcing the Board's fair pricing rules. The MSRB offers a market-wide real-time feed of trade information and provides the data free of charge on EMMA, as discussed below. In addition, in January of this year, the MSRB implemented an enhancement to the system with the addition of free public access to interest rate reset information on municipal auction-rate securities, including information on the success or failure of individual auctions. Free interest rate and related information on variable-rate demand obligations will be added to the system next week. And, beginning July 1 of this year, continuing disclosure filings made by state and local governments will be available as well. Once completed in July, 2009, the MSRB's EMMA system will provide the most comprehensive and free database of municipal securities information as exists in any of the fixed income markets.--------------------------------------------------------------------------- \8\ The MSRB's transaction reporting rules require dealers to report transactions in municipal securities within 15 minutes of the time of trade execution.--------------------------------------------------------------------------- Currently, EMMA does not contain information about the credit ratings of municipal securities, although they are of considerable importance to investors. The MSRB would welcome the submission by the rating agencies of such ratings on a real-time basis. Given the large number of bond insurer downgrades in the last year, investors should have access to underlying ratings as well as ratings on the municipal securities themselves.II. Background on the Municipal Securities MarketA. Market Overview When Section 15B of the Exchange Act was adopted in 1975, yearly issuance of municipal securities was approximately $58 billion. \9\ Much of this total represented general obligation debt, which reflected the simple, unconditional promise of a state or local government unit to pay to the investor a specific rate of interest for a specific period of time. The investors in these bonds tended to be commercial banks and property/casualty insurers interested in tax-exempt interest.--------------------------------------------------------------------------- \9\ See The Bond Buyer/Thomson Financial 2004 Yearbook at 10. Approximately half of this figure represents short-term debt maturing in less than 13 months.--------------------------------------------------------------------------- The municipal securities market has grown into a much larger and more complex market. Annual issuance of municipal securities has averaged $458 billion in recent years \10\ and a total of $2.7 trillion in principal value is outstanding. \11\ In addition to providing capital for governmental projects and operations, the municipal securities market helps to fund a variety of other public purposes, including transportation and environmental infrastructure, education, housing and healthcare.--------------------------------------------------------------------------- \10\ Source: Thomson Reuters (based on 2005-2008 data). \11\ December 2008 estimates. See Federal Reserve Flow of Funds (March 2009) available at www.federalreserve.gov. As a comparison, the outstanding principal value of marketable U.S. Treasury Securities was $5.8 trillion.--------------------------------------------------------------------------- Most municipal securities come to market with investment grade credit ratings, i.e., with ratings that are ``BBB-'' or above. \12\ Historically, investment grade municipal securities have been considered relatively safe investments, because of the very low rate of default. A 2002 report by Moody's Investor Service concluded that the default rate for investment grade municipal securities debt over a 10 year period was .03 percent, compared to 2.32 percent for investment grade corporate debt. \13\ A low rate of default for investment grade municipal securities also has been observed in studies by Standard and Poor's and Fitch Ratings.--------------------------------------------------------------------------- \12\ Over 99 percent of rated long-term municipal securities coming to market in 2008 were rated investment grade by at least one rating agency. \13\ Moody's Rating Service, ``Special Comment: Moody's US Municipal Bond Rating Scale'' (November 2002), available at http://www.moodys.com (also noting increased default risks for nonrated issues).---------------------------------------------------------------------------B. Issuers Issuers of municipal securities include towns, cities, counties, and states, as well as other state and local government agencies and authorities that issue securities for special purposes (e.g., hospitals and colleges). There are over 55,000 issuers of municipal securities that have outstanding approximately 1.23 million unique securities. Major issuer types, with the associated volume of issuance in 2008, are shown in Figure 1. \14\--------------------------------------------------------------------------- \14\ Source: Thomson Reuters (includes issuance of both long-term and short-term securities). The market is unique among the world's major capital markets because the number of issuers is so large--no other direct capital market encompasses so many borrowers. The issues range from multi-billion dollar financings of large state and city governments to issues less than $100,000 in size, issued by localities, school districts, fire districts, and various other issuing authorities. The purposes for which these securities are issued include not only financing for basic government functions, but also a variety of public needs such as transportation, utilities, health care, higher education, and housing as well as some essentially private functions to enhance industrial development. In the last two decades debt issuance has become an important management tool for many municipalities, allowing flexibility in arranging finances and meeting annual budget considerations according to local needs and local priorities. The terms and features of some municipal securities have evolved over time into highly complex structures to meet a multitude of issuer borrowing and investment needs. Differences in laws among the 50 states, as well in local ordinances and codes among the tens of thousands of localities, that affect borrowing authority, lending of credit, powers to impose taxes and special assessments, contracting powers, budgeting restrictions, and many other matters result in an enormous variety of financing structures across the country that defies commoditization of the municipal securities market. By contrast, there are only approximately 5,500 issuers of corporate debt and less than 50,000 corporate debt securities, \15\ even though the amount of corporate debt outstanding is $6.3 trillion. \16\--------------------------------------------------------------------------- \15\ Source: FINRA. Includes all TRACE-eligible securities. \16\ December 2008 estimates. See Federal Reserve Flow of Funds (March 2009), available at www.federalreserve.gov. Corporate debt outstanding excludes asset-backed securities and foreign issues held by U.S. residents.---------------------------------------------------------------------------C. Investors The municipal securities market has one of the highest levels of participation by individual investors, either through direct investments or through mutual funds, together representing the majority of total municipal securities holdings. The other major categories of investors in municipal securities include property and casualty insurers and commercial banks. Figure 2 shows the percentages of direct investments in municipal securities in categories tracked by the Federal Reserve Board. The ``household'' category in Figure 2 includes both direct investments by individual investors as well as trusts and other accounts (e.g., some types of hedge fund accounts that do not fall into other tracked categories). The ``mutual funds'' category includes both municipal bond funds and money market funds. \17\--------------------------------------------------------------------------- \17\ Data collected by the Investment Company Institute (``ICI'') indicate that, as of September 24, 2008, the total net assets in tax-exempt money market accounts were approximately $482 billion, which would account for more than half of the Federal Reserve estimates of mutual fund holdings of municipal securities at this time. Of the $482 billion in tax-exempt money market funds tracked by the ICI in September, approximately $295 billion was held in retail money market funds and $187 billion was held in institutional money market funds. Source: ICI, ``Weekly Total Net Assets (TNA) and Number of Money Market Funds,'' available at www.ici.org.---------------------------------------------------------------------------D. Municipal Securities Dealers The municipal securities market is an over-the-counter, dealer market. There are no central exchanges, specialists, or formal market maker designations. At the end of 2008, approximately 2,040 securities firms and banks were authorized to act as brokers and dealers in municipal securities (collectively, ``dealers''). During a given year, approximately 1,430 dealers report transactions in municipal securities to the MSRB under its price transparency program. About 185 of these dealers serve as managing underwriters of new issues.E. Market Activity In general, municipal securities investors tend to be ``buy and hold'' investors. Trading patterns for municipal securities with fixed interest rates typically involve relatively frequent trading during the initial weeks after issuance, followed by infrequent or sporadic trading activity during the remaining life of the security. Issues with variable interest rates tend to trade more frequently. Of the approximately 1.23 million outstanding municipal securities, the likelihood of any specific security trading on a given day is about one percent. Less than 10 percent of outstanding municipal securities are likely to trade in any given month. \18\--------------------------------------------------------------------------- \18\ Source: MSRB transaction data.--------------------------------------------------------------------------- Notwithstanding the thin secondary market trading in individual municipal securities, aggregate daily trading activity in the market is substantial. During the period 2005-2008, an average of approximately 36,000 transactions in municipal securities was reported to the MSRB each business day, resulting in par values averaging about $23.2 billion per day. For the same period, nearly two-thirds of par value traded was variable rate securities, while fixed-rate securities accounted for almost 30 percent. Figure 3 shows the 30-day trailing average of daily transaction activity and volume in par (principal) amount traded for all types of municipal securities. \19\--------------------------------------------------------------------------- \19\ The MSRB provides statistical data on market activity on its Web site at www.msrb.org and through EMMA.III. MSRB Actions To Promote Transparency in the Municipal MarketA. Primary Market Disclosure As noted above, since 1990, the MSRB has sought to improve the availability of municipal securities issuer disclosure documents to investors through its MSIL system. At that time, the SEC adopted its Rule 15c2-12 to, among other things, require the underwriter for most offerings of municipal securities to receive and review the issuer's official statement before underwriting the issue. In turn, MSRB Rule G-36 requires underwriters to submit such official statements to the MSIL system. The MSIL system was the first comprehensive library of primary market disclosure documents in the municipal securities market. The MSRB developed the MSIL system to serve as a repository of disclosure documents and a ``wholesaler'' of these documents to market participants and information vendors. Since most disclosure documents in 1990 were made available in paper form, the MSIL system received such documents, scanned them, and provided electronic versions to subscribers for a minimal fee for use in information products provided to the market. More recently, many primary market disclosure documents are available in electronic form and the MSRB receives such documents and provides them directly to subscribers. In March 2008, the MSRB launched its Electronic Municipal Market Access (``EMMA'') pilot. EMMA is an Internet-based disclosure portal that provides free public access to primary market disclosure documents and real-time municipal securities trade price data for the municipal securities market, in a manner specifically tailored to retail investors. The EMMA Web site is accessible at www.emma.msrb.org. EMMA currently provides an easily navigable integrated display of primary market disclosures and transaction pricing data for a specific security, incorporating detailed user help and investor education information designed to make the information easily understood by retail investors. EMMA currently provides free access to the MSRB's full collection of issuer disclosure documents dating back to 1990, as well as to trade price information since January 2005. On Monday of this week, the MSRB filed with the SEC a proposal to continue operation of EMMA on a permanent basis and to provide for more rapid dissemination of primary market disclosures through a centralized electronic submission and public access service. The MSRB expects that this new phase of EMMA will be fully operational by the end of May of this year. At that time, all underwriters will be required to submit official statements and related documents and information to EMMA electronically for immediate free public access through the EMMA Web site portal. Users of the Web site will be able to sign up for free optional e-mail alerts to be notified of new and updated postings of disclosure documents and other information offered on EMMA. These documents will continue to be displayed in conjunction with real-time trade price information so that users viewing trading data for a specific municipal security will have immediate access to key disclosure information about that security. EMMA's search engine is designed to assist retail investors in quickly finding the right document and information for a particular security. EMMA is the central force in moving the municipal securities market from the old paradigm where only the buyer of a specific new issue municipal security could be assured of receiving a copy of the disclosure document for that security when the trade is completed to a new marketplace where the general public will have free ongoing immediate access to disclosure documents for all issues as soon as the documents become available. To further ensure broad access to the disclosures provided in official statements and advance refunding documents, the MSRB will make these documents available by subscription to information vendors and other bulk data users on terms that will promote the development of value-added services by subscribers for use by market participants.B. Continuing Disclosure The SEC revised its Rule 15c2-12 in 1995 to require underwriters to ensure that issuers have contracted to provide certain continuing disclosure information, including annual financial and operating data and material events notices, to certain private-sector information services designated as Nationally Recognized Municipal Securities Information Repositories (``NRMSIRs''). In these amendments, the MSRB was included as an alternative recipient of material event notices only. During the last few years, however, the MSRB grew concerned about investor access to continuing disclosure documents through the current NRMSIR system. As a result, after consultation with the SEC and review of the SEC's White Paper to Congress on the municipal securities market, \20\ the MSRB began to plan for a continuing disclosure component of EMMA. This enhancement will combine continuing disclosure information with the primary market disclosure and trade information currently available to provide a central location for all such municipal securities market information.--------------------------------------------------------------------------- \20\ July 26, 2007, available at http://www.sec.gov/news/press/2007/2007-148wp.pdf.--------------------------------------------------------------------------- On December 5, 2008, the SEC approved amendments to its Rule 15c2-12 to make the MSRB the central location for issuer continuing disclosure documents, effective July 1, 2009. EMMA's continuing disclosure service will provide a user-friendly interface for free electronic submission of continuing disclosure documents by issuers, other obligated parties and their agents. As with official statements, these continuing disclosure documents will become immediately available for free to the general public through the EMMA Web site portal. Free optional e-mail alerts relating to new postings will also be made available in connection with continuing disclosure documents. In addition, the continuing disclosure documents will be integrated into the existing official statement and trade data display to produce an all-encompassing view of the relevant primary market, secondary market, and trade price information for each security in the marketplace easily accessible through EMMA's powerful search engine. The MSRB expects to file with the SEC next week a proposed rule that would permit EMMA to accept voluntary filings of continuing disclosure by issuers and obligors. We hope that this will encourage disclosure beyond that which is currently required by SEC Rule 15c2-12, such as quarterly financial information and information about related municipal derivative transactions.C. Auction Rate Securities/Variable Rate Demand Obligation Transparency In 2009, the MSRB implemented its Short-term Rate Transparency (``SHORT'') System to increase transparency of municipal ARS and VRDOs. The SHORT System is the first centralized system for collection and dissemination of critical market information about ARS and VRDOs. Information collected by the SHORT System is made available to the public, free of charge, on EMMA. The SHORT System will be implemented in phases. The first phase, which became operational on January 30, 2009, collects and disseminates interest rate and related information about municipal ARS, including information about the success or failure of each auction. The SHORT System is scheduled to become operational for VRDOs on April 1, 2009. This interest rate information allows market participants to compare ARS and VRDOs across issues and track current interest rates. Included in this information is the current interest rate, the length of the interest rate reset period as well as characteristics of the security, such as the identities of broker-dealers associated with the operation of the securities. Later phases of this initiative to increase transparency of ARS and VRDOs include the collection and dissemination of ARS bidding information. This information will allow market participants to obtain important information about the liquidity of ARS and greater granularity into the results of the auction process. In addition, the MSRB plans to collect ARS documents that describe auction procedures and interest rate setting mechanisms as well as VRDO documents that describe the provisions of liquidity facilities, such as letters of credit and standby bond purchase agreements.D. Market Statistics and Data EMMA provides market activity information, including transaction price data for the most recent daily trades and a daily summary of trading activity throughout the municipal securities market. EMMA's daily trade summary provides the type of trade (i.e., customer bought, customer sold or inter-dealer trades), the number of securities and the number of trades for each trade type and the par amount of the trades for all published trades disseminated by the MSRB for every trading day since May 2006. This information is provided on EMMA's market statistics pages and provides municipal securities investors with a market-wide view of the municipal securities market. An example of such information follows: Market statistics on EMMA also include the par amount traded for the most active sectors of the municipal securities market and trading volume by trade size, maturity, and source of repayment.E. Investor Outreach and Education The MSRB is conducting an aggressive campaign to reach out to investors about all the information that is easily available to them through EMMA. We have also added important educational materials to the EMMA site to assist investors in their understanding of the municipal securities market. The MSRB is gratified that we have had over 53,000 visitors to EMMA in its 12 months of pilot operation who have downloaded almost 4.0 terabytes of files and data. Messages we have received through the EMMA feedback and contact pages indicate a very positive response from users, which include retail and institutional investors, brokers, investment advisors, issuers, information services, researchers, media, and others. We plan to continue diligently to improve EMMA's service to both investors and issuers. The MSRB has long sought to improve investor access to municipal securities disclosure as well as to require, through its dealer regulation, that the municipal securities market continue to be fair to investors and efficient for all market participants. Once fully operational, EMMA will allow for more timely and accurate disclosures, valuations, and information regarding municipal securities, which will benefit all market participants. EMMA's free public access to real-time trade price information and to the key disclosure documents has already provided unprecedented transparency to this market. As we complete each new phase of EMMA, the MSRB will provide increasing levels of transparency that will greatly benefit both investors and issuers alike and which is unparalleled in other markets.IV. An Expanded Role for the MSRB To Enhance Investor Protection and Regulation of the Securities MarketsA. Unregulated Parties in the Municipal Securities Market. The current financial crisis has exposed gaps in the regulatory structure that governs U.S. financial institutions and the products they offer. It is clear that regulatory reform is necessary to address changes in the capital markets, such as the creation of new financial products and the emergence of firms providing advice regarding these products. The municipal securities marketplace has evolved from one in which states and municipalities offered traditional, fixed rate bonds to finance specific projects into a market that involves the use of complex derivative products and intricate investment strategies. Current federal law does not permit the MSRB to regulate the swap firms that assist in the creation of these derivative products for municipal issuers. The law also does not permit the MSRB to regulate other nondealer municipal market participants, such ``independent'' financial advisors that provide advice to issuers regarding bond offerings or investment brokers that assist issuers with investing bond proceeds. The MSRB believes regulation of these entities and other municipal advisors is essential to protect investors and ensure market integrity, and that the MSRB is in the best position to provide this regulation and therefore should be given such authority. The MSRB believes that its current regulatory structure for municipal securities dealers provides a ready model for oversight of municipal advisors, including financial advisors and investment brokers. The MSRB also believes that expanded oversight would be most effective in a dual regulatory structure with the SEC. Under this approach, firms would be required to register with the SEC, and the MSRB would provide more prescriptive rules applicable to these firms and their activities. With the expansion of its jurisdiction, the MSRB's composition should be reviewed to provide for appropriate representation of all types of regulated parties as well as to ensure expanded public representation. 1. Financial Advisors and Investment Brokers and Other Municipal Market Participants. As federal lawmakers and policymakers are looking into unregulated participants throughout the financial markets such as mortgage brokers, so too should attention be paid to these participants in the municipal market. As municipal finance transactions have evolved and become more complex, there are many more advisors who work with municipal issuers, and brokers who act as intermediaries between issuers and others who provide necessary investment and other services. These participants have significant influence with issuers, earn significant fees, and many times, are not subject to any constraints on pay-to-play, as dealers have been since 1994. Unfortunately, the regulatory structure over the municipal market has not kept up with the evolving marketplace and nearly all of these participants are unregulated. At a minimum, municipal advisors such as financial advisors and investment brokers should be held to standards of conduct that protect municipal issuers, taxpayers, and investors in this market. The existing MSRB rulebook provides a ready model for the types of rules that could be developed for these market participants--particularly in light of the fiduciary nature of many of the advisory services they provide. Preventing pay-to-play throughout the municipal market is even more important now as the Congress has recognized the importance of rebuilding the Nation's infrastructure and has supported that goal through the stimulus bill. Also, as Treasury seeks to find solutions to assist the municipal bond market through the financial crisis, ensuring that all market participants adhere to the highest professional standards is essential. Investors in the municipal securities market would be best served by subjecting unregulated market professionals to a comprehensive body of rules that (i) prohibit fraudulent and manipulative practices, (ii) require the fair treatment of investors, issuers, and other market participants, (iii) mandate full transparency, (iv) restrict real and perceived conflicts of interests, (v) ensure rigorous standards of professional qualifications, and(vi) promote market efficiencies. The municipal securities dealer community undertook the transition from being unregulated to becoming subject to such a body of rules and standards beginning in 1975 with the creation of the MSRB. The MSRB believes it is now time for the unregulated professionals in this market to undertake this same transition, and that the MSRB is the most appropriate regulatory body to provide this regulation. 2. Current Regulation of Financial Advisors. It should be noted that many financial advisory firms are registered as broker-dealers or municipal securities dealers and are, therefore, subject to MSRB rules, including Rules G-23 and G-37. Rule G-23 is a disclosure rule designed to minimize the apparent conflict of interest that exists when a municipal securities professional acts as both financial advisor and underwriter with respect to the same issue. With respect to financial advisors that are not dealers (known as ``independent'' financial advisors), approximately fifteen states have some form of pay-to-play prohibition. Some states have very broad pay-to-play rules that cover most state and local contracts, including those for financial advisory services. Other states have very narrow rules that apply only to specific situations. Some municipalities also have enacted such rules. Additionally, certain states and municipalities and agencies have disclosure obligations. While some states and localities have such pay-to-play laws, in many cases based on MSRB Rule G-37, the limited and patchwork nature of these state and local laws has not been effective in addressing in a comprehensive way the possibility and appearance of pay-to-play activities in the unregulated portions of the national municipal securities market. It is time for a coordinated and comprehensive approach to regulating municipal advisors, including ``independent'' financial advisors. 3. Number of Financial Advisors Active in the Marketplace. Given the unregulated nature of this market, it is difficult to identify with precision the number of financial advisors, the number of offerings in which they participated, or the nature and scope of their advice. Nevertheless, the MSRB has reached out to market participants and has reviewed data on financial advisors supplied by Thomson Reuters. The MSRB believes that this information provides a reasonable estimate of the size of the market, but does not capture the entirety of it. Based on the MSRB's review, of the 358 financial advisory firms that participated in at least one primary market transaction in 2008, only 98 were registered with the MSRB as dealers. It appears that the vast majority of active financial advisory firms currently are not regulated by the MSRB or, in general, anyone else. 4. Volume of Municipal Debt Issued With the Assistance of Financial Advisors. According to data obtained by the MSRB, approximately 70 percent of the total volume of municipal debt (by par amount) issued in 2008 was issued with the assistance of financial advisors. The total amount of municipal debt issued in 2008 was $453 billion, and financial advisors provided advice in offerings that accounted for $315 billion of this total. This percentage has increased over the last 2 years. In 2007, financial advisors participated in 66 percent of the total volume of offerings and, in 2006, financial advisors participated in 63 percent of the total volume of offerings. The length of maturity of the offerings did not change the percentages significantly. In short-term offerings (maturities of less than 13 months) in 2008, financial advisors participated in 69.3 percent of the offerings, and in long term offerings, financial advisors participated in 69.7 percent of the offerings. Hence, an overwhelming percentage of short and long term offerings were issued with the assistance of financial advisors. 5. Percentage of Unregistered Firms That Participated in Offerings. Dealers participated as financial advisors in 38 percent of the total volume of offerings in which financial advisors provided assistance. Correspondingly, unregistered financial advisors participated in 62 percent of those offerings, which represented $196 billion of the $315 billion total. 6. The Role of Swap Advisors. The municipal securities derivatives market emerged in the 1980s and is still evolving. This market is very complex, with a variety of derivative products such as floating-to-fixed rate swaps, fixed-to-floating rate swaps, basis swaps, and swaptions. According to market participants, the vast majority of transactions are floating-to-fixed swaps, which are used to create synthetic fixed rate structures. These derivative products carry numerous embedded risks that may not be easily understood by less financially sophisticated issuers. Some such risks are interest rate risk, basis risk, tax risk, termination risk, and counterparty risk. Recent market conditions highlight this concern. Many sophisticated issuers face large swap termination fees due to changes in short-term interest rates. The extent to which many of these issuers may have underestimated the potential termination fees is of great concern to the MSRB. To assist issuers in understanding the characteristics, risks, and potential benefits of these products, many firms developed expertise as swap advisors. These firms, of which there are approximately four dozen, according to the Bond Buyer's Municipal Marketplace Directory 2008, provide financial advice to issuers regarding swap policy development, transaction structuring, documentation, and pricing. Swap advisors now include boutique firms, registered broker-dealers, and banks. While many firms adhere to their own standards of professional conduct, their swap advisory services are, for the most part, unregulated. Also problematic is the lack of available public information regarding the size of the municipal securities derivative market. Market participants have suggested that the market is between $100 billion and $300 billion, annually, in notional principal amount, but until these derivative transactions are formally tracked, the figures will be unreliable. Given the complexity of municipal derivative transactions, the variety of risks, the growth of the market, and the reliance by issuers on the expertise of swap advisors, the MSRB believes these municipal market professionals should also be regulated. Moreover, the MSRB believes that its rules provide an appropriate framework for such regulation. 7. The Role of Investment Brokers. A small group of advisory firms also provide investment advice to issuers concerning funds that are available to invest. These funds are typically bond funds, construction funds, escrow funds, debt service reserve funds, or capitalized interest funds. Advisory firms may recommend a variety of investments to the issuer, including bank investment agreements, guaranteed investment contracts, repurchase agreements, or forward delivery agreements. These investments may be offered by banks, insurance companies, or broker-dealers, and are bid competitively. Firms that offer such investment advice to issuers are not, for the most part, regulated. Given the complexity of these investments, their integral relationship to the municipal securities transactions, and the investment advice provided by these firms, MSRB believes that these municipal market professionals should be regulated as well. At a minimum, given the investment advice they provide to clients, these firms should be registered as investment advisors with the SEC. Additionally, MSRB believes that its rules, which go significantly beyond the antifraud provisions of the federal securities laws, provide an appropriate model for regulation of these market professionals. 8. Municipal Issuers. When considering a new regulatory structure for the municipal securities market, it is important to recognize that the municipal market is distinct from other securities markets due to the role of sovereign municipal issuers, the diversity of issuer types, federal tax law and state law requirements and restrictions that relate to the issuance and sale of municipal securities. As the regulator of municipal securities dealers, the MSRB is keenly attuned to its role at the boundary between the federal government (establishing an efficient national marketplace and uniform investor protections) and states and municipalities exercising their public trust to meet the unique needs of their citizens. In the service of these goals, the MSRB has sought to provide rulemaking that is based on an understanding of the products that are being created and sold, and the dynamics driving decisions and market practices of the issuers, investors, and dealers. This requires careful tailoring of basic securities regulation principles to achieve key investor protection objectives without unduly imposing direct or indirect restraints on municipal issuers. The SEC 's current jurisdiction includes authority to enforce antifraud laws with respect to issuers of municipal securities, and the SEC has brought enforcement actions in a number of high profile cases in the past few years. In addition, the associations representing state and local municipal issuers (Government Finance Officers Association and National Association of State Treasurers, in particular) also have an extensive body of recommended practices and an impressive educational outreach effort to help municipal issuers adhere to the highest standards of conduct. The MSRB is not suggesting the need for any additional federal regulation governing municipal issuers. We believe that the MSRB's new EMMA system is a key turning point in moving forward with considerably improved disclosure practices in the municipal securities market, and the issuer community wholeheartedly supports this evolution. The current system of continuing disclosure based on a limited number of private enterprises, through which disclosures are available for a fee and in most cases only through a laborious process that does not promote public access, fails to provide the sunshine on disclosure practices that EMMA soon will. Good and bad disclosure practices alike are largely obscured in the current restrictive continuing disclosure scheme. This will no longer be the case with the advent of the MSRB's continuing disclosure service through EMMA. The EMMA system will serve as a red flag for poor disclosure by issuers, while revealing good disclosure practices. It also will remove existing impediments to ensuring that investors buy and sell in securities based on the most up-to-date disclosures. The EMMA Web site will make it abundantly clear to investors when disclosures are less than satisfactory, as opposed to the current restrictive system. If investors are not satisfied with an issuer's disclosure standards, or if they are alerted to information of concern through disclosures, they will extract a penalty, and the issuer eventually will pay the price through higher borrowing costs. In partnership with the state and local government issuer community, the MSRB believes that recent improvements in the quality and timeliness of disclosures in the municipal securities market will accelerate.B. Financial Markets Regulatory Structure The MSRB supports the concept of a multi-layered regulatory framework as a starting point for consideration of a new regulatory structure for the financial markets, as has been proposed by a number of governmental and nongovernmental bodies in recent months. \21\--------------------------------------------------------------------------- \21\ See, e.g., U.S. Government Accountability Office, ``Financial Regulation: A Framework for Crafting and Assessing Proposals to Modernize the Outdated U.S. Financial Regulatory System (GAO-09-216),'' January 8, 2009, available at http://www.gao.gov/new.items/d09216.pdf; Group of Thirty, ``Financial Reform: A Framework for Financial Stability,'' January 15, 2009, available at http://www.group30.org/pubs/pub_1460.htm; U.S. Department of the Treasury, ``Blueprint for a Modernized Financial Regulatory Structure,'' available at http://www.treas.gov/press/releases/reports/Blueprint.pdf.--------------------------------------------------------------------------- Such a multi-layered regulatory framework would consist of (1) a market stability regulator to address overall conditions of financial market stability that could impact the general economy; (2) a prudential financial regulator; and (3) a business conduct regulator (linked to consumer protection regulation) to address standards for business practices. The MSRB stands ready to work closely with any systemic regulator to gather and analyze data about the municipal market as it relates to systemic risk in the financial markets. As well as a repository for municipal market data, the MSRB can be even better equipped to proactively monitor market activity and assist aggressively in enforcement activities. A multi-layered regulatory approach, or in fact any scenario, requires that the regulatory entities have deep and extensive knowledge of all financial markets. The lack of municipal finance expertise at the federal level became apparent during the past year and resulted in a very late and limited recognition of the impact of the credit crisis on state and local municipal finances, and the failure of federal programs intended to alleviate the economic impact of the credit crisis to address the needs of state and local governments. To this end, the MSRB strongly recommends the creation of a Treasury Department office or other significant federal position charged with representing the unique needs of the municipal securities market. We have proposed to President Obama's Administration, as an alternative to such a federal position, the development of a senior level group to coordinate municipal finance issues among the White House, Department of the Treasury, Federal Reserve, SEC, MSRB, and other federal agencies and stakeholders.C. Self-Regulatory Organizations The MSRB also believes that there is an important role for market-specific, self-regulatory organizations in any comprehensive regulatory framework. These SROs would continue to adopt rules and standards, establish market mechanisms and systems and standards of operations, and adopt market-specific rules and standards for investor protection. These SRO activities can far exceed the antifraud standards of the federal securities laws and can extend to the regulation of the behavior of market intermediaries, thereby ensuring the goals of investor protection and integrity of the securities markets. SROs are also uniquely situated to work with the industry to develop effective rules and information systems, and can be vital links between the industry and the broader regulatory community. SRO jurisdiction must be flexible and broad enough to encompass new products, market developments, new market entrants, market movements, and other changes.D. Enforcement Enforcement is key to an effective system of municipal regulation. Traditionally, enforcement activities have been spread across numerous federal and state governmental entities and self-regulatory organizations, consisting of the SEC, FINRA, various bank regulatory agencies, and state attorneys general, creating a patchwork of overlapping jurisdiction and inconsistent and uncoordinated enforcement activities. The SEC can be more effective if given additional resources for municipal enforcement. Further, while some coordination of enforcement activities currently exists, the MSRB strongly recommends that each of the entities that are charged with the enforcement of securities laws--regardless of the genesis of those laws--develop a more formal process to coordinate their regulatory and enforcement activities. Coordinated actions could avoid regulatory gaps, provide clearer statutory authority and promote an efficient and consistent enforcement mechanism for the industry. Finally, we recommend that Congress modify the MSRB's regulatory authority to include an enforcement and examination support function that would further strengthen enforcement in the municipal securities market. With an increased statutory mandate, the MSRB could better analyze the large amount of data that we collect to assist in surveillance of the market. The MSRB and its staff have a depth of expertise in all aspects of the municipal market that is found nowhere else in the federal government, and we stand ready to further assist, if given the congressional mandate.E. Derivative Products While derivatives can be an important risk management tool, they can be dangerous if the state and local government issuers who purchase them do not understand the risks they may create. The current state of the law as articulated in the Commodities Futures Modernization Act of 2000 prohibits regulation of swap agreements (which are broadly defined) with the exception of antifraud, and the issue of whether and how to regulate credit default swaps (``CDS'') and other derivative instruments remains controversial. While municipal derivatives play an important risk management role in the overall municipal securities market, municipal derivatives are only a fraction of the overall derivatives markets. The MSRB recognizes that the question of whether to regulate municipal derivative instruments should be answered by Congress in the context of the broader derivatives market and that, should Congress choose to place such derivative products under new regulations, the regulatory structure should encompass municipal derivatives as well. In particular, consideration should be given to the inclusion of municipal CDS in the types of CDS covered by central counterparties and clearinghouses. The application of central counterparties and clearinghouses to municipal CDS would address concerns about the problems of lack of minimum capitalization of CDS protection sellers. It would also address the lack of transparency in CDS pricing, which currently may disadvantage certain investors and dealers. Furthermore, it would provide municipal issuers with information about whether dealers who underwrite their securities are also selling CDS on their debt. Issuers who considered such a dual role to pose a conflict of interest could then take whatever actions they deemed appropriate. Should enhanced disclosures in derivative instruments be a part of any regulatory scheme, the MSRB is well poised with its EMMA system to provide disclosures of municipal derivative contracts and provide the necessary transparency for our market.V. Executive Summary Since its creation in 1975, the MSRB has worked diligently to foster and preserve a fair and efficient municipal securities market that serves the public interest. The dual goals of investor protection and market integrity have guided this mission. However, the increased sophistication of our market, changing financial markets generally, and the importance of investor protection in the market require a review of the regulatory structure of this market. To that end, we make the following recommendations: We believe that financial advisors, investment brokers, and other intermediaries in the municipal market should be brought under a comprehensive regulatory scheme. Further, we believe that the MSRB is the appropriate regulatory body to regulate these unregulated municipal market participants, as part of a dual regulatory structure with the SEC. We support a multi-layered overall regulatory framework for the financial markets consisting of a market stability regulator, a prudential financial regulator, and a business conduct regulator. We believe that there is an important role for market- specific SROs that are charged with adopting rules and standards, market mechanisms, information systems, and standards of operations that embody and expand upon the basic antifraud standards of the federal securities laws. We recommend the creation of a Treasury Department office or other significant federal position charged with representing the unique needs of the municipal securities market, or alternatively, a senior-level multiple-agency group to coordinate municipal finance issues among all market stakeholders. We strongly recommend that federal and state entities charged with the enforcement of securities laws develop a more formal process to coordinate their regulatory and enforcement activities. We believe that derivative instruments based on municipal securities should be subject to the same comprehensive regulatory framework that may be developed for swaps and other types of derivative financial products in other markets. The rules governing dealer activity developed by the MSRB over its history provide an appropriate model for the comprehensive regulation that should apply to all financial intermediaries active in the municipal market. We stand ready to assist in this important work and are certain that investor protection will be served by increasing our mandate. ______ CHRG-111hhrg53234--105 Mr. Kohn," In March, the Federal Open Market Committee decided to purchase up to $300 billion of Treasury--intermediate and long-term Treasury securities. We did that because we thought it would be helpful not for the Treasury per se, but because we thought it would push down interest rates for businesses and households at a time when the economy was falling very rapidly, very weak, and we needed to free up the credit markets so businesses and households would face lower charges and lower cost of capital, and then do some more spending. I am not exactly sure where we are in that process. I think we are about halfway through. We said, I think, it would be done by the end of September. At our last meeting we didn't make any change in that plan. " FOMC20060328meeting--18 16,MR. KOS.," I thought that the Committee’s patience might be limited. Yes, there was a downgrade by one of the rating agencies of Iceland. There were some concerns about some of the Icelandic banks, and so that seemed to be part of the story. You did have some weak data in New Zealand, and I guess the central bank there is now expected to be easing over the course of the next year. So some other things were going on. Yet another factor affecting New Zealand—which, again, may be more detail than you want—is that Japanese retail investors have been big buyers of these Uridashis, which I know you know about. And some of that money is now flowing back. Thus, a number of factors are affecting it. Again, at the next meeting I will give you a full report. [Laughter]" CHRG-111hhrg49968--154 Mr. Bernanke," I think it is very important, as I mentioned in my testimony, to begin the planning process as soon as possible so it will have a persuasive exit strategy that will not only give us a plan but will also help to reassure lenders in the bond markets that in fact the U.S. Government is going to find a fiscally sustainable path going forward. You asked about 2009. No one knows the future of course, but based on our best projections we think that the economy will be pretty weak albeit starting to grow at the end of 2009 and the unemployment rate will probably still be rising. So would unlikely be a period of robust growth at that point. " CHRG-111shrg57321--36 Mr. Raiter," Well, it is clear from a lot of these emails people were making very poor calls in terms of the analytics. But whether that is fraud or not, it was wrong, it did not look good. They certainly would not want it to have the headline risk in the Wall Street Journal. But there was no one over there watching over them to tell them this is not the right thing to do. Senator Kaufman. No. I understand that, and I am very sympathetic to that. And if you heard any of the speeches I have given on the floor, I pretty much beat up on the regulators for what they did not do. But I spent a lot of time in business. I worked for corporations. There were always incentives of some kind to make the quarterly earnings, push the stuff out the door, do the rest of it. But when you have the incredible amount of--the chart that he put up there on the number of RMBSs that were rated AAA and ended up turning to junk, many of them you were going after. And maybe ``fraud'' is too strong a word, but things that just are not common business practice no matter what the incentives are, no matter whether you are being regulated or not. " CHRG-111shrg54789--187 RESPONSES TO WRITTEN QUESTIONS OF SENATOR VITTER FROM MICHAEL S. BARRQ.1. Mr. Barr, do you agree with Sheila Bair, Chair of the Federal Deposit Insurance Corporation, that safety and soundness cannot be separated from consumer protection?A.1. I agree with Ms. Bair and other regulators who have testified that safety and soundness and consumer protection need not conflict. Following all applicable laws, including consumer protection laws, is a requirement of a safe and sound institution. And as we've seen in the mortgage and credit card markets, poor treatment of consumers actually undermines the safety and soundness of financial institutions. I think, however, that these complementarities can be preserved with separate agencies. Two banking agencies today, including the FDIC, typically conduct their consumer compliance and safety and soundness examinations with separate teams of examiners. It is a further step to separate the examiners into different agencies, but we would propose to require the CFPA and the prudential agencies to communicate and coordinate closely, and to share examination reports. Ultimately, we believe the complementarities will be strengthened if the CFPA is given the mandate and authority, as we propose, to identify questionable practices and provide the market and institutions clear rules of the road. The CFPA can help the prudential regulator identify practices that exploit consumer confusion for short-term profits but undermine bank earnings and reputations in the long run.Q.2. Appearing before the House Energy and Commerce Committee, you said that this new agency would not set prices, dictate what products could be offered, or regulate a firm's advertising practices. Section 1039 of the President's proposals states that, ``It shall be unlawful for any person to advertise, market, offer, sell, enforce, or attempt to enforce, any term, agreement, change in terms, fee or charge in connection with a consumer financial product or service that is not in conformity with this title or applicable rule or order issued by the Agency.'' How do you explain this discrepancy?A.2. In my testimony before the House Energy and Commerce Committee on July 8, I did state that the CFPA would not set prices. Section 1022(g) of the legislation specifically forbids the CFPA from establishing usury limits. I also stated correctly that the CFPA could not dictate what products firms could offer. With respect, however, I did not testify that the CFPA would not regulate the advertising practices of those offering financial products and services to consumers. Advertising regulations have long been a core element of Federal consumer protection statutes such as the Truth in Lending Act. Regrettably these regulations were not kept up-to-date. Indeed, before the mortgage market collapsed, the marketplace was awash with misleading advertising about low-rate mortgage loans, credit cards, or financial products. Accordingly, the CFPA would have authority, as you note, to regulate advertising practices of persons that provide consumer financial products and services to prevent incomplete or misleading information from undermining competition.Q.3. In the past, Mr. Barr, you've argued that derivation from a standard, plain-vanilla product ``would require heightened disclosures and additional legal exposure for lenders.'' Please explain why this would, or would not, discourage lenders from offering any products that are deemed unstandard or outside of the agency's safe harbor?A.3. A standard product would serve to provide a standard of comparison for borrowers, so they can make more informed choices about what loan product would be best for them. It's another tool besides disclosure, but less intrusive than outright banning complex contract terms (as Congress just did on credit cards). Since borrowers would be entirely free to select alternative, more complex products and many would do so, lenders would have substantial incentives to offer them.Q.4. How much latitude would this new agency have over determining what is a ``consumer financial product or service?'' The President's proposal says ``any financial product or service to be used by a consumer primarily for personal, family, or household purposes.'' Could agency have authority over small business loans or commercial real estate?A.4. As you note, the definition of ``consumer financial product or service'' in the CFPA Act is limited to any ``financial product or service to be used by a consumer primarily for personal, family or household purposes.'' In applying that language, the CFPA would need to determine whether the product or service is used ``primarily'' for personal, family or household purposes as a factual matter. Similar language appears in the definitions of several other consumer protection statutes, including the Truth in Lending Act (15 U.S.C. 1602(h)), the Electronic Funds Transfer Act (15 U.S.C. 1693a(2)), the Fair Debt Collection Practices Act (15 U.S.C. 1692a(5)), the Fair Credit Reporting Act (15 U.S.C. 1681a(d)(1)(A)), and the Equal Credit Opportunity Act (12 CFR 202.2(h)), which implements 15 U.S.C. 1691, et seq.). The use of such language is generally understood as meaning to exclude business credit. As a general matter, under the new authority granted to the CFPA under the CFPA Act, the CFPA would not have authority over small business loans or commercial real estate loans. However, the Equal Credit Opportunity Act (ECOA) prohibits discrimination against certain protected classes in lending for business as well as personal and household purposes, and the proposal would grant the CFPA rulemaking and enforcement authority under the ECOA. To that extent, the CFPA would have authority over business loans under the ECOA.Q.5. How did the Treasury determine that the Securities and Exchange Commission has done an adequate job protecting consumers? For example, many of Allan Stanford's victims were everyday people, not large, sophisticated institutional investors.A.5. In establishing a regulatory framework for the protection of consumers and investors, the Administration's goal was for there to be a Federal agency with the mission of consumer protection. In the consumer financial products and services area, this agency is lacking; in the nonbank sector, no Federal agency has supervision and examination authority, regardless of the mission, and in the banking sector, five different agencies share this responsibility but each has safety and soundness as its primary mission. The Securities and Exchange Commission (SEC), on the other hand, does have as its mission the protection of retail investors, so there was no need to duplicate this responsibility within the CFPA. As the SEC has acknowledged with respect to the Stanford and Madoff cases, existing authority should have been sufficient to address these frauds much earlier. The SEC needs additional authorities, however, to provide the broader and more effective oversight that is needed, and that is why the Administration proposes strengthening the agency's authority in several important ways.Q.6. Should one of the goals of the CFPA be to ``optimize household behavior''? What do you think optimal savings means?A.6. The CFPA will not optimize household behavior. It is for every family to make its own financial decisions. In order to help families make responsible decisions, the CFPA will work to ensure that markets are transparent, people have the information they need about their financial decisions, and bank and nonbank firms alike follow clear rules of the road. For many years, until the current recession, the personal saving rate in the United States has been exceedingly low. In addition, tens of millions of U.S. households have not placed themselves on a path to become financially prepared for retirement. In order to address this problem, the President has proposed two innovative initiatives in his 2010 Budget: (1) introducing an ``Automatic IRA'' (with opt-out) for employees whose employers do not offer a plan; and (2) increasing tax incentives for retirement savings for families that earn less than $65,000 by modifying the ``saver's credit'' and making it refundable. The proposals would offer a meaningful saving incentive to tens of millions of additional households while simplifying the current complex structure of the credit and raising the eligibility income threshold to cover millions of additional moderate-income taxpayers.Q.7. Mr. Barr, do you believe that the Government should steer people's choices in directions that will ``improve their lives'' or should the Government allow consumers to make their own choices free of interference or direction?A.7. We believe that it is the responsibility of consumers to make their own decisions on financial matters. There must be clear rules of the road so that firms do not deceive consumers by hiding the true costs of products. The CFPA will create a level playing field with high standards for all firms, bank and nonbank alike, which means that the marketplace will provide a broader array of high quality products from which consumers can freely choose.Q.8. Do you believe that it is more profitable for a bank to issue a mortgage or credit card loan to a customer who defaults or to one who makes their payments?A.8. If incentives are properly aligned, banks should make as much or more money when a mortgage or credit card borrower pays their loan as when they default. Problems arise, however, when markets are structured so that the bank is indifferent to future loan performance, as when the lender immediately sells the loan into an investment conduit without retaining any of the risk of default. This ``originate to distribute'' model caused incentives to deviate. The lenders--the parties in the best position to determine the creditworthiness of the borrowers--had no incentive to carefully underwrite; they were paid up front when the loan was made regardless of future performance. That is why the Administration proposes that originators of loans or the securitizer must retain 5 percent of the credit risk associated with loans sold into a conduit.Q.9. Will you please define what an ``objective reasonableness standard'' means?A.9. Disclosure mandates for consumer credit and other financial products are typically very technical and detailed, and it takes time for regulators to update them because of the need for consumer testing and public input. The growth in the types of risks stemming from new and complex credit card plans and mortgages that preceded the credit crisis far outpaced the ability of disclosure regulations to keep up. We propose a regime strict enough to keep disclosures standard throughout the marketplace, yet flexible enough to adapt to new products. Our proposed legislation authorizes the CFPA to prescribe rules that require disclosures and communications to be reasonable, not merely technically compliant. The proposal is based in part on the banking agencies' supervisory guidance on subprime and nontraditional mortgages. This guidance requires originators to make balanced disclosures.Q.10. If a financial institution developed a new product today, under the CFPA would that product be able to be brought to the marketplace tomorrow? What will financial institutions be required to do before introducing a new product?A.10. If a financial institution developed a new product today, under the CFPA Act that product could be offered in the market tomorrow--the CFPA will not be approving financial products. Of course, all products must comply with existing laws. For example, credit cards may not contain terms, such as retroactive rate increases, that would violate the Credit CARD Act of 2009. It is the institution's responsibility to determine that a new product complies with applicable laws before the institution brings the product to the market. It is CFPA's role to help ensure that products offered in the market comply with applicable laws, and to take appropriate steps if a product does not. ------ CHRG-111hhrg53238--176 Mr. Perlmutter," Thanks, Mr. Chairman. And, Professor, I would just say that ordinarily I don't agree very often with George Mason because my economic philosophy is a little different than yours. But I do agree with you I think with respect to the subprime piece and whether it was really a consumer protection issue or whether it was just a deregulation or refusal to do appropriate underwriting that affected financial institutions and people who invested in financial institutions and people who bought big portfolios. That I agree with. I think you are off base on the credit card piece. That really is a consumer issue. And all the bells and whistles that come along with credit cards are probably one of the top five things discussed if you were to go door-to-door, walk in a precinct or having a town hall. People didn't expect ``X,'' ``Y,'' or ``Z'' with respect to their credit cards. So--which brings me to sort of the general question of who is best, who best can assist consumers with a credit card that has, you know, this fee and that fee and, you know, this surcharge and that penalty charge? Is it a new agency? Is it the FTC? Is it the FDIC? The OCC? The Federal Reserve? And so my question, if we don't go with what has been proposed and create a new agency, how do we--do we set up ombudsmen or new departments in every one of the regulators? If anybody has an answer to that, I would like to hear it. Or do we just beef up the FTC? " fcic_final_report_full--32 Maker told the board that she feared an “enormous economic impact” could re- sult from a confluence of financial events: flat or declining incomes, a housing bub- ble, and fraudulent loans with overstated values.  In an interview with the FCIC, Maker said that Fed officials seemed impervious to what the consumer advocates were saying. The Fed governors politely listened and said little, she recalled. “They had their economic models, and their economic mod- els did not see this coming,” she said. “We kept getting back, ‘This is all anecdotal.’”  Soon nontraditional mortgages were crowding other kinds of products out of the market in many parts of the country. More mortgage borrowers nationwide took out interest-only loans, and the trend was far more pronounced on the West and East Coasts.  Because of their easy credit terms, nontraditional loans enabled borrowers to buy more expensive homes and ratchet up the prices in bidding wars. The loans were also riskier, however, and a pattern of higher foreclosure rates frequently ap- peared soon after. As home prices shot up in much of the country, many observers began to wonder if the country was witnessing a housing bubble. On June , , the Economist magazine’s cover story posited that the day of reckoning was at hand, with the head- line “House Prices: After the Fall.” The illustration depicted a brick plummeting out of the sky. “It is not going to be pretty,” the article declared. “How the current housing boom ends could decide the course of the entire world economy over the next few years.”  That same month, Fed Chairman Greenspan acknowledged the issue, telling the Joint Economic Committee of the U.S. Congress that “the apparent froth in housing markets may have spilled over into the mortgage markets.”  For years, he had warned that Fannie Mae and Freddie Mac, bolstered by investors’ belief that these in- stitutions had the backing of the U.S. government, were growing so large, with so lit- tle oversight, that they were creating systemic risks for the financial system. Still, he reassured legislators that the U.S. economy was on a “reasonably firm footing” and that the financial system would be resilient if the housing market turned sour. “The dramatic increase in the prevalence of interest-only loans, as well as the in- troduction of other relatively exotic forms of adjustable rate mortgages, are develop- ments of particular concern,” he testified in June. To be sure, these financing vehicles have their appropriate uses. But to the extent that some households may be employing these instruments to purchase a home that would otherwise be unaffordable, their use is be- ginning to add to the pressures in the marketplace. . . . Although we certainly cannot rule out home price declines, espe- cially in some local markets, these declines, were they to occur, likely would not have substantial macroeconomic implications. Nationwide banking and widespread securitization of mortgages makes it less likely that financial intermediation would be impaired than was the case in prior episodes of regional house price corrections.  CHRG-111hhrg54868--44 Mr. Bowman," Yes. Two examples. First, we do have some rulewriting authority in terms of consumer complaints, and we took the lead in coming up with an unfair and deceptive acts and practices rule that related to credit card practices and other activities. Second, we have additional authority as it relates to deceptive advertising and issues like that, which we have used to enforce consumer rules and regulations against those institutions we regulate and their holding companies. Fair lending referrals to the Department of Justice have been fairly constant throughout. In the last couple of years, formal enforcement actions brought against our institutions are up somewhat dramatically as a result of increased consumer complaints that we are receiving. But I would share Comptroller Dugan's concern about the number of consumer complaints and abuses that existed outside of the regulated depository institution area where we don't have the authority to regulate or oversee. One of the advantages, in my opinion, of something like the Consumer Financial Products Agency, would be a uniform set of regulations that would be applicable to all providers of consumer products and services. " CHRG-111hhrg52406--8 The Chairman," Next, the prime sponsor of the bill here on the committee, the gentleman from North Carolina, Mr. Miller, for 2 minutes. Mr. Miller of North Carolina. Thank you, Mr. Chairman. One of the issues arising from the financial crisis that this committee must address is how compensation in the financial industry created incentives for taking immediate profits while ignoring only slightly less immediate risk. We will consider how to adjust compensation to ally the long-term interests of companies with the interest of those who work for them. The issue before us today is more difficult and more important, how to ally the interests of the financial industry with those of society. The financial industry has defended every consumer credit practice, regardless of how predatory the practice appeared to those unsophisticated in finance, like me, as an innovation that made it possible to extend needed credit to those who were excluded from traditional lending. And the industry's innovations resulted in inflating the housing bubble, evading existing consumer protections, trapping the middle class in unsustainable debt, and creating risk for financial companies that were dimly understood by regulators, by investors, and even by the investors and CEOs of the companies that created them. And it plunged the country and the world into the worst recession since the Great Depression. The regulatory system we are considering is less restrictive than the regulation of many industries that have done much less damage. At bottom, the question is this: Are consumer lending practices that the industry celebrates as innovation actually useful to society, or are they just a way to make more and more money by betraying the trust of the American people? Other regulators don't just take the regulated industry's word for it that their products are beneficial, and neither should the regulation of the financial industry. I yield back my time. " CHRG-111shrg57709--172 Mr. Volcker," And you have got to rebuild a strong mortgage market, and I think looking at---- Senator Schumer. You don't think the Consumer Protection Agency--I mean, I think if we had a Financial Consumer Protection Agency, it wouldn't have allowed a lot of the practices that we saw that, frankly, came initially not from banks, but from mortgage brokers. " CHRG-111hhrg54872--146 Mr. John," I would see actually that the individual regulator should accept the complaints from the public and the like. One of the problems is that the individual regulators, whether under this system or under the CFPA as far as I can tell, is not an ombudsman, that they basically look for abusive practices and abusive situations and then go to correct them. They are not there to litigate specific complaints by individual consumers. " CHRG-111shrg56415--52 Mr. Dugan," On the area of overdraft fees, we actually don't have the rulemaking authority in that area. The Federal Reserve has that authority. They currently have a proposal that is out. We also don't have authority to write rules for unfair and deceptive practices. We have done, as regulators---- Senator Schumer. Don't you have general authority on consumer-type issues? Not at all? " CHRG-111hhrg67816--137 Mr. Pitts," Unfair is defined as any act that causes or is likely to cause substantial injury to consumers which is not reasonably avoidable by consumers themselves and not outweighed by countervailing benefits to consumers or to competition. Bringing an enforcement action for violation of a deceptive practice is much more common for the FTC. Why are unfair cases brought so infrequently? " CHRG-111shrg50815--110 Mr. Clayton," So as a practical matter, it is--they hold the risk, and if these trusts unwind, that comes back on the balance sheet. So there are real risks and checks and balances, which is what I think you are referring to, in this area. If the marketplace believes that this doesn't work, the cost of borrowing for that company goes up significantly. So there are real prices to be paid. " FinancialCrisisInquiry--523 MAYO: I think significantly less oversight. Yes, the main reason for regulation is to make sure you make those who cause the externalities pay the cost for those externalities. It would also be to make sure the whole system doesn’t fail. To use the example, not being able to turn your water on in the morning. And it might also be to make sure that there’s no, you know, egregious practices taking place. fcic_final_report_full--248 On February , Goldman CEO Lloyd Blankfein questioned Montag about the  million in losses on residual positions from old deals, asking, “Could/should we have cleaned up these books before and are we doing enough right now to sell off cats and dogs in other books throughout the division?”  The numbers suggest that the answer was yes, they had cleaned up pretty well, even given a  million write-off and billions of dollars of subprime exposure still retained. In the first quarter of , its mortgage business earned a record  mil- lion, driven primarily by short positions, including a  billion short position on the bellwether ABX BBB index, whose drop the previous November had been the red flag that got Goldman’s attention. In the following months, Goldman reduced its own mortgage risk while continu- ing to create and sell mortgage-related products to its clients. From December  through August , it created and sold approximately . billion of CDOs— including . billion of synthetic CDOs. The firm used the cash CDOs to unload much of its own remaining inventory of other CDO securities and mortgage-backed securities.  Goldman has been criticized—and sued—for selling its subprime mortgage secu- rities to clients while simultaneously betting against those securities. Sylvain Raynes, a structured finance expert at R&R Consulting in New York, reportedly called Gold- man’s practice “the most cynical use of credit information that I have ever seen,” and compared it to “buying fire insurance on someone else’s house and then committing arson.”  During a FCIC hearing, Goldman CEO Lloyd Blankfein was asked if he believed it was a proper, legal, or ethical practice for Goldman to sell clients mortgage securi- ties that Goldman believed would default, while simultaneously shorting them. Blankfein responded, “I do think that the behavior is improper and we regret the re- sult—the consequence [is] that people have lost money”  The next day, Goldman is- sued a press release declaring Blankfein did not state that Goldman’s “practices with respect to the sale of mortgage-related securities were improper. . . . Blankfein was re- sponding to a lengthy series of statements followed by a question that was predicated on the assumption that a firm was selling a product that it thought was going to de- fault. Mr. Blankfein agreed that, if such an assumption was true, the practice would be improper. Mr. Blankfein does not believe, nor did he say, that Goldman Sachs had behaved improperly in any way.”  CHRG-111hhrg48874--18 Mr. Long," Chairman Frank, Ranking Member Bachus and members of the committee, 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 role in ensuring banks remain safe and sound, while at the same time meet the credit needs of their communities and customers. The last few months have underscored the importance of credit availability and prudent lending to our Nation's economy. Recent actions to provide facilities and programs to help banks strengthen their balance sheets and restore liquidity to various credit segments are important steps in restoring our banking system and we support these initiatives. Nonetheless, the current economic environment poses significant challenges to banks and their loan customers that we and bankers must address. As a bank examiner for nearly 30 years, I have experienced firsthand the importance of the dynamics between bankers and examiners during periods of market and credit stress. One of the most important lessons I have learned is the need to effectively communicate with bankers about the problems facing their institutions and how we expect them to confront those problems without exacerbating the situation. Delay or denial about conditions by bankers or regulators is not an effective strategy. It only makes things worse. Against that backdrop, here are some facts that bankers and regulators are facing today: First, asset quality in many bank loan portfolios is deteriorating. Non-performing loan levels are increasing. Borrowers who could afford a loan when the economy is expanding are now having problems repaying their loans. Increased levels of non-performing loans will likely persist for some time before they work through the banking system. Second, bankers have appropriately become more selective in their underwriting criteria for some types of loans. Where markets are over-lent or borrowers overleveraged, this is both prudent and appropriate. Third, loan demand and loan growth have slowed. This is normal in a recession. Consumers cut back on spending; businesses cut back on capital expenditures. What is profoundly different in this cycle has been the complete shut-down of the securitization markets. Restoring these markets is a critical part of stabilizing and revitalizing our financial system. Despite these obstacles, bankers are making loans to creditworthy borrowers. The bankers I talk with are committed to meeting the credit needs of their communities, and they recognize the critical role they play in the wellbeing of our economy. Simply put, banks have to lend money to make money. The OCC's mission is to ensure that national banks meet these needs in a safe and sound manner. This requires a balance: supervise too lightly, and some banks will make unsafe loans that can ultimately cause them to fail; supervise too strictly, and some banks will become too conservative and not make loans to creditworthy borrowers. We strive to get this balance right through strong and consistent supervision. In the 1980's, we waited too long to warn the industry about excesses building up in the system which resulted in bankers and regulators slamming on the brakes once the economy turned down. Because of this lesson, we have taken a series of actions starting as early as 2003 to alert bankers to the risks we were seeing and to direct them when needed to take corrective actions. Today, our message to bankers is straightforward. Make loans that you believe will be repaid, don't make loans that are unlikely to be repaid, and work constructively with borrowers who may be facing difficulties with their obligations, but recognize repayment problems and loans when you see them. Contrary to some press reports, our examiners are not telling bankers which loans to approve and which to deny. Rather, our message to examiners is this: Take a balanced approach in your supervision. Communicate concerns and expectations clearly and consistently. Provide bankers a reasonable time to document and correct credit risk management weaknesses, but don't hesitate to require corrective action when needed. It is important to keep in mind that it is normal for our banks to experience an increase in problem loan levels during economic downturns. This should not preclude bankers from working with borrowers to restructure or modify loans so foreclosure is avoidable wherever possible. When a workout is not feasible, and the bank is unlikely to be repaid, examiners will direct bankers to have adequate reserves and capital to absorb their loan losses. Finally, the reality is that some community banks are so overextended in relation to capital and reserves, the management needs to reduce the bank's exposures and concentrations to ensure the long-term viability of the bank. In all of these cases, our goal is to work constructively with bankers so that they can have the financial strength to meet the credit needs of their communities and borrowers. Thank you, and I will be happy to answer any questions. [The prepared statement of Mr. Long can be found on page 132 of the appendix.] " fcic_final_report_full--512 Moreover, there is very strong financially-based evidence that Fannie either never tried or was never financially able to compete for market share with Countrywide and other subprime lenders from 2004 to 2007. For example, set out below are Fannie’s key financial data, published by OFHEO, its former regulator, in early 2008. 110 Table 8. Fannie Mae Financial Highlights Earnings Performance: 2003 2004 2005 2006 2007 Net Income ($ billions) 8.1 5.0 6.3 4.2 -2.1 Net Interest Income ($ billions) 19.5 18.1 11.5 6.8 4.6 Guarantee Fees ($ billions) 3.4 3.8 4.0 4.3 5.1 Net Interest margin (%) 2.12 1.86 1.31 0.85 0.57 Average Guarantee Fee (bps) 21.9 21.8 22.3 22.2 23.7 Return on Common Equity (%) 27.6 16.6 19.5 11.3 -8.3 Dividend Payout Ratio (%) 20.8 42.1 17.2 32.4 N/M Table 8 shows that Fannie’s average guarantee fee increased during the period from 2003 to 2007. To understand the significance of this, it is necessary to understand the way the mortgage business works. Most of Fannie’s guarantee business—the business that competed with securitizations of PMBS by Countrywide and others—was done with wholesale sellers of mortgage pools. In these deals, the wholesaler or issuer, a Countrywide or a Wells Fargo, would assemble a pool of mortgages and look for a guaranty mechanism that would offer the best pricing. In the case of a Fannie MBS, the key issue was the GSEs’ guarantee fee, because that determined how much of the profit the issuer would be able to retain. In the case of a PMBS issue, it was the amount and cost of the credit enhancement needed to attain a AAA rating for a large percentage of the securities backed by the mortgage pool. The issuer had a choice of securitizing through Fannie, Freddie or one of the Wall Street underwriters. Thus, if Fannie wanted to compete with the private issuers for subprime and other loans there was only one way to do it—by reducing its guarantee fees (called “G-fees” at Fannie and Freddie) and in this way making itself a more attractive outlet than using a Wall Street underwriter. The fact that Fannie does not appear to have done so is strong evidence that it never tried to compete for share with Countrywide and the other subprime issuers after the date of the Crossroads memo in June 2005. The OFHEO financial summary also shows that Fannie in reality had very 109 110 Stephen B. Ashley Fannie Mae Chairman, remarks at senior management meeting, June 27, 2006. OFHEO, “Mortgage Markets and the Enterprises in 2007,” pp. 33-34. little flexibility to compete by lowering its G-fees. Its net income and its return on equity were all declining quickly during this period, and a cut in its G-fees would have hastened this decline. fcic_final_report_full--207 And if a relatively small number of the underlying loans were to go into fore- closure, the losses would render virtually all of the riskier BBB-rated tranches worth- less. “The whole system worked fine as long as everyone could refinance,” Steve Eisman, the founder of a fund within FrontPoint Partners, told the FCIC. The minute refinancing stopped, “losses would explode. . . . By , about half [the mortgages sold] were no-doc or low-doc. You were at max underwriting weakness at max hous- ing prices. And so the system imploded. Everyone was so levered there was no ability to take any pain.”  On October , , James Grant wrote in his newsletter about the “mysterious alchemical processes” in which “Wall Street transforms BBB-minus-rated mortgages into AAA-rated tranches of mortgage securities” by creating CDOs. He es- timated that even the triple-A tranches of CDOs would experience some losses if na- tional home prices were to fall just  or less within two years; and if prices were to fall , investors of tranches rated AA- or below would be completely wiped out.  In , Eisman and others were already looking for the best way to bet on this disaster by shorting all these shaky mortgage-related securities. Buying credit default swaps was efficient. Eisman realized that he could pick what he considered the most vulnerable tranches of the mortgage-backed bonds and bet millions of dollars against them, relatively cheaply and with considerable leverage. And that’s what he did. By the end of , Eisman had put millions of dollars into short positions on credit default swaps. It was, he was sure, just a matter of time. “Everyone really did believe that things were going to be okay,” Eisman said. “[I] thought they were certifi- able lunatics.”  Michael Burry, another short who became well-known after the crisis hit, was a doctor-turned-investor whose hedge fund, Scion Capital, in Northern California’s Silicon Valley, bet big against mortgage-backed securities—reflecting a change of heart, because he had invested in homebuilder stocks in . But the closer he looked, the more he wondered about the financing that supported this booming mar- ket. Burry decided that some of the newfangled adjustable rate mortgages were “the most toxic mortgages” created. He told the FCIC, “I watched those with interest as they migrated down the credit spectrum to the subprime market. As [home] prices had increased on the back of virtually no accompanying rise in wages and incomes, I came to the judgment that in two years there will be a final judgment on housing when those two-year [adjustable rate mortgages] seek refinancing.”  By the middle of , Burry had bought credit default swaps on billions of dollars of mortgage- backed securities and the bonds of financial companies in the housing market, in- cluding Fannie Mae, Freddie Mac, and AIG. Eisman, Cornwall, Paulson, and Burry were not alone in shorting the housing mar- ket. In fact, on one side of tens of billions of dollars worth of synthetic CDOs were in- vestors taking short positions. The purchasers of credit default swaps illustrate the im- pact of derivatives in introducing new risks and leverage into the system. Although these investors profited spectacularly from the housing crisis, they never made a single subprime loan or bought an actual mortgage. In other words, they were not purchasing insurance against anything they owned. Instead, they merely made side bets on the risks undertaken by others. Paulson told the FCIC that his research indicated that if home prices remained flat, losses would wipe out the BBB-rated tranches; meanwhile, at the time he could purchase default swap protection on them very cheaply.  On the other side of the zero-sum game were often the major U.S. financial insti- tutions that would eventually be battered. Burry acknowledged to the FCIC, “There is an argument to be made that you shouldn’t allow what I did.” But the problem, he said, was not the short positions he was taking; it was the risks that others were ac- cepting. “When I did the shorts, the whole time I was putting on the positions . . . there were people on the other side that were just eating them up. I think it’s a catas- trophe and I think it was preventable.”  fcic_final_report_full--50 Then, beginning in , the Federal Reserve accommodated a series of requests from the banks to undertake activities forbidden under Glass-Steagall and its modifi- cations. The new rules permitted nonbank subsidiaries of bank holding companies to engage in “bank-ineligible” activities, including selling or holding certain kinds of se- curities that were not permissible for national banks to invest in or underwrite. At first, the Fed strictly limited these bank-ineligible securities activities to no more than  of the assets or revenue of any subsidiary. Over time, however, the Fed re- laxed these restrictions. By , bank-ineligible securities could represent up to  of assets or revenues of a securities subsidiary, and the Fed also weakened or elimi- nated other firewalls between traditional banking subsidiaries and the new securities subsidiaries of bank holding companies.  Meanwhile, the OCC, the regulator of banks with national charters, was expand- ing the permissible activities of national banks to include those that were “function- ally equivalent to, or a logical outgrowth of, a recognized bank power.”  Among these new activities were underwriting as well as trading bets and hedges, known as derivatives, on the prices of certain assets. Between  and , the OCC broad- ened the derivatives in which banks might deal to include those related to debt secu- rities (), interest and currency exchange rates (), stock indices (), precious metals such as gold and silver (), and equity stocks (). Fed Chairman Greenspan and many other regulators and legislators supported and encouraged this shift toward deregulated financial markets. They argued that fi- nancial institutions had strong incentives to protect their shareholders and would therefore regulate themselves through improved risk management. Likewise, finan- cial markets would exert strong and effective discipline through analysts, credit rat- ing agencies, and investors. Greenspan argued that the urgent question about government regulation was whether it strengthened or weakened private regulation. Testifying before Congress in , he framed the issue this way: financial “modern- ization” was needed to “remove outdated restrictions that serve no useful purpose, that decrease economic efficiency, and that . . . limit choices and options for the con- sumer of financial services.” Removing the barriers “would permit banking organiza- tions to compete more effectively in their natural markets. The result would be a more efficient financial system providing better services to the public.”  During the s and early s, banks and thrifts expanded into higher-risk loans with higher interest payments. They made loans to oil and gas producers, fi- nanced leveraged buyouts of corporations, and funded developers of residential and commercial real estate. The largest commercial banks advanced money to companies and governments in “emerging markets,” such as countries in Asia and Latin Amer- ica. Those markets offered potentially higher profits, but were much riskier than the banks’ traditional lending. The consequences appeared almost immediately—espe- cially in the real estate markets, with a bubble and massive overbuilding in residential and commercial sectors in certain regions. For example, house prices rose  per year in Texas from  to .  In California, prices rose  annually from  to .  The bubble burst first in Texas in  and , but the trouble rapidly spread across the Southeast to the mid-Atlantic states and New England, then swept back across the country to California and Arizona. Before the crisis ended, house prices had declined nationally by . from July  to February   —the first such fall since the Depression—driven by steep drops in regional markets.  In the s, with the mortgages in their portfolios paying considerably less than current interest rates, spiraling defaults on the thrifts’ residential and commercial real estate loans, and losses on energy-related, leveraged-buyout, and overseas loans, the indus- try was shattered.  CHRG-111hhrg53238--106 Mr. Yingling," Congressman, I would just say that I think what your question points out is the need for some kind of systemic oversight body. Did anybody see it coming? Some did. Should we have seen? Absolutely. It is a terrible failure of ours. It is a terrible failure of our regulatory system. We had a previous discussion in a previous hearing. I had a previous discussion with the Chairman, that the Fed had the numbers; and we really should have done something about it, and that is true. But the weakness in our regulatory structure is there is really nobody at this point who is charged with looking for these kinds of disasters coming down the pike, ringing the alarm bell, and making sure something is done about it. And I think it points out the need for some type of oversight regulator that doesn't regulate, but says there is a disaster coming. " CHRG-110hhrg46591--102 Mr. Johnson," I will be brief. Since I believe that the financial regulatory system should be consolidated around bank holding companies, I think you need one bank holding company regulator. I think the Federal Reserve is already doing that. It should continue to be the regulator there. I think that their resources are inadequate and their expertise in supervision is weak and we need to concentrate on that much more. For securitization, which covers a lot of finance, you have the SEC. Transparency, securitization, and supervising the rules of running a clearing system should be an SEC-like function. You already have one. I think it could be strengthened. But there needs to be coordination between a bank holding company regulator and someone overseeing the securities markets. There should be mandated coordination to avoid turf battles. " CHRG-110shrg46629--118 Chairman Bernanke," There has not been any changes to my knowledge. The last time that the Japanese intervened was in--as far as we know, was in March 2004 and there has not been a subsequent intervention since then. The yen has been quite weak reflecting in large part the fact that interest rates in Japan are quite low, which in turn reflects the policies of the Bank of Japan in the face of still very low, near deflation, inflation rates. I view the end as being essentially a market determined exchange rate and I think that market determined rates are the way to go. And so I would not advocate any particular policy changes with respect to Japan. Senator Carper. Thank you. Are you alarmed at all by our growing reliance on foreign oil? " FinancialCrisisReport--62 In 2004, WaMu set the stage for its High Risk Lending Strategy by formally adopting aggressive financial targets for the upcoming five-year time period. The new earnings targets created pressure for the bank to shift from its more conservative practices toward practices that carried more risk. Mr. Killinger described those targets in a June 2004 “Strategic Direction” memorandum to WaMu’s Board of Directors: “Our primary financial targets for the next five years will be to achieve an average ROE [Return on Equity] of at least 18%, and average EPS [Earnings Per Share] growth of at least 13%.” 148 In his memorandum to the Board, Mr. Killinger predicted continuing growth opportunities for the bank: “In a consolidating industry, it is appropriate to continually assess if shareholder value creation is best achieved by selling for a short-term change of control premium or to continue to build long-term value as an independent company. We believe remaining an independent company is appropriate at this time because of substantial growth opportunities we see ahead. We are especially encouraged with growth prospects for our consumer banking group. We would also note that our stock is currently trading at a price which we believe is substantially below the intrinsic value of our unique franchise. This makes it even more important to stay focused on building long-term shareholder value, diligently protecting our shareholders from inadequate unsolicited takeover proposals and maintaining our long held position of remaining an independent company.” 149 Mr. Killinger identified residential nonprime and adjustable rate mortgage loans as one of the primary bank businesses driving balance sheet growth. 150 Mr. Killinger also stated in the memorandum: “Wholesale and correspondent will be nationwide and retooled to deliver higher margin products.” 151 (2) Approval of Strategy After 2002, Washington Mutual stopped acquiring lenders specializing in residential mortgages, 152 and embarked upon a new strategy to push the company’s growth, focused on increasing its issuance and purchase of higher risk home loans. OTS took note of this strategy in WaMu’s 2004 Report on Examination: 148 6/1/2004 Washington Mutual memorandum from Kerry Killinger to the Board of Directors, “Strategic Direction,” JPM_WM05385579 at 581. 149 Id. at 582. 150 Id. 151 Id. at 585. 152 The only new lender that Washington Mutual acquired after 2004 was Commercial Capital Bancorp in 2006. “Management provided us with a copy of the framework for WMI’s 5-year (2005-2009) strategic plan [which] contemplates asset growth of at least 10% a year, with assets increasing to near $500 billion by 2009.” 153 CHRG-110shrg50409--9 Chairman Dodd," Well, thank you very much, Mr. Chairman. And let me just briefly say I appreciate the efforts of the Fed regarding both credit cards and the things dealing with predatory lending practices. We welcome those rules, and we welcome the suggestions in the credit card areas, and a future point here, we will maybe have more discussion about that. But I wanted to at least reflect my appreciation of what the Fed has done regarding those matters, and we appreciate it very much. I am going to put this clock on at 5 minutes so we can give everyone a chance to raise any questions they have on the monetary policy issues. Some of the questions may overlap, and at the conclusion of that, Secretary Paulson and Chairman Cox will be here to have a broader discussion about the proposals being made by Treasury over the weekend. Let me, if I can, jump to the economic projections for 2009, the concerns about economic growth that you have raised in your statement here this morning. Given the fact that we have, as you point out, acknowledged the risk to your forecast for economic growth are skewed to the downside, to use your words, and given the fact that the stimulus package is about to--the effects of it are going to run out by the end of the year. The housing crisis continues, obviously, as we all know painfully. Gasoline prices, as you point out, are at record levels, costing consumers tremendously. The issues involving the weakness in the labor market are significant, 94,000 jobs lost every month for the last 6 months on a consistent basis. Inflation, as you point out, while it may abate in the coming years, it certainly is going to be with us for some time. What suggestions do you have for us in all of this? And I realize you may want to reserve some final judgment on the effects of the stimulus package and will not know the full effects of that until maybe toward the end of the year. But as we look down the road as policy setters here in the Congress looking at ideas, including a possibly a second stimulus package, one of the suggestions we made to increase productivity is to invest more heavily in infrastructure, the infrastructure needs of the country. I wonder if you might just share with us your views as to what ideas, as a menu of ideas, without necessarily embracing one or the other, but what you would be planning to do rather than just sort of waiting out the year and a new administration coming in, we will be leaving here, adjourning in late September, early October, maybe coming back, maybe not until after inauguration of the President late in January, it seems to me this would be an opportune time for us to be considering very seriously policy considerations that would provide for greater economic growth and opportunity than what we are presently looking at. " FOMC20070321meeting--105 103,MR. LOCKHART.," Thank you, Mr. Chairman. Thank you for the earlier welcome. Over the intermeeting period, aggregate economic activity in the Sixth District showed signs of slowing. Manufacturing activity appeared to soften, with the majority of reports suggesting declining orders. Retail reports pointed to a slowing pace of sales. The BLS employment data revisions for 2006 supported the view that Florida’s economy has decelerated considerably in the wake of the housing downturn. Sales tax data suggest that retail spending in Florida actually declined in late 2006. Recovery on the Gulf Coast of Mississippi and Louisiana continues to proceed more slowly than hoped. The immediate post-hurricane boost to spending has waned, and the problems of housing and insurance availability remain largely unresolved. The biggest concern for the Sixth District continues to be in real estate markets. As stated at the last meeting, it appears to be too early to suggest that the region’s housing situation has stabilized or that the housing sector’s drag on the District has ended. Reports indicate that many areas in Florida are experiencing dramatic declines in sales of single-family homes and condos, even while new product continues to come onto the market. As a result of this oversupply, construction plans have been cut back. In January, permit issuance for single-family homes in Florida was 57 percent lower than a year earlier. For the rest of the United States the decline was 25 percent. Permits for multifamily development declined 40 percent versus a 7 percent decline nationally. This situation is most extreme in Florida. Interestingly, we do hear anecdotal reports of improved potential buyer traffic in Florida, but that improvement is not translating into sales. Buyers appear to be expecting lower prices. In the other states in the District, single-family permits were down 19 percent in January, less than the decline nationally. Regarding the region’s exposure to nonprime and subprime mortgages, the concern is again mostly in Florida. According to the Mortgage Bankers Association, over 9 percent of mortgages serviced in Florida in the fourth quarter of 2006 were subprime ARM loans; this exposure was second only to Nevada, which was at 13 percent, and compares with 6½ percent nationally. In contrast, the exposures of the other states in the District were all at or below the national level. Reports from banking contacts suggest that delinquency rates on nonprime ARM loans in Florida will continue to trend higher this year. Reduced access to credit for nonprime borrowers will slow the absorption of the current oversupply of housing product and will put downward pressure on house prices. Also, the boom in condo conversions and condo construction in 2005 and 2006 drained the supply of apartments in many areas in the District, and landlords have been able to increase rental prices as a result. Turning to our perspective on the country as a whole, much of the slowdown in real activity that occurred in the second half of 2006 reflected weakness in the housing sector. If weakness remains contained within the housing sector, the outlook, although subdued, is acceptable in our view. Much of the recent moderation in real activity is consistent with what we had forecast several months ago. Realization of this moderation does not in itself imply that we should revise our outlook. Some professional forecasters continue to anticipate that real GDP growth will rebound to close to its trend rate of 3 percent for the rest of 2007, in effect discounting any drag from prolonged weakness in residential investment. The Atlanta Fed staff forecasts for real GDP growth are consistent with these optimistic commercial forecasts. The current Greenbook forecast implies a slightly weaker outlook from extended weakness in residential investment and weaker growth of consumer expenditures, perhaps incorporating some signal from the recent financial distress in subprimes. Despite slight differences in these forecasts, the outlooks do not suggest recession at this point. Measured core inflation remains in excess of 2 percent. Our staff consensus forecast sees core inflation continuing in the range of 2 to 2½ percent for all of 2007. This forecast is a bit less favorable than the Greenbook forecast, but we have no sense that the inflation outlook has deteriorated significantly. The implications of the outlook for real output and inflation are that current policy is set about where it should be. The U.S. economy has performed about as expected. Financial market turbulence and subprime mortgage distress raise potential concerns that should be monitored, but for now it seems that the outlook has not substantially changed. Thank you, Mr. Chairman." CHRG-111hhrg58044--401 Mr. Cohen," Obviously, you do not know. I will tell you it is a fact. Anybody would know it is a fact. We had 400 years of slavery and 100 years of Jim Crow as distinguished from another group who had property, who owned slaves, who sold slaves, who had discriminatory practices where they could have advantages and they could get credit and they could get loans. They owned the insurance companies and the banks and the credit bureaus, so they had the wealth. When they lose their job or they have a difficult financial time, they have mama or daddy or grand-daddy's money to fall back on. Their credit scores are good. Yet when you look at the credit scores, you say that credit score indicates whether they do good work and have hard values. I submit to you good work and hard values is not a constant. If you have money to fall back on, resources, because of family wealth, you submit that shows because your credit report is good that you have good work habits and hard values, that credit history equals hard work. That is not necessarily true. Credit history shows you have family sometimes and you have support from years and years of opportunity that was denied others, and the fact is the Equal Employment Opportunity Commission has sued certain people over the practice of using credit reports because they believe it has an effect, it is a racial barrier, and there are racial disparities, and it should be pursued. I think it should be, too. I think what you are talking about is a world where all is equal. If you do statistics, Ms. Fortney, you are great on statistics, I think you were thinking about fraud and not accidents. Mr. Green was talking about accidents. There is no way to predict accidents. Maybe a few people might not file claims because they can afford it. You are submitting people who have bad histories might commit fraud, have an accident, which really is not an accident, so they can make a report and get some money. I think that is what you are alluding to. Mr. Hensarling talking about discriminating against the person who does not have a good credit rating, you do not discriminate against him, you let that person, he or she operate against the other person on an equal basis, and the employer can choose them on who can do the best job. Mr. Pratt, you said a lot of jobs do not use credit reports. If that is the case, would you agree that maybe we should pass a bill to make sure that those jobs that you concur where they do not use credit reports now, like skills, etc., that there should not be the permission to use credit reports? Could you sit down with us and come up with those particular industries? " FOMC20070509meeting--49 47,MS. YELLEN.," Thank you, Mr. Chairman. My assessment of the economic outlook and the risks to it is largely unchanged since our last meeting. The data since that meeting have been mixed. On the one hand, the very sluggish real GDP growth in the first quarter gives me pause concerning potential downside risks. Much of the first-quarter weakness, of course, was due to housing, and I really don’t see that sector starting to turn around at this point. My homebuilder and banking contacts report stricter underwriting standards for all mortgages, not just subprime ones, so residential investment could remain a significant drag on the economy over the near term as the Greenbook now envisions. Indeed, whereas the Greenbook assumes that national house prices are flat going forward, I am worried that they may actually fall. On the other hand, the improved picture of auto inventories along with some positive glimmers on manufacturing and business investment suggests that those sectors may prove to be less of a drag on the economy going forward. With respect to inflation, the recent news has also been somewhat mixed with lower-than- expected readings on core consumer prices and labor compensation offset by higher prices for energy, other commodities, and imports. Taking a longer view, I anticipate real GDP growth over the next two and a half years of about 2.6 percent, just a bit below my assessment of potential. My forecasts of both actual and potential growth are a tenth or two stronger than the Greenbook forecasts; but the basic story is very similar, and the underlying assumptions, including the path for the nominal funds rate, are essentially the same. I view the stance of monetary policy as remaining somewhat restrictive throughout the entire forecast period. The key factors shaping the longer-term outlook include continued fallout from the housing sector, with housing wealth projected to be roughly flat through 2008. Given the reduced impetus from housing wealth, household spending should advance at a more moderate pace going forward than over the past few years. This slowdown in consumption is reinforced by more-moderate gains in personal income, as the unemployment rate gradually rises, reaching 5 percent in 2009. Although I anticipate that the labor market will remain fairly tight over the next year, I do not expect faster compensation growth to exert significant upward pressure on prices. I expect it instead to restrain profits, given that labor’s share of income is now at an exceptionally low level. I also anticipate that various temporary factors that have been boosting inflation, such as the run-up in owners’ equivalent rent and the pass-through of energy prices, should dissipate, while inflation expectations remain well anchored. Overall, I’m more optimistic regarding inflation than the Greenbook and anticipate that core PCE price inflation will edge down below 2 percent after next year. One of the more interesting questions about the outlook, as David noted in the questions to him, is how to reconcile the strong labor market performance with the weak growth in output or, equivalently, how much of the recent slowdown in productivity growth is likely to persist. And that is something that we have been thinking about, too. Over the four quarters of 2006, nonfarm business productivity rose 1.6 percent, about half as fast as the average pace set from 2000 through 2005. Whether these recent lower numbers reflect a transitory drop in growth or a downshift in the trend rate is an important issue. A lot of excellent research has been done on this topic by staff at the Board and elsewhere in the System. My reading of the evidence at this point is that the recent decline in productivity growth does largely reflect cyclical factors. I think productivity growth has fallen significantly below trend because of labor hoarding and lags in the adjustment of employment to output. We have also been giving close scrutiny to the behavior of the residential construction sector and productivity in that sector. My staff has done some work on estimating what productivity growth has been over the past year or so in residential investment and in the nonfarm business sector outside residential investment. They estimate that essentially all of last year’s slowdown in labor productivity growth is due to the behavior of productivity in residential construction. We estimate that residential construction productivity dropped 10 to 15 percent in 2006, whereas productivity in the nonfarm business sector outside residential investment was well maintained. Exactly why those lags exist, again, is a mystery to me as well as to David and others. But going forward, it seems to us that, as the adjustment lags work themselves out, residential construction employment will likely post significant declines, and productivity in that sector and the economy as a whole will rebound. That said, the pace of structural productivity growth may also have declined slightly as the Greenbook hypothesizes. Relative to the second half of the 1990s, both the pace of productivity growth in the IT sector and the pace of investment in equipment and software have slowed, and these factors have probably depressed trend productivity growth slightly in recent years and are likely to continue depressing it somewhat going forward. But the hypothesis that the recent decline in productivity growth is mainly structural does not seem to me to square well with the broad range of available evidence. Recall that in the 1990s there was a whole constellation of evidence—including a booming stock market, robust consumption, and rapid business investment—that was consistent with a hypothesis of a lasting increase in the rate of productivity growth. In contrast, over the past year or so, business investment in equipment has been very sluggish and more so than seems warranted by the deceleration in business output. So such weakness could reflect lower assessments by companies of their ability to improve productivity through the installation of new capital, and that is, I think, consistent with the lower trend of productivity growth. But you would think that a marked slowdown in secular productivity growth would also result in downward revisions to the expected paths of future profits and real wages, weakening equity market valuations and crimping consumption growth. I have seen no signs over the past year that household perceptions of their future wealth accumulation have been downgraded. In sum, the data seem consistent with the view that the recent slowdown in nonfarm business productivity represents a temporary cyclical drop that is concentrated in residential construction combined with a modest decline in the trend. So I remain optimistic that the underlying productivity trend is at or only slightly below 2½ percent." CHRG-111hhrg54868--72 Mr. Dugan," Okay. I will give you a couple of examples, and then I will also say that a bunch of the practices, the very worst subprime mortgage lending, was not occurring inside national banks or State banks for that matter. It was in unregulated State entities where the States were in charge of them. And the numbers show that. In terms of the things that we have leaned on people, payday lending was something where the payday lenders tried to get ahold of national banking franchises to run payday lending operations in them, and we stopped it. We stopped them from so-called renting the national bank charter to do that. I mentioned subprime lending and credit cards, where we saw a number of abuses that caused real problems. Both on the consumer protection side and the safety and soundness side, we came down very hard on it, and we essentially ended that practice for the monoline stand-alone subprime lenders in the credit card business. I can provide you other examples and specific cases and would be happy to do that for the record. Mr. Miller of North Carolina. My time is nearly up. " CHRG-111hhrg52400--191 Mr. Manzullo," And if I could stop you right there, that is my point. The man who is the whistleblower--I can't think of his name right now--oh, Mr. Makopoulous--testified that he had been screaming at the SEC for 5, 6, 7 years, and no one would listen. So the authority and the regulators were in place, they just failed with Madoff. And the same thing with the Federal Reserve. Now, you said, Mr. McRaith that, ``We restrict the nature and extent of the investments of insurance companies.'' And the Federal Reserve has jurisdiction to restrict the nature and extent of mortgage instruments and underwriting standards. And they sat on their butts and did nothing. In fact, Chairman Bernanke testified here in October of 2008 that it wasn't until December of 2007 that the Fed ever got involved in the whole subprime housing market. And I find that astonishing. And Mr. Capuano is giving you hell that--he said where were the States when this went down the tube, but it was the Federal agency with direct jurisdiction that did absolutely nothing. And now we're talking about using that standard, the SEC standard that blew it with Madoff, the Federal Reserve standard that blew it with doing nothing on governing these instruments to stop the 2/28s and 3/27s, and making sure that people who took loans could afford to buy them, and now we're expected to sit here and have a Federal insurance regulator. Why? I mean, I'm looking at your testimony here. You plead the Tenth Amendment on some certain areas, and I could understand what you're trying to do. The problem is, how do you think you can stop the Fed from going only as far as you want them to go, and then not going beyond the area where you don't want them to go? That's a tough question, Patrick, but if you want to handle it, go ahead. " CHRG-111hhrg53245--119 Mr. Zandi," Right. If I were king for the day, I would design it differently. I would think that a model where the regulatory function was in a separate entity, that was a systemic risk regulator that was separate from the Federal Reserve would make the most sense. I think in the context of where we are starting from and just the practicality of the situation, I think the most logical place for that to reside is the Federal Reserve. " CHRG-111hhrg53244--70 Mr. Bernanke," I am very open to discussing the role of the council. I think a very important role is to coordinate regulators, to oversee the system, to identify risks and so on. But there may be situations where the council can have authority to harmonize different practices or to identify problems and to take action. So I think the Congress should discuss what powers the council should have. " CHRG-111hhrg52407--37 Mr. Diaz," Well, that is a big hypothetical. Remittances are obviously a current standard practice that many immigrant families transfer excess income down to families of their place of origin. I can't imagine the question of whether they would ban remittances. I mean, that is--I don't know if there is anything in the legislation where they have written or seen about that that would be even the case. So it is a hypothetical-- " CHRG-111hhrg54869--189 Mr. Zandi," I am a little nervous about answering, to tell you the truth, I think given what happened before. My sense is that in theory it would be nice to say that if you are ``too-big-to-fail,'' you are ``too-big-to-exist.'' But in reality, in practice, that is not going to happen. That won't happen. I don't think it is efficient. Our institutions won't be competitive globally. " CHRG-110hhrg46593--35 Mr. Bernanke," Yes. We only lend to good quality banks. We lend on a recourse basis, that is post, post, post collateral, and if the collateral were to be insufficient, then the bank itself is still responsible. We have never lost a penny doing this. I think it is a totally standard practice for central banks around the world, and it is very constructive to provide liquidity to the financial system. " CHRG-111shrg50814--36 Mr. Bernanke," Well, Senator, as I mentioned in my testimony, we are going to go beyond what is best practice among the world's central banks and go a step further and make sure we provide all the information we can. We have just unveiled the new Web site, which has extensive information, including information about collateral, including descriptions and discussions of each of the programs, and---- Senator Bunning. To whom the money is going? " CHRG-111hhrg55811--275 Mr. Hill," Thank you. My name is James Hill. I am a managing director at Morgan Stanley, and I am appearing today on behalf of the securities association known as SIFMA. We appreciate your invitation to testify. There is much in the committee discussion draft that SIFMA and its members support, and we believe that it includes many significant improvements over the Administration's proposal relating to over-the-counter derivatives. We appreciate the thoughtful consideration that you and your committee colleagues, as well as your staff, have given to comments that industry participants have provided, in particular those of corporate end-users. I would like to express SIFMA's support for legislative proposals to ensure that systemically significant market participants are subject to comprehensive regulatory oversight. It was lack of meaningful regulation of AIG's derivatives affiliate that allowed poor business practices to lead to a situation in which the Federal Government had to invest tens of billions of dollars in order to avert what would have been a systemically significant business failure. The discussion draft would address this regulatory shortcoming by creating a legislative and regulatory framework that ensures such a lapse would not likely occur again. We also support measures that would improve regulatory transparency and thereby facilitate oversight of the derivatives markets and the activities of individual market participants. The discussion draft accomplishes this by requiring that swaps be submitted to a derivatives clearing organization or reporting to a swap repository. We do, however, have concerns about some of the particular provisions in the discussion draft. I will briefly describe several. Although the discussion draft generally excludes corporate end-users from the provisions that would require exchange trading or clearing of swap transactions, they would be covered by other provisions. For example, the discussion draft would authorize regulators to impose margin requirements on swaps in which one of the counterparties is a corporate end-user. We do not believe that counterparty credit exposure created through a swap transaction should be required to be collateralized when lending arrangements between the parties can be made on an unsecured basis. We believe the decision to require margin and the details of how it is handled should be left to an individual negotiation between the dealer and its end-user client. The provisions of the discussion draft regarding security-based swaps are another area of concern. The draft gives the SEC jurisdiction over these swaps in part by amending the Securities Act of 1933 to include them in the definition of ``security.'' This approach is expedient, but likely would have unintended consequences that would be difficult and time-consuming to resolve. This is because many of the concepts and requirements under Federal and State securities laws do not readily apply to securities-based swaps. A better approach to providing for SEC oversight and regulation of securities-based swaps would be to give the SEC broad authority to adopt regulations that are consistent with the regulatory framework for other swaps. This would enable the SEC to address unforeseen issues without contorting the existing Federal securities laws and regulations to accommodate instruments for which they were not designed. Finally, we have practical concerns about constraints on the SEC and the CFTC's exemptive authority and the Act's short implementation period. The legislation could well have unintended consequences, some of which may be adverse to the market and individual market participants. Rather than having to pass new legislation to address such consequences each time they arise, we believe it would be more practical to grant the CFTC and the SEC authority to create exemptions that are consistent with the purposes and intentions of the act. With respect to implementation, we note the Act's provisions generally would become effective 180 days after enactment. We don't believe this would give derivatives dealers and other market participants, as well as corporate end-users, sufficient time to comply with the Act's complex and far-reaching provisions. We believe the effective date should be no less than 1 year after the date of enactment. In conclusion, I would like to emphasize that SIFMA and its members support legislation to address the weaknesses in the current regulatory framework for derivatives. The events of the past year have made clear that improvements are needed. However, the use of derivatives have become an integral part of our economy because they enable corporate end-users to effectively manage risk. As such, it is important that legislation intended to improve derivatives regulation and reduce systemic risk do not unnecessarily impair the usefulness of derivatives as an important risk management tool. Thank you. [The prepared statement of Mr. Hill can be found on page 124 of the appendix.] Ms. Bean. Thank you very much. We move to Mr. Stuart Kaswell, executive vice president and managing director, general counsel, of the Managed Funds Association. STATEMENT OF STUART J. KASWELL, EXECUTIVE VICE PRESIDENT & MANAGING DIRECTOR, GENERAL COUNSEL, MANAGED FUNDS ASSOCIATION (MFA) " FOMC20081216meeting--492 490,MR. LACKER.," The reason I ask--the point that I'm making--is that you can reference theories but, at the end of the day, it's not just those predictions. It's the whole range of things about the theory. We haven't, in this, seen many theories put on the table, and the ones that have been--things like cash-in-the-market pricing--just don't seem to match up well with the facts. There's a gigantic, billions of dollars worth of investors out there who have the capability of buying any of this stuff. In Treasuries, people are capable of arbitraging that on-the-run and off-the-run thing. To explain this by appealing to some market segmentation seems really weak in this environment. You know, I welcome discussing theories under which these are Pareto improving programs, but I haven't seen one that's convincing yet. " CHRG-110hhrg44903--61 Mr. Scott," Another part of my question is yesterday, we made a very bold and I think a very, very, very good and substantial move with our housing package. And given the fact that now we have addressed our housing package, let me ask you, do you believe that a second round of stimulus package is necessary? Would you support a second round of stimulus in the face of what people are saying and economists, that we still expect sustained economic weakness to last, many say, for the next 2 or 3 years? So my point is, given the housing package, given the earlier stimulus, do you foresee down the road a necessity to move with a second stimulus package? And what do you think the first stimulus package has done? " CHRG-111shrg56415--38 Mr. Smith," I would only add, Senator, that in the most successful period I know of in home lending in the United States, there were mainly two, maybe three varieties of loans generally in the underwriting standards world, as you say. There was a requirement of a downpayment, for standard documentation, and the people that made the loans kept them. And on the basis of that lending experience, we projected--the magicians on Wall Street did projections about the loans that weren't like that. So, I think there is--as you point out, the issue there is the issue of access to housing, and that is what it is. There is no free lunch and no easy answer. Senator Gregg. Thank you. Thank you very much for your testimony. Senator Johnson. Senator Bennet. Senator Bennet. Thank you, Mr. Chairman, and I would also like to thank the panel for your excellent testimony. Every weekend when I go home to Colorado, what I hear from small businesses is they have no access to capital, no access to credit, and we are in this, as the panel has talked about, in this remarkably difficult period where, on the one hand, the securitized market that blew up or imploded is now gone and has not been replaced, which is probably a good thing from a leverage point of view, but it hasn't been replaced. On the other hand, we have got this looming commercial real estate issue that is still out there. And sort of caught in between all that are our small businesses who need access to capital in order to grow and in order to deal with the unemployment rate that Senator Tester talked about and sort of this folding back on top of itself. And I wondered, Mr. Tarullo, you mentioned in your testimony at the beginning your view that maybe some more direct efforts--I think you described it as temporary targeted programs--might be necessary to get our small businesses access to the credit that they need, and I wonder if you could elaborate a little bit more on that, because I suspect you are right. And in addition to that, I would ask to what extent we think the current accounting regimes are ones that are either helping banks extend credit to small businesses or are intruding on their ability to do that. " CHRG-110hhrg46591--198 Mr. Manzullo," I thank the chairman. In 2000, this committee, through the efforts of Richard Baker, began a more intensive focus on the potential systemic risk posed by Fannie and Freddie. In an effort to lobby against Mr. Baker's bill, Fannie Mae engineered over 2,000 letters from my constituents in my district concerned about the ``inside the Beltway'' regulatory reform bill. That was a reform bill in 2000. The problem was the letter campaign was a fraud. My constituents did not agree to send those letters. And what ensued was a confrontation with Mr. Raines in which he arrogantly claimed Fannie did nothing wrong in stealing the identities of 2,000 of my constituents. At that point, I threw the Fannie Mae lobbyists out of my office and said, ``You are not welcome to come back.'' That was 8 years ago. Then again in 2004, there was a confrontation between myself and the head of OFHEO over the fraudulent accounting motivated by executive greed and Mr. Raines, who took away $90 million. That led to a lawsuit, and he unfortunately had to give back only $27 million of that. And I cosponsored the reform bills in 2000 and 2004, and again--2003 and 2005. Dr. Rivlin, I have been one of your biggest fans, even though you don't know that, because you make astounding statements such as on page 3, ``Americans have been living beyond our means individually and collectively.'' You talk about personal responsibility. You also talk about commonsense regulations, that you should not be allowed to take out a mortgage unless you have the ability to pay for it and have proof of your earnings. My question to you today is, as we discuss restructuring and reform, what kind of changes or curbs should be placed upon GSEs in your opinion? Ms. Rivlin. I think you have a really hard problem with the GSEs, because the problem was that they were structured in such a way that they had very conflicting missions. They were told they were private corporations, owned by stockholders, responsible to those stockholders to make money, and they were also told that they had public responsibilities to support affordable housing. And they interpreted those--they came late to the party on subprime, but they came, as you pointed out, in a very big way. And that turned out to be part of fueling the collective delusion. And then they got caught in a really big way when the market--when the crash happened. I think the real problem going forward is how to unwind this untenable situation. Either you have to have Fannie and Freddie being truly private institutions with no government guarantee, in which case they have to be a lot smaller--that would take a long time to accomplish, but it is one model--or they have to be fully regulated, with the rules clear what they are to do in the mortgage markets, and that they should lean against the wind when a bubble seems to be getting out of hand. That is another possible model. But the thing that isn't possible is this combination of conflicting incentives. " FOMC20050630meeting--140 138,MS. JOHNSON.," We didn’t do price-rent ratios, and given what Josh has described in terms of the care he has to put in before he feels he has something close to the right number, I think we might feel a little hesitant to do so. I take it back; there are price-rent ratios—[laughter] in the back portion of that paper. What data we have, we used. But there are huge variations in the financing practices in housing markets across foreign countries. There is some degree of securitization but less than here. Practices with respect to the tax-favored treatment of borrowing to finance houses differ relative to those in the United States. There’s a host of different characteristics, in terms of variable-rate, fixed-rate, and other types of instruments used in various foreign countries. But one of the things our paper was intended to point out was the prevalence of really rapid rises in house prices. According to this chart—the first few pages of which are right here anyway— June 29-30, 2005 49 of 234 There is only a subset of the countries we covered for which we have price-rent charts, but there are some in the paper." FinancialCrisisInquiry--245 And, Congressman Baker, if you remember, used to love to hold hearings on Fannie and Freddie. That was—he did a lot of that. And he talked about systemic risk. And—and the groups on the panel that day, in the—it was a large consumer group in the audience, complaining about Citigroup merging with another finance company, and that—their predatory lending practices they had. And, of course, you know, Congress said we’re going to get the Fed to look into it. Well, it never really came that way. It ended up being that the attorney general of New York, filed charges against them for their practices of credit life insurance, which they finally pled nolo contendere to and just moved on. So, you know, you’re absolutely right. There’s been a very lackadaisical treatment of that situation that continues to go on. As I said, a very interesting question for this commission. With all the problems you’ve heard about the large banks -- ask how many MOUs or cease-and-desists they’re under. I think the answer will be not many. CHAIRMAN ANGELIDES: Would you like some more time, Ms. Born? BORN: No, that’s fine. CHAIRMAN ANGELIDES: Because we’ve got two, three minutes on the clock. BORN: I am—I’m done. CHAIRMAN ANGELIDES: You’re sated? All right. fcic_final_report_full--177 Robert Mueller, the FBI’s director since , said mortgage fraud needed to be considered “in context of other priorities,” such as terrorism. He told the Commis- sion that he hired additional resources to fight fraud, but that “we didn’t get what we had requested” during the budget process. He also said that the FBI allocated addi- tional resources to reflect the growth in mortgage fraud, but acknowledged that those resources may have been insufficient. “I am not going to tell you that that is adequate for what is out there,” he said. In the wake of the crisis, the FBI is continuing to inves- tigate fraud, and Mueller suggested that some prosecutions may be still to come.  Alberto Gonzales, the nation’s attorney general from February  to Septem- ber , told the Commission that while he might have done more on mortgage fraud, in hindsight he believed that other issues were more pressing: “I don’t think anyone can credibly argue that [mortgage fraud] is more important than the war on terror. Mortgage fraud doesn’t involve taking loss of life so it doesn’t rank above the priority of protecting neighborhoods from dangerous gangs or predators attacking our children.”  In , the Office of Federal Housing Enterprise Oversight, the regulator of the GSEs, released a report showing a “significant rise in the incidence of fraud in mort- gage lending in  and the first half of .” OFHEO stated it had been working closely with law enforcement and was an active member of the Department of Justice Mortgage Fraud Working Group.  “The concern about mortgage fraud and fraud in general was an issue,” Richard Spillenkothen, head of banking supervision and regu- lation at the Fed from  to , told the FCIC. “And we understood there was an increasing incidence of [mortgage fraud].”  Michael B. Mukasey, who served as U.S. attorney general from November  to the end of , told the Commission that he recalled “receiving reports of mort- gage failures and of there being fraudulent activity in connection with flipping houses, overvaluation, and the like. . . . I have a dim recollection of outside people commenting that additional resources should be devoted, and there being specula- tion about whether resources that were being diverted to national security investiga- tions, and in particular the terrorism investigations were somehow impeding fraud investigations, which I thought was a bogus issue.” He said that the department had other pressing priorities, such as terrorism, gang violence, and southwestern border issues.  In letters to the FCIC, the Department of Justice outlined actions it undertook along with the FBI to combat mortgage fraud. For example, in , the FBI launched Operation Continued Action, targeting a variety of financial crimes, in- cluding mortgage fraud. In that same year, the agency started to publish an annual mortgage fraud report. The following year, the FBI and other federal agencies an- nounced a joint effort combating mortgage fraud. From July to October , this program, Operation Quick Flip, produced  indictments,  arrests, and  convictions for mortgage fraud. In , the FBI started specifically tracking mort- gage fraud cases and increased personnel dedicated to those efforts. And in , Operation Malicious Mortgage resulted in  mortgage fraud cases in which  defendants were charged by U.S. Attorneys offices throughout the country.  William Black told the Commission that Washington essentially ignored the issue and allowed it to worsen. “The FBI did have severe limits,” because of the need to re- spond to the / attacks, Black said, and the problem was compounded by the lack of cooperation: “The terrible thing that happened was that the FBI got virtually no assistance from the regulators, the banking regulators and the thrift regulators.”  Swecker, the former FBI official, told the Commission he had no contact with bank- ing regulators during his tenure.  FinancialCrisisInquiry--698 CLOUTIER: I don’t think the regulators are very interested in starting any new banks. They have to deal with the current crisis they have, so there’s not a lot of new charters coming right now. Raising capital is still somewhat difficult in a new environment. You don’t raise that on Wall Street. You raise it in the communities. As I said in my opening statement, communities are very, very nervous. And there is a need for the loans. The problem is, is that a lot of the customers are very weak, and the scores have been increased. Let me—let me say one thing that the committee could ask Ms. Bair tomorrow when she testifies would be very interesting—I would love to know this myself—is, how many memorandums of understanding or cease-and-desist orders were put against the largest financial institutions in America versus the numbers that have been put against the community banks in America, percentage-wise? I can pretty much guess the percentage on the high end, on the higher bigger boys. And, I mean, once they come and threaten you with an MOU, they just shut down shop at the community banks. I’m being honest with you. They really do. FinancialCrisisInquiry--841 CLOUTIER: And I would—I would add, I’ve testified many times—I think, most probably, 13 times, here— but I remember one that sticks in my mind. Congressman Richard Baker was having a hearing. This was about 2001. January 13, 2010 And, Congressman Baker, if you remember, used to love to hold hearings on Fannie and Freddie. That was—he did a lot of that. And he talked about systemic risk. And—and the groups on the panel that day, in the—it was a large consumer group in the audience, complaining about Citigroup merging with another finance company, and that—their predatory lending practices they had. And, of course, you know, Congress said we’re going to get the Fed to look into it. Well, it never really came that way. It ended up being that the attorney general of New York, filed charges against them for their practices of credit life insurance, which they finally pled nolo contendere to and just moved on. So, you know, you’re absolutely right. There’s been a very lackadaisical treatment of that situation that continues to go on. As I said, a very interesting question for this commission. With all the problems you’ve heard about the large banks -- ask how many MOUs or cease-and-desists they’re under. I think the answer will be not many. fcic_final_report_full--109 In the same FCIC interview, Greenspan recalled that he sat in countless meetings on consumer protection, but that he couldn’t pretend to have the kind of expertise on this subject that the staff had.  Gramlich, who chaired the Fed’s consumer subcommittee, favored tighter super- vision of all subprime lenders—including units of banks, thrifts, bank holding com- panies, and state-chartered mortgage companies. He acknowledged that because such oversight would extend Fed authority to firms (such as independent mortgage companies) whose lending practices were not subject to routine supervision, the change would require congressional legislation “and might antagonize the states.” But without such oversight, the mortgage business was “like a city with a murder law, but no cops on the beat.”  In an interview in , Gramlich told the Wall Street Journal that he privately urged Greenspan to clamp down on predatory lending. Greenspan demurred and, lacking support on the board, Gramlich backed away. Gramlich told the Journal, “He was opposed to it, so I did not really pursue it.”  (Gramlich died in  of leukemia, at age .) The Fed’s failure to stop predatory practices infuriated consumer advocates and some members of Congress. Critics charged that accounts of abuses were brushed off as anecdotal. Patricia McCoy, a law professor at the University of Connecticut who served on the Fed’s Consumer Advisory Council between  and , was famil- iar with the Fed’s reaction to stories of individual consumers. “That is classic Fed mindset,” said McCoy. “If you cannot prove that it is a broad-based problem that threatens systemic consequences, then you will be dismissed.” It frustrated Margot Saunders of the National Consumer Law Center: “I stood up at a Fed meeting in  and said, ‘How many anecdotes makes it real? . . . How many tens [of] thousands of anecdotes will it take to convince you that this is a trend?’”  The Fed’s reluctance to take action trumped the  HUD-Treasury report and reports issued by the General Accounting Office in  and .  The Fed did not begin routinely examining subprime subsidiaries until a pilot program in July , under new chairman Ben Bernanke.  The Fed did not issue new rules under HOEPA until July , a year after the subprime market had shut down. These rules banned deceptive practices in a much broader category of “higher-priced mortgage loans”; moreover, they prohibited making those loans without regard to the borrower’s ability to pay, and required companies to verify income and assets.  The rules would not take effect until October , , which was too little, too late. FOMC20071031meeting--98 96,MR. ROSENGREN.," I had a follow-up question on nonresidential structures. You talked about drilling and mining, and I was wondering about the other parts of commercial real estate. Was anything in there? I don’t know if you had a chance to look at it, but the reason I ask is that, if you thought financing was starting to become a problem and you do have very weak nonresidential investment going forward, you would expect to start seeing it there. So I’m wondering if anything was in that breakout. I have a second question, which is that you didn’t mention durable goods. But if I thought that credit problems, particularly subprime and other things, were starting to create issues, I would expect to start seeing more imprints in the data for some of the durable goods. So was seeing durable goods a little stronger in the consumption figures a surprise at all?" CHRG-111hhrg54872--243 The Chairman," If the gentlewoman would yield her remaining time--and I appreciate her raising that question. While there is no usury flat prohibition, I believe that you could not deal with unfairness without taking into account duration, interest rate, etc., and I believe the legislation should be clarified to make it clear that that could be an element in an overall judgment this was an unfair and abusive practice. So that will be. Ms. Speier. I have an amendment in mind. " CHRG-110hhrg41184--117 Mr. Bernanke," So we are able to address certain practices of billing, rate setting, rate changing and so on, and in terms of the delay issue, as I mentioned earlier, we will have some rules under this authority out for your examination, and for public comment, sometime this spring, just a few months from now. So you will see what we're able to do with that, and you'll have to make your decision whether or not more action by Congress is needed. " CHRG-111shrg50564--23 Mr. Volcker," That is true. Then you have to consider how the systemic risk regulator matches up with the other prudential regulators. There are very interesting questions here. The G-30 issued a report, a rather detailed report, a year or so ago or 9 months ago, on different regulatory practices around the world, which raised the questions that you are raising, and almost all countries are struggling with these questions now. " CHRG-111hhrg48873--153 Secretary Geithner," Our immediate priority is to lay out guidelines to apply the new legislative requirements on compensation that were passed as part of the American Recovery and Reinvestment Act, but we are going to move quickly, we hope, to lay out broad standards that help govern compensation practices in the future, beyond those that would apply to institutions that receive taxpayer assistance. " CHRG-111shrg50815--2 Chairman Dodd," The Committee will come to order. My apologies to our witnesses and my colleagues. Today is the 200th anniversary of Abraham Lincoln's birthday and I took my daughter up to Lincoln's cottage this morning up at the Old Soldier's Home where there was a ceremony this morning to unveil a wonderful statue of Abraham Lincoln and his horse Old Boy that he used to ride every morning for about a quarter of his Presidency from the White House to the Old Soldiers Home where he lived for a quarter of that Presidency and he wrote the Emancipation Proclamation. So I thought I would take my daughter out of school this morning for a bit of history and I am sorry to be a few minutes late getting back here this morning, so apologies to everybody for being a few minutes late for enjoying a moment of history with a 7-year-old. Well, let me begin with some opening comments, if I can. I will turn to Senator Shelby. We are honored to have such a distinguished panel of witnesses with us this morning on an issue that many of my colleagues know has been a source of interest of mine for literally two decades, the issue of reform of the credit card industry. And so this hearing this morning will give us a chance to reengage in that debate and discussion, and I want my colleagues to know at some point, and I say this to my good friend, the former Chairman of the Committee, at some point, I would like to be able to mark up a bill in this area. I know he knows that, but I wanted to say so publicly. So good morning to everyone, and today the Committee meets to look into an issue of vital importance to American consumers, their families, and to the stability of our financial system, and that is the need to reform the practices of our nation's credit card companies and to provide some tough new protections for consumers. In my travels around my State, as I am sure it is true of my colleagues, as well, we frequently hear from constituents about the burden of abusive credit card practices. In fact, the average amount of household credit card debt in my State is over $7,100. Actually, the number is higher, I think, nationally. Non-business bankruptcy filings in the State are increasing. In the second quarter of last year, credit card delinquencies increased in seven of eight counties in my State. Across the country, cardholders are paying $12 billion in penalty fees annually, every year. It is a major problem throughout our nation. At a time when our economy is in crisis and consumers are struggling financially, credit card companies in too many cases are gouging, hiking interest rates on consumers who pay on time and consistently meet the terms of their credit card agreements. They impose penalty interest rates, some as high as 32 percent, and many contain clauses allowing them to change the terms of the agreement, including the interest rate, at any time, for any reason. These practices can leave mountains of debt for families and financial ruin in far too many cases. When I introduced Secretary Geithner earlier this week as he unveiled the framework of the President's plan to stabilize our financial system, I noted then for too long, our leading regulators had failed fully to realize that financial health and security of the consumers is inextricably linked to the success of the American economy. In fact, for too many years, I think people assumed that consumer protection and economic growth were antithetical to each other. Quite the opposite is true. I noted that unless we apply the same urgent focus to helping consumers that we apply to supporting our banks' efforts to restart lending, we will not be able to break the negative cycle of rising foreclosures and declining credit that is damaging our economy. In this hearing, the Committee examines abusive credit card practices that harm consumers and explores some very specific legislative ideas to end them. These kinds of consumer protections must be at the forefront of our efforts to modernize our financial regulatory system. Why is this both important and urgent? Well, today, far too many American families are forced to rely on short-term, high-interest credit card debt to finance their most basic necessities. And as layoffs continue, home values plunge, and home equity lines of credit are cut or canceled, they are increasingly falling behind. This December, the number of credit card payments that were late by 60 days or more went up 16.2 percent from last year. Banks increasingly worried about taking more debt, bad debt, into their balance sheets are monitoring their credit card portfolios very closely, slashing credit lines and increasing fees and interest rates even more for consumers who have held up their end of the bargain. That puts consumers, including many of my constituents and others around the country, in the worst possible position at the worst possible time. For too long, the use of confusing, misleading, and predatory practices have been standard operating procedures for many in the credit card industry. The list of troubling practices that credit card companies are engaged in is lengthy and it is disturbing: Predatory rates, fees, and charges; anytime, any reason interest rate increases and account charges; retroactive interest rate increases; deceptive marketing to young people; shortening the period consumers have to pay their bills with no warning. Even the Federal financial regulators, of whom I have been openly critical for a lack of appropriate oversight throughout this subprime mortgage market crisis, recognize the harm these sinister practices pose not only to credit card customers, but also to our economy. Last May, the Federal Reserve, the Office of Thrift Supervision, and the National Credit Union Administration proposed rules aimed at curbing some of these practices. These rules were a good step and I applaud them, but they are long overdue. But they fell far short of what is actually needed, in my view, to protect American families. Just as we have seen in this housing crisis, when companies lure people into financial arrangements that are deceptive, abusive, and predatory, it only means mountains of debt for families, bankruptcy, and financial ruin for far too many. It also proved catastrophic, of course, for our economy. Today as the Committee examines how best to modernize and reform our outdated and ineffective financial regulatory system, we have a clear message to send to the industry. Your days of bilking American families at the expense of our economy are over. Today, we will discuss proposals to reform abusive credit card practices that drag so many American families deeper and deeper and deeper into debt, including the Credit Card Accountability, Responsibility, and Disclosure Act, which I recently reintroduced. We must protect the rights of financially responsible credit card users so that if a credit card company delayed crediting your payment, you aren't charged for this mistake. We must prevent issuers from changing the terms of a credit card contract before the term is up. And perhaps most importantly, we must protect our young people who are faced with an onslaught of credit card offers, often years before they turn 18, or as soon as they set foot onto a college campus. These practices are wrong and they are unfair. And mark my words, in the coming months, they are going to end. Of course, we must do all we can to encourage consumers to also act responsibly when it comes to using credit cards. But we should demand such responsible behavior when it comes to the companies that issue these cards, as well. The need to reform credit card practice has never been more important. It is not only the right thing to do for families and our consumers, it is the right thing to do for our economy, as well. I have been working on reforms in this area for many, many years and I am determined to move forward on these reforms. With that, let me turn to our former Chairman and Ranking Member, Richard Shelby. FinancialCrisisReport--124 In July 2007, Moody’s and S&P downgraded the credit ratings of hundreds of subprime RMBS and CDO securities, due to rising mortgage delinquencies and defaults. Included were approximately 40 Long Beach securities. 446 A July 12, 2007 presentation prepared by Moody’s to explain its ratings action shows that Long Beach was responsible for only 6% of all the subprime RMBS securities issued in 2006, but received 14% of the subprime RMBS ratings downgrades that day. 447 Only Fremont had a worse ratio. Over time, even AAA rated Long Beach securities performed terribly. Of the 75 Long Beach mortgage backed security tranches rated AAA by Standard and Poor’s in 2006, all 75 have been downgraded to junk status, defaulted, or been withdrawn. 448 In most of the 2006 Long Beach securitizations, the underlying loans have delinquency rates of 50% or more. 449 The problems were not confined to Long Beach loans. In early 2008, for example, an investment adviser posted information on his personal blog about a WaMu-sponsored RMBS securitization known as WMALT 2007-OC1. Formed in May 2007, this pool contained about 1,700 Alt A loans with a total outstanding balance of about $515 million. WaMu was the sole underwriter. The credit rating agencies gave AAA and other investment grade ratings to more than 92% of the securitization, but within eight months, 15% of the pool was in foreclosure. The posting suggested that the poor performance of WaMu securities was systemic. When informed by David Schneider of the complaint about the negative publicity surrounding the pool, David Beck responded: “Yes (ughh!) we are doing some peer group performance and looking at the servicing data … and putting together an analysis. … The collateral is full of limited doc layered risk alt a paper and at least half is TPO [third party originated]. The performance is not great but my opinion is not a WaMu specific issue.” 450 445 “WaMu subprime ABS delinquencies top ABX components,” Reuters (3/27/2007), Hearing Exhibit 4/13-52. 446 7/10/2007-7/12/2007 excerpts from Standard & Poor’s and Moody’s Downgrades, Hearing Exhibit 4/23-99. 447 7/12/2007 “Moody’s Structured Finance Teleconference and Web Cast: RMBS and CDO Rating Actions,” MOODYS-PSI2010-0046902, Hearing Exhibit 4/23-106. 448 See Standard and Poor’s data at www.globalcreditportal.com. 449 See, e.g., wamusecurities.com (subscription website maintained by JPMorgan Chase with data on Long Beach and WaMu mortgage backed securities showing, as of March 2011, delinquency rates for particular mortgage backed securities, including LBMLT 2006-1 – 58.44%; LBMLT 2006-6 – 60.06%; and LBMLT 2005-11 – 54.32%). 450 2/2/2008 email from David Beck to David Schneider and others, JPM_WM02445758, Hearing Exhibit 4/13-51. CHRG-111shrg54789--79 Mr. Barr," Thank you, Senator. Our judgment is that the new agency will have the ability to set high standard across the financial services marketplace, including for mortgages, that we will continue to see innovation in the mortgage sector, but that if firms want to offer products that are difficult for consumers to understand, there will be a higher burden on them to explain those products and services. And I think that we have seen the consequences of a system in which there is inadequate supervision of those kinds of practices. So I do think we are going to see a rebalancing, if you will, where it is a much lighter regulatory burden even than we have today with respect to straightforward products. So you can do things like combine the Truth in Lending Form and the Real Estate Settlement Practices Form into one simple Mortgage Disclosure Form everybody can use. That is easy under the new approach, very hard under the current approach. It is a way of reducing regulatory burden for banks, improving disclosure for consumers. We can see a lot of that happening in this space with the new agency. Senator Johnson. My time is up. " CHRG-111shrg56376--53 Mr. Tarullo," Senator, as you know, I agree, personally--it is not a Board position--with you that the Fed took too long to use its existing authority to enact consumer protection associated with mortgages. I was referring a few moments ago--and I will elaborate on it now--to the authority to provide consolidated supervision for any systemically important institution. As you know, a year-and-a-half ago, that statement would have, in practical terms, meant that a whole set of institutions--at that point, the five free-standing investment banks--would likely have been brought in by law to the consolidate supervision program. Because of the financial crisis, and the fact that a couple of those institutions are no longer with us and others have become bank holding companies, the immediate practical importance of the authority would not be as great as it would have been a year-and-a-half or 2 years ago. However, there is first the possibility that an institution which has become a bank holding company in the middle of the crisis, in an effort to get the imprimatur of having consolidated supervision, would, when things calm down, decide it does not so much like being a supervised entity, so it would dis-elect being a holding company. Senator Bunning. We could prevent that. " CHRG-111shrg52619--197 RESPONSE TO WRITTEN QUESTIONS OF SENATOR REED FROM DANIEL K. TARULLOQ.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. Chair Bair's written testimony for today's hearing put it very well: `` . . . the success of any effort at reform will ultimately rely on the willingness of regulators to use their authorities more effectively and aggressively.'' 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. Changing regulatory structures and--for that matter--augmenting existing regulatory authorities are necessary, but not sufficient, steps to engender strong and effective financial regulation. The regulatory orientation of agency leadership and staff are also central to achieving this end. While staff capacities and expertise will generally not deteriorate (or improve) rapidly, leadership can sometimes change extensively and quickly. While this fact poses a challenge in organizing regulatory systems, there are some things that can be done. Perhaps most important is that responsibilities and authorities be both clearly defined and well-aligned, so that accountability is clear. Thus, for example, assigning a particular type of rulemaking and rule implementation to a specific agency makes very clear who deserves either blame or credit for outcomes. Where a rulemaking or rule enforcement process is collective, on the other hand, the apparent shared responsibility may mean in practice that no one is responsible: Procedural delays and substantive outcomes can also be attributed to someone else's demands or preferences. When responsibility is assigned to an agency, the agency should be given adequate authority to execute that responsibility effectively. In this regard, Congress may wish to review the Gramm-Leach-Bliley Act and other statutes to ensure that authorities and responsibilities are clearly defined for both primary and consolidated supervisors of financial firms and their affiliates. Some measure of regulatory overlap may be useful in some circumstances--a kind of constructive redundancy--so long as both supervisors have adequate incentives for balancing various policy objectives. But if, for example, access to information is restricted or one supervisor must rely on the judgments of the other, the risk of misaligned responsibility and authority recurs.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. Your questions highlight a very real and important issue--how best to ensure that financial supervisors exercise the tools at their disposal to address identified risk management weaknesses at an institution or within an industry even when the firm, the industry, and the economy are experiencing growth and appear in sound condition. In such circumstances, there is a danger that complacency or a belief that a ``rising tide will lift all boats'' may weaken supervisory resolve to forcefully address issues. In addition, the supervisor may well face pressure from external sources--including the supervised institutions, industry or consumer groups, or elected officials--to act cautiously so as not to change conditions perceived as supporting growth. For example, in 2006, the Federal Reserve, working in conjunction with the other federal banking agencies, developed guidance highlighting the risks presented by concentrations in commercial real estate. This guidance drew criticism from many quarters, but is particularly relevant today given the substantial declines in many regional and local commercial real estate markets. Although these dangers and pressures are to some degree inherent in any regulatory framework, there are ways these forces can be mitigated. For example, sound and effective leadership at any supervisory agency is critical to the consistent achievement of that agency's mission. Moreover, supervisory agencies should be structured and funded in a manner that provides the agency appropriate independence. Any financial supervisory agency also should have the resources, including the ability to attract and retain skilled staff, necessary to properly monitor, analyze and--when necessary--challenge the models, assumptions and other risk management practices and internal controls of the firms it supervises, regardless of how large or complex they may be. Ultimately, however, supervisors must show greater resolve in demanding that institutions remain in sound financial condition, with strong capital and liquidity buffers, and that they have strong risk management. While these may sound like obvious statements in the current environment, supervisors will be challenged when good times return to the banking industry and bankers claim that they have learned their lessons. At precisely those times, when bankers and other financial market actors are particularly confident, when the industry and others are especially vocal about the costs of regulatory burden and international competitiveness, and when supervisors cannot yet cite recognized losses or writedowns, regulators must be firm in insisting upon prudent risk management. Once again, regulatory restructuring can he helpful, but will not be a panacea. Financial regulators should speak with one, strong voice in demanding that institutions maintain good risk management practices and sound financial condition. We must be particularly attentive to cases where different agencies could be sending conflicting messages. Improvements to the U.S. regulatory structure could provide added benefit by ensuring that there are no regulatory gaps in the U.S. financial system, and that entities cannot migrate to a different regulator or, in some cases, beyond the boundary of any regulation, so as to place additional pressure on those supervisors who try to maintain firm safety and soundness policies.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? While we know that certain hedge funds, for example, have failed, have any of them contributed to systemic risk? 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.3. My expectation is that, when the history of this financial crisis and its origins is ultimately written, culpability will be shared by essentially every part of the government responsible for constructing and implementing financial regulation, as well as many financial institutions themselves. Since just about all financial institutions have been adversely affected by the financial crisis, all supervisors have lessons to learn from this crisis. The Federal Reserve is already implementing a number of changes, such as enhancing risk identification processes to more quickly detect emerging risks, not just at individual institutions but across the banking system. This latter point is particularly important, related as it is to the emerging consensus that more attention must be paid to risks created across institutions. The Board is also improving the processes to issue supervisory guidance and policies to make them more timely and effective. In 2008 the Board issued supervisory guidance on consolidated supervision to clarify the Federal Reserve's role as consolidated supervisor and to assist examination staff as they carry out supervision of banking institutions, particularly large, complex firms with multiple legal entities. With respect to hedge funds, although their performance was particularly poor in 2008, and several large hedge funds have failed over the past 2 years, to date none has been a meaningful source of systemic risk or resulted in significant losses to their dealer bank counterparties. Indirectly, the failure of two hedge funds in 2007 operated by Bear Stearns might be viewed as contributing to the ultimate demise of that investment bank 9 months later, given the poor quality of assets the firm had to absorb when it decided to support the funds. However, these failures in and of themselves were not the sole cause of Bear Stearns' problems. Of course, the experience with Long Term Capital Management in 1998 stands as a reminder that systemic risk can be associated with the activities of large, highly leveraged hedge funds. On-site examiners of the federal banking regulators did identify a number of issues prior to the current crisis, and in some cases developed policies and guidance for emerging risks and issues that warranted the industry's attention--such as in the areas of nontraditional mortgages, home equity lending, and complex structured financial transactions. But it is clear that examiners should have been more forceful in demanding that bankers adhere to policies and guidance, especially to improve their own risk management capacities. Going forward, changes have been made in internal procedures to ensure appropriate supervisory follow-through on issues that examiners do identify, particularly during good times when responsiveness to supervisory policies and guidance may be lower.Q.4. While I think having a systemic risk regulator is important, I have concerns with handing additional authorities to the Federal Reserve after hearing GAO's testimony yesterday at my subcommittee hearing. Some of the Fed's supervision authority currently looks a lot like what it might conduct as a systemic risk regulator, and the record there is not strong from what I have seen. If the Federal Reserve were to be the new systemic risk regulator, has there been any discussion of forming a board, similar to the Federal Open Market Committee, that might include other regulators and meet quarterly to discuss and publicly report on systemic risks? If the Federal Reserve were the systemic risk regulator, would it conduct horizontal reviews that it conducts as the supervisor for bank holding companies, in which it looks at specific risks across a number of institutions? If so, and given what we heard March 18, 2009, at my subcommittee hearing from GAO about the weaknesses with some of the Fed's follow-up on reviews, what confidence can we have that the Federal Reserve would do a better job than it has so far?A.4. In thinking about reforming financial regulation, it may be useful to begin by identifying the desirable components of an agenda to contain systemic risk, rather than with the concept of a specific systemic risk regulator. In my testimony I suggested several such components--consolidated supervision of all systemically important financial institutions, analysis and monitoring of potential sources of systemic risk, special capital and other rules directed at systemic risk, and authority to resolve nonbank, systemically important financial institutions in an orderly fashion. As a matter of sound administrative structure and practice, there is no reason why all four of these tasks need be assigned to the same agency. Indeed, there may be good reasons to separate some of these functions--for example, conflicts may arise if the same agency were to be both a supervisor of an institution and the resolution authority for that institution if it should fail. Similarly, there is no inherent reason why an agency charged with enacting and enforcing special rules addressed to systemic risk would have to be the consolidated supervisor of all systemically important institutions. If another agency had requisite expertise and experience to conduct prudential supervision of such institutions, and so long as the systemic risk regulator would have necessary access to information through examination and other processes and appropriate authority to address potential systemic risks, the roles could be separated. For example, were Congress to create a federal insurance regulator with a safety and soundness mission, that regulator might be the most appropriate consolidated supervisor for nonbank holding company firms whose major activities are in the insurance area. With respect to analysis and monitoring, it would seem useful to incorporate an interagency process into the framework for systemic risk regulation. Identification of inchoate or incipient systemic risks will in some respects be a difficult exercise, with a premium on identifying risk correlations among firms and markets. Accordingly, the best way to incorporate more expertise and perspectives into the process is through a collective process, perhaps a designated sub-group of the President's Working Group on Financial Markets. Because the aim, of this exercise would be analytic, rather than regulatory, there would be no problem in having both executive departments and independent agencies cooperating. Moreover, as suggested in your question, it may be useful to formalize this process by having it produce periodic public reports. An additional benefit of such a process would be that to allow nongovernmental analysts to assess and, where appropriate, critique these reports. As to potential rule-making, on the other hand, experience suggests that a single agency should have both authority and responsibility. While it may be helpful for a rule-maker to consult with other agencies, having a collective process would seem a prescription for delay and for obscuring accountability. Regardless of whether the Federal Reserve is given additional responsibilities, we will continue to conduct horizontal reviews. Horizontal reviews of risks, risk management practices and other issues across multiple financial firms are very effective vehicles for identifying both common trends and institution-specific weaknesses. The recently completed Supervisory Capital Assessment Program (SCAP) demonstrates the effectiveness of such reviews and marked an important evolutionary step in the ability of such reviews to enhance consolidated supervision. This exercise was significantly more comprehensive and complex than horizontal supervisory reviews conducted in the past. Through these reviews, the Federal Reserve obtained critical perspective on the capital adequacy and risk management capabilities of the 19 largest U.S. bank holding companies in light of the financial turmoil of the last year. While the SCAP process was an unprecedented supervisory exercise in an unprecedented situation, it does hold important lessons for more routine supervisory practice. The review covered a wide range of potential risk exposures and available firm resources. Prior supervisory reviews have tended to focus on fewer firms, specific risks and/or individual business lines, which likely resulted in more, ``siloed'' supervisory views. A particularly innovative and effective element of the SCAP review was the assessment of individual institutions using a uniform set of supervisory devised stress parameters, enabling better supervisory targeting of institution-specific strengths and weaknesses. Follow-up from these assessments was rapid, and detailed capital plans for the institutions will follow shortly. As already noted, we expect to incorporate lessons from this exercise into our consolidated supervision of bank holding companies. In addition, though, the SCAP process suggests some starting points for using horizontal reviews in systemic risk assessment. Regarding your concerns about the Federal Reserve's performance in the run-up to the financial crisis, we are in the midst of a comprehensive review of all aspects of our supervisory practices. Since last year, Vice Chairman Kohn has led an effort to develop recommendations for improvements in our conduct of both prudential supervision and consumer protection. We are including advice from the Government Accountability Office, the Congress, the Treasury, and others as we look to improve our own supervisory practices. Among other things, our analysis reaffirms that capital adequacy, effective liquidity planning, and strong risk management are essential for safe and sound banking; the crisis revealed serious deficiencies on the part of some financial institutions in one or more of the areas. The crisis has likewise underscored the need for more coordinated, simultaneous evaluations of the exposures and practices of financial institutions, particularly large, complex firms.Q.5. Mr. Tarullo, the Federal Reserve has been at the forefront of encouraging countries to adopt Basel II risk-based capital requirements. This model requires, under Pillar I of Basel II, that risk-based models calculate required minimum capital. It appears that there were major problems with these risk management systems, as I heard in GAO testimony at my subcommittee hearing on March l8th, 2009, so what gave the Fed the impression that the models were ready enough to be the primary measure for bank capital? Moreover, how can the regulators know what ``adequately capitalized'' means if regulators rely on models that we now know had material problems?A.5. The current status of Basel II implementation is defined by the November 2007 rule that was jointly issued by the Office of the Comptroller of the Currency, Federal Deposit Insurance Corporation, Office of Thrift Supervision, and Federal Reserve Board. Banks will not be permitted to operate under the advanced approaches until supervisors are confident the underlying models are functioning in a manner that supports using them as basis for determining inputs to the risk-based capital calculation. The rule imposes specific model validation, stress testing, and internal control requirements that a bank must meet in order to use the Basel II advanced approaches. In addition, a bank must demonstrate that its internal processes meet all of the relevant qualification requirements for a period of at least 1 year (the parallel run) before it may be permitted by its supervisor to begin using those processes to provide inputs for its risk-based capital requirements. During the first 3 years of applying Basel II, a bank's regulatory capital requirement would not be permitted to fall below floors established by reference to current capital rules. Moreover, banks will not be allowed to exit this transitional period if supervisors conclude that there are material deficiencies in the operation of the Basel II approach during these transitional years. Finally, supervisors have the continued authority to require capital beyond the minimum requirements, commensurate with a bank's credit, market, operational, or other risks. Quite apart from these safeguards that U.S. regulators will apply to our financial institutions, the Basel Committee has undertaken initiatives to strengthen capital requirements--both those directly related to Basel II and other areas such as the quality of capital and the treatment of market risk. Staff of the Federal Reserve and other U.S. regulatory agencies are participating fully in these reviews. Furthermore, we have initiated an internal review on the pace and nature of Basel II implementation, with particular attention to how the long-standing debate over the merits and limitations of Basel II has been reshaped by experience in the current financial crisis. While Basel II was not the operative capital requirement for U.S. banks in the prelude to the crisis, or during the crisis itself, regulators must understand how it would have made things better or worse before permitting firms to use it as the basis for regulatory capital requirements. ------ fcic_final_report_full--470 First, the gradual increase of the AH goals, the competition between the GSEs and the FHA, the effect of HUD’s Best Practices Initiative, and bank lending under the CRA, assured a continuing flow of funds into weaker and weaker mortgages. This had the effect of extending the life of the housing bubble as well as increasing its size. The growth of the bubble in turn disguised the weakness of the subprime mortgages it contained; as housing prices rose, subprime borrowers who might otherwise have defaulted were able to refinance their mortgages, using the equity that had developed in their homes solely through rising home prices. Without the continuous infusion of government or government-directed funds, delinquencies and defaults would have begun showing up within a year or two, bringing the subprime PMBS market to a halt. Instead, the bubble lasted ten years, permitting that market to grow until it reached almost $2 trillion. Second, as housing prices rose in the bubble, it was necessary for borrowers to seek riskier mortgages so they could afford the monthly payments on more expensive homes. This gave rise to new and riskier forms of mortgage debt, such as option ARMs (resulting in negative amortization) and interest-only mortgages. Mortgages of this kind could be suitable for some borrowers, but not for those who were only eligible for subprime loans. Nevertheless, subprime loans were necessary for PMBS, because they generally bore higher interest rates and thus could support the yields that investors were expecting. As subprime loans were originated, Fannie and Freddie were willing consumers of those that might meet the AH goals; moreover, because of their lower cost of funds, they were able to buy the “best of the worst,” the highest quality among the NTMs on offer. These factors—the need for higher yielding loans and the ability of Fannie and Freddie to pay up for the loans they wanted—drove private sector issuers further out on the risk curve as they sought to meet the demands of investors who were seeking exposure to subprime PMBS. From the investors’ perspective, as long as the bubble kept growing, PMBS were offering the high yields associated with risk but were not showing commensurate numbers of delinquencies and defaults. 5. What was Known About NTMs Prior to the Crisis? Virtually everyone who testified before the Commission agreed that the financial crisis was initiated by the mortgage meltdown that began when the housing bubble began to deflate in 2007. None of these witnesses, however, including the academics consulted by the Commission, the representatives of the rating agencies, the offi cers of financial institutions that were ultimately endangered by the mortgage downdraft, regulators and supervisors of financial institutions and even the renowned investor Warren Buffett, 33 seems to have understood the dimensions 33 See Buffett, testimony before the FCIC, June 2, 2010. 465 of the NTM problem or recognized its significance before the bubble deflated. The Commission majority’s report notes that “there were warning signs.” There always are if one searches for them; they are most visible in hindsight, in which the Commission majority, and many of the opinions it cites for this proposition, happily engaged. However, as Michael Lewis’s acclaimed book, The Big Short , showed so vividly, very few people in the financial world were actually willing to bet money— even at enormously favorable odds—that the bubble would burst with huge losses. Most seem to have assumed that NTMs were present in the financial system, but not in unusually large numbers. CHRG-111shrg54789--179 REGULATORS Current regulators may already have some of the powers that the new agency would be given, but they haven't used them. Conflicts of interest and a lack of will work against consumer enforcement. In this section, we detail numerous actions and inactions by the Federal banking regulators that have led to or encouraged unfair practices, higher prices for consumers, and less competition.A. The Federal Reserve Board ignored the growing mortgage crisis for years after receiving Congressional authority to enact antipredatory mortgage lending rules in 1994. The Federal Reserve Board was granted sweeping antipredatory mortgage regulatory authority by the 1994 Home Ownership and Equity Protection Act (HOEPA). Final regulations were issued on 30 July 2008 only after the world economy had collapsed due to the collapse of the U.S. housing market triggered by predatory lending. \47\--------------------------------------------------------------------------- \47\ 73 FR 147, p. 44522, Final HOEPA Rule, 30 July 2008.---------------------------------------------------------------------------B. At the same time, the Office of the Comptroller of the Currency engaged in an escalating pattern of preemption of State laws designed to protect consumers from a variety of unfair bank practices and to quell the growing predatory mortgage crisis, culminating in its 2004 rules preempting both State laws and State enforcement of laws over national banks and their subsidiaries. In interpretation letters, amicus briefs and other filings, the OCC preempted State laws and local ordinances requiring lifeline banking (NJ 1992, NY, 1994), prohibiting fees to cash ``on-us'' checks (par value requirements) (TX, 1995), banning ATM surcharges (San Francisco, Santa Monica and Ohio and Connecticut, 1998-2000), requiring credit card disclosures (CA, 2003) and opposing predatory lending and ordinances (numerous States and cities). \48\ Throughout, OCC ignored Congressional requirements accompanying the 1994 Riegle-Neal Act not to preempt without going through a detailed preemption notice and comment procedure, as the Congress had found many OCC actions ``inappropriately aggressive.'' \49\--------------------------------------------------------------------------- \48\ ``Role of the Office of Thrift Supervision and Office of the Comptroller of the Currency in the Preemption of State Law'', USGAO, prepared for Financial Services Committee Chairman James Leach, 7 February 2000, available at http://www.gao.gov/corresp/ggd-00-51r.pdf (last visited 21 June 2009). \49\ Statement of managers filed with the conference report on H.R. 3841, the Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994, Congressional Record Page S10532, 3 August 1994.--------------------------------------------------------------------------- In 2000-2004, the OCC worked with increasing aggressiveness to prevent the States from enforcing State laws and stronger State consumer protection standards against national banks and their operating subsidiaries, from investigating or monitoring national banks and their operating subsidiaries, and from seeking relief for consumers from national banks and subsidiaries. These efforts began with interpretative letters stopping State enforcement and State standards in the period up to 2004, followed by OCC's wide-ranging preemption regulations in 2004 purporting to interpret the National Bank Act, plus briefs in court cases supporting national banks' efforts to block State consumer protections. We discuss these matters in greater detail below, in Section 5, rebutting industry arguments against the CFPA.C. The agencies took little action except to propose greater disclosures, as unfair credit card practices increased over the years, until Congress stepped in. Further, between 1995 and 2007, the Office of the Comptroller of Currency issued only one public enforcement action against a Top Ten credit card bank (and then only after the San Francisco District Attorney had brought an enforcement action). In that period, ``the OCC has not issued a public enforcement order against any of the eight largest national banks for violating consumer lending laws.'' \50\ The OCC's failure to act on rising credit card complaints at the largest national banks triggered Congress to investigate, resulting in passage of the 2009 Credit Card Accountability, Responsibility and Disclosure Act (CARD Act). \51\ While this Committee was considering that law, other Federal regulators finally used their authority under the Federal Trade Commission Act to propose and finalize a similar rule. \52\ By contrast, the OCC requested the addition of two significant loopholes to a key protection of the proposed rule.--------------------------------------------------------------------------- \50\ Testimony of Professor Arthur Wilmarth, 26 April 2007, before the Subcommittee on Financial Institutions and Consumer Credit, hearing on Credit Card Practices: Current Consumer and Regulatory Issues at http://www.house.gov/financialservices/hearing110/htwilmarth042607.pdf. \51\ H.R. 627 was signed into law by President Obama as Pub. L. No. 111-24 on 22 May 2009. \52\ The final rule was published in the Federal Register a month later. 74 FR 18, page 5498 Thursday, January 29, 2009.--------------------------------------------------------------------------- Meanwhile, this Committee and its Subcommittee on Financial Institutions and Consumer Credit had conducted numerous hearings on the impact of current credit card issuer practices on consumers. The Committee heard testimony from academics and consumer representatives regarding abusive lending practices that are widespread in the credit card industry, including: The unfair application of penalty and ``default'' interest rates that can rise above 30 percent; Applying these interest rate hikes retroactively on existing credit card debt, which can lead to sharp increases in monthly payments and force consumers on tight budgets into credit counseling and bankruptcy; High and increasing ``penalty'' fees for paying late or exceeding the credit limit. Sometimes issuers use tricks or traps to illegitimately bring in fee income, such as requiring that payments be received in the late morning of the due date or approving purchases above the credit limit; Aggressive credit card marketing directed at college students and other young people; Requiring consumers to waive their right to pursue legal violations in the court system and forcing them to participate in arbitration proceedings if there is a dispute, often before an arbitrator with a conflict of interest; and Sharply raising consumers' interest rates because of a supposed problem a consumer is having paying another creditor. Even though few credit card issuers now admit to the discredited practice of ``universal default,'' eight of the ten largest credit card issuers continue to permit this practice under sections in cardholder agreements that allow issuers to change contract terms at ``any time for any reason.'' \53\--------------------------------------------------------------------------- \53\ Testimony of Linda Sherry of Consumer Action, House Subcommittee on Financial Institutions and Consumer Credit, April 26, 2007. In contrast to this absence of public enforcement action by the OCC against major national banks, State officials and other Federal agencies have issued numerous enforcement orders against leading national banks or their affiliates, including Bank of America, Bank One, Citigroup, Fleet, JPMorgan Chase, and USBancorp--for a wide variety of abusive practices over the past decade. \54\--------------------------------------------------------------------------- \54\ Testimony of Arthur E. Wilmarth, Jr., Professor of Law, George Washington University Law School, April 26, 2007.--------------------------------------------------------------------------- The OCC and PRB were largely silent while credit card issuers expanded efforts to market and extend credit at a much faster speed than the rate at which Americans have taken on credit card debt. This credit expansion had a disproportionately negative effect on the least sophisticated, highest risk and lowest income households. It has also resulted in both relatively high losses for the industry and record profits. That is because, as mentioned above, the industry has been very aggressive in implementing a number of new--and extremely costly--fees and interest rates. \55\ Although the agencies did issue significant guidance in 2003 to require issuers to increase the size of minimum monthly payments that issuers require consumers to pay, \56\ neither agency has proposed any actions (or asked for the legal authority to do so) to rein in aggressive lending or unjustifiable fees and interest rates.--------------------------------------------------------------------------- \55\ Testimony of Travis B. Plunkett of the Consumer Federation of America, Senate Banking Committee, January 25, 2007. \56\ Joint press release of Board of Governors of the Federal Reserve System, Federal Deposit Insurance Corporation, Office of the Comptroller of the Currency and Office of Thrift Supervision, ``FFIEC Agencies Issue Guidance on Credit Card Account Management and Loss Allowance Practices,'' January 8, 2003, see attached ``Account Management and Loss Allowance Guidance'' at 3.--------------------------------------------------------------------------- In addition, in 1995 the OCC amended a rule, with its action later upheld by the Supreme Court, \57\ that allowed credit card banks to export fees nationwide, as if they were interest, resulting in massive increases in the size of penalty late and overdraft fees.--------------------------------------------------------------------------- \57\ The rule is at 12 C.F.R. 7.4001(a). The case is Smiley v. Citibank, 517 U.S. 735.---------------------------------------------------------------------------D. The Federal Reserve has allowed debit card cash advances (overdraft loans) without consent, contract, cost disclosure, or fair repayment terms. The FRB has refused to require banks to comply with the Truth in Lending Act (TILA) when they loan money to customers who are permitted to overdraw their accounts. While the FRB issued a staff commentary clarifying that TILA applied to payday loans, the Board has refused in several proceedings to apply the same rules to banks that make nearly identical loans. \58\ As a result, American consumers spend at least $17.5 billion per year on cash advances from their banks without signing up for the credit and without getting cost-of-credit disclosures or a contract stating that the bank would in fact pay overdrafts. Consumers are induced to withdraw more cash at ATMs than they have in their account and spend more than they have with debit card purchases at point of sale. In both cases, the bank could simply deny the transaction, saving consumers average fees of $35 each time.--------------------------------------------------------------------------- \58\ National Consumer Law Center and Consumer Federation of America, Comments to the Federal Reserve Board, Docket No. R-1136, January 27, 2003. Appendix ``Bounce Protection: How Banks Turn Rubber Into Gold by Enticing Consumers To Write Bad Checks.'' Also, CFA, Consumers Union, and U.S. Public Interest Research Group, Supplemental Comments relating to Docket R-1136, May 2, 2003. CFA, et al. Comments to the Federal Reserve System, 12 CFR Part 230, Docket No. R-1197, Proposed Amendments to Regulation DD, August 6, 2004. Letter from CFA and national groups to the Chairman of the Federal Reserve Board and Federal Bank Regulators, urging Truth in Lending for overdraft loans, June 8, 2005. CFA, et al., Comments, Federal Reserve System, OTS, and NCUA, FRB Docket No. R-1314, OTS-2008-0004, NCUA RIN 3133-AD47, August 4, 2008. CFA Comments, Federal Reserve System, FRB Docket No. R-1343, March 30, 2009.--------------------------------------------------------------------------- The FRB has permitted banks to avoid TILA requirements because bankers claim that systematically charging unsuspecting consumers very high fees for overdraft loans they did not request is the equivalent to occasionally covering a paper check that would otherwise bounce. Instead of treating short term bank loans in the same manner as all other loans covered under TILA, as consumer organizations recommended, the FRB issued and updated regulations under the Truth in Savings Act, pretending that finance charges for these loans were bank ``service fees.'' In several dockets, national consumer organizations provided well-researched comments, urging the Federal Reserve to place consumer protection ahead of bank profits, to no avail. As a result, consumers unknowingly borrow billions of dollars at astronomical interest rates. A $100 overdraft loan with a $35 fee that is repaid in 2 weeks costs 910 percent APR. The use of debit cards for small purchases often results in consumers paying more in overdraft fees than the amount of credit extended. The FDIC found last year that the average debit card point of purchase overdraft is just $20, while the sample of State banks surveyed by the FDIC charged a $27 fee. If that $20 overdraft loan were repaid in two weeks, the FDIC noted that the APR came to 3,520 percent. \59\--------------------------------------------------------------------------- \59\ FDIC Study of Bank Overdraft Programs, Federal Deposit Insurance Corporation, November 2008 at v.--------------------------------------------------------------------------- As the Federal Reserve has failed to protect bank account customers from unauthorized overdraft loans, banks are raising fees and adding new ones. In the CFA survey of the 16 largest banks updated in July 2009, we found that 14 of the 16 largest banks charge $35 or more for initial or repeat overdrafts and nine of the largest banks use a tiered fee structure to escalate fees over the year. For example, USBank charges $19 for the first overdraft in a year, $35 for the second to fourth overdraft, and $37.50 thereafter. Ten of the largest banks charge a sustained overdraft fee, imposing additional fees if the overdraft and fees are not repaid within days. Bank of America began in June to impose a second $35 fee if an overdraft is not repaid within 5 days. As a result, a Bank of America customer who is permitted by her bank to overdraw by $20 with a debit card purchase can easily be charged $70 for a 5 day extension of credit. \60\ (For more detail, please see CFA Survey: Sixteen Largest Bank Overdraft Fees and Terms, Appendix 5.)--------------------------------------------------------------------------- \60\ Bank of America, ``Important Information Regarding Changes to Your Account'' p. 2. Accessed online June 15, 2009. ``Extended Overdrawn Balance Charge, June 5, 2009: For each time we determine your account is overdrawn by any amount and continues to be overdrawn for 5 or more consecutive business days, we will charge one fee of $35. This fee is in addition to applicable Overdraft Item Fees and NSF Returned Item Fees.''--------------------------------------------------------------------------- Cash advances on debit cards are not protected by the Truth in Lending Act prohibition on banks using set off rights to collect payment out of deposits into their customers' accounts. If the purchase involved a credit card, on the other hand, it would violate Federal law for a bank to pay the balance owed from a checking account at the same bank. Banks routinely pay back debit card cash advances to themselves by taking payment directly out of consumers' checking accounts, even if those accounts contain entirely exempt funds such as Social Security. The Federal Reserve is considering comments filed in yet another overdraft loan docket, this time considering whether to require banks to permit consumers to opt-out of fee-based overdraft programs, or, alternatively, to require banks to get consumers to opt in for overdrafts. This proposal would change Reg E which implements the Electronic Fund Transfer Act and would only apply to overdrafts created by point of sale debit card transactions and to ATM withdrawals, leaving all other types of transactions that are permitted to overdraw for a fee unaddressed. Consumer organizations urged the Federal Reserve to require banks to get their customers' affirmative consent, the same policy included in the recently enacted credit card bill which requires affirmative selection for creditors to permit over-the-limit transactions for a fee. \61\--------------------------------------------------------------------------- \61\ Federal Reserve Board, Docket No. R-1343, comments were due March 30, 2009.---------------------------------------------------------------------------E. The Fed is allowing a shadow banking system (prepaid cards) outside of consumer protection laws to develop and target the unbanked and immigrants; The OTS is allowing bank payday loans (which preempt State laws) on prepaid cards. The Electronic Funds Transfer Act requires key disclosures of fees and other practices, protects consumer bank accounts from unauthorized transfers, requires resolution of billing errors, gives consumers the right to stop electronic payments, and requires Statements showing transaction information, among other protections. The EFTA is also the statute that will hold the new protections against overdraft fee practices that the Fed is writing. Yet the Fed has failed to include most prepaid cards in the EFTA's protections, even while the prepaid industry is growing and is developing into a shadow banking system. In 2006, the Fed issued rules including payroll cards--prepaid cards that are used to pay wages instead of a paper check for those who do not have direct deposit to a bank account--within the definition of the ``accounts'' subject to the EFTA. But the Fed permitted payroll card accounts to avoid the Statement requirements for bank accounts, relying instead on the availability of account information on the Internet. Forcing consumers to monitor their accounts online to check for unauthorized transfers and fees and charges is particularly inappropriate for the population targeted for these cards: consumers without bank accounts, who likely do not have or use regular Internet access. Even worse, the Fed refused to adopt the recommendations of consumer groups that self-selected payroll cards--prepaid cards that consumers shop for and choose on their own as the destination for direct deposit of their wages--should receive the same EFTA protections that employer designated payroll cards receive. The Fed continues to take the position that general prepaid cards are not protected by the EFTA. This development has become all the more glaring as Federal and State government agencies have moved to prepaid cards to pay many Government benefits, from Social Security and Indian Trust Funds to unemployment insurance and State-collected child support. Some agencies, such as the Treasury Department when it created the Social Security Direct Express Card, have included in their contract requirements that the issuer must comply with the EFTA. But not all have, and compliance is uneven, despite the fact that the EFTA itself clearly references and anticipates coverage of electronic systems for paying unemployment insurance and other non-needs-tested Government benefits. The Fed's failure to protect this shadow banking system is also disturbing as prepaid cards are becoming a popular product offered by many predatory lenders, like payday lenders. Indeed, the Fed is not the only one that has recently dropped the ball on consumer protection on prepaid cards. One positive effort by the banking agencies in the past decade was the successful effort to end rent-a-bank partnerships that allowed payday lenders to partner with depositories to use their preemptive powers to preempt State payday loan laws. \62\ But more recently, one prepaid card issuer, Meta Bank, has developed a predatory, payday loan feature--iAdvance--on its prepaid cards that receive direct deposit of wages and Government benefits. At a recent conference, an iAdvance official boasted that Meta Bank's regulator--the OTS--has been very ``flexible'' with them and ``understands'' this product.--------------------------------------------------------------------------- \62\ Payday lending is so egregious that even the Office of the Comptroller of the Currency refused to let storefront lenders hide behind their partner banks' charters to export usury.---------------------------------------------------------------------------F. Despite advances in technology, the Federal Reserve has refused to speed up availability of deposits to consumers. Despite rapid technological changes in the movement of money electronically, the adoption of the Check 21 law to speed check processing, and electronic check conversion at the cash register, the Federal Reserve has failed to shorten the amount of time that banks are allowed to hold deposits before they are cleared. Money flies out of bank accounts at warp speed. Deposits crawl in. Even cash that is deposited over the counter to a bank teller can be held for 24 hours before becoming available to cover a transaction. The second business day rule for local checks means that a low-income worker who deposits a pay check on Friday afternoon will not get access to funds until the following Tuesday. If the paycheck is not local, it can be held for five business days. This long time period applies even when the check is written on the same bank where it is deposited. Consumers who deposit more than $5,000 in one day face an added wait of about 5 to 6 more business days. Banks refuse to cash checks for consumers who do not have equivalent funds already on deposit. The combination of unjustifiably long deposit holds and banks' refusal to cash account holders' checks pushes low income consumers towards check cashing outlets, where they must pay 2 to 4 percent of the value of the check to get immediate access to cash. Consumer groups have called on the Federal Reserve to speed up deposit availability and to prohibit banks from imposing overdraft or insufficient fund (NSF) fees on transactions that would not have overdrawn if deposits had been available. The Federal Reserve vigorously supported Check 21, which has speeded up withdrawals but has refused to reduce the time period for local and nonlocal check hold periods for consumers.G. The Federal Reserve has supported the position of payday lenders and telemarketing fraud artists by permitting remotely created checks (demand drafts) to subvert consumer rights under the electronic funds transfer act. In 2005, the National Association of Attorneys General, the National Consumer Law Center, Consumer Federation of America, Consumers Union, the National Association of Consumer Advocates, and U.S. Public Interest Research Group filed comments with the Federal Reserve in Docket No. R-1226, regarding proposed changes to Regulation CC with respect to demand drafts. Demand drafts are unsigned checks created by a third party to withdraw money from consumer bank accounts. State officials told the FRB that demand drafts are frequently used to perpetrate fraud on consumers and that the drafts should be eliminated in favor of electronic funds transfers that serve the same purpose and are covered by protections in the Electronic Funds Transfer Act. Since automated clearinghouse transactions are easily traced, fraud artists prefer to use demand drafts. Fraudulent telemarketers increasingly rely on bank debits to get money from their victims. The Federal Trade Commission earlier this year settled a series of cases against telemarketers who used demand drafts to fraudulently deplete consumers' bank accounts. Fourteen defendants agreed to pay a total of more than $16 million to settle FTC charges while Wachovia Bank paid $33 million in a settlement with the Comptroller of the Currency. \63\--------------------------------------------------------------------------- \63\ Press Release, ``Massive Telemarketing Scheme Affected Nearly One Million Consumers Nationwide; Wachovia Bank To Provide an Additional $33 Million to Suntasia Victims,'' Federal Trade Commission, January 13, 2009, viewed at http://www.ftc.gov/opa/2009/01/suntasia.shtm.--------------------------------------------------------------------------- Remotely created checks are also used by high cost lenders to remove funds from checking accounts even when consumers exercise their right to revoke authorization to collect payment through electronic funds transfer. CFA first issued a report on Internet payday lending in 2004 and documented that some high-cost lenders converted debts to demand drafts when consumers exercised their EFTA right to revoke authorization to electronically withdraw money from their bank accounts. CFA brought this to the attention of the Federal Reserve in 2005, 2006, and 2007. No action has been taken to safeguard consumers' bank accounts from unauthorized unsigned checks used by telemarketers or conversion of a loan payment from an electronic funds transfer to a demand draft to thwart EFTA protections or exploit a loophole in EFTA coverage. The structure of online payday loans facilitates the use of demand drafts. Every application for a payday loan requires consumers to provide their bank account routing number and other information necessary to create a demand draft as well as boiler plate contract language to authorize the device. The account information is initially used by online lenders to deliver the proceeds of the loan into the borrower's bank account using the ACH system. Once the lender has the checking account information, however, it can use it to collect loan payments via remotely created checks per boilerplate contract language even after the consumer revokes authorization for the lender to electronically withdraw payments. The use of remotely created checks is common in online payday loan contracts. ZipCash LLC ``Promise to Pay'' section of a contract included the disclosure that the borrower may revoke authorization to electronically access the bank account as provided by the Electronic Fund Transfer Act. However, revoking that authorization will not stop the lender from unilaterally withdrawing funds from the borrower's bank account. The contract authorizes creation of a demand draft which cannot be terminated. ``While you may revoke the authorization to effect ACH debit entries at any time up to 3 business days prior to the due date, you may not revoke the authorization to prepare and submit checks on your behalf until such time as the loan is paid in full.'' (Emphasis added.) \64\--------------------------------------------------------------------------- \64\ Loan Supplement (ZipCash LLC) Form #2B, on file with CFA.---------------------------------------------------------------------------H. The Federal Reserve has taken no action to safeguard bank accounts from Internet payday lenders. In 2006, consumer groups met with Federal Reserve staff to urge them to take regulatory action to protect consumers whose accounts were being electronically accessed by Internet payday lenders. We joined with other groups in a follow up letter in 2007, urging the Federal Reserve to make the following changes to Regulation E: Clarify that remotely created checks are covered by the Electronic Funds Transfer Act. Ensure that the debiting of consumers' accounts by Internet payday lenders is subject to all the restrictions applicable to preauthorized electronic funds transfers. Prohibit multiple attempts to ``present'' an electronic debit. Prohibit the practice of charging consumers a fee to revoke authorization for preauthorized electronic funds transfers. Amend the Official Staff Interpretations to clarify that consumers need not be required to inform the payee in order to stop payment on preauthorized electronic transfers. While FRB staff was willing to discuss these issues, the FRB took no action to safeguard consumers when Internet payday lenders and other questionable creditors evade consumer protections or exploit gaps in the Electronic Fund Transfer Act to mount electronic assaults on consumers' bank accounts. As a result of inaction by the Federal Reserve, payday loans secured by repeat debit transactions undermine the protections of the Electronic Fund Transfer Act, which prohibits basing the extension of credit with periodic payments on a requirement to repay the loan electronically. \65\ Payday loans secured by debit access to the borrower's bank account which cannot be cancelled also functions as the modern banking equivalent of a wage assignment--a practice which is prohibited when done directly. The payday lender has first claim on the direct deposit of the borrower's next paycheck or exempt Federal funds, such as Social Security, SSI, or Veterans Benefit payments. Consumers need control of their accounts to decide which bills get paid first and to manage scarce family resources. Instead of using its authority to safeguard electronic access to consumers' bank accounts, the Federal Reserve has stood idly by as the online payday loan industry has expanded.--------------------------------------------------------------------------- \65\ Reg E, 12 C.F.R. 205.10(e). 15 U.S.C. 1693k states that ``no person'' may condition extension of credit to a consumer on the consumer's repayment by means of a preauthorized electronic fund transfer.---------------------------------------------------------------------------I. The banking agencies have failed to stop banks from imposing unlawful freezes on accounts containing social security and other funds exempt from garnishment. Federal benefits including Social Security and Veteran's benefits (as well as State equivalents) are taxpayer dollars targeted to relieve poverty and ensure minimum subsistence income to the Nation's workers. Despite the purposes of these benefits, banks routinely freeze bank accounts containing these benefits pursuant to garnishment or attachment orders, and assess expensive fees--especially insufficient fund (NSF) fees--against these accounts. The number of people who are being harmed by these practices has escalated in recent years, largely due to the increase in the number of recipients whose benefits are electronically deposited into bank accounts. This is the result of the strong Federal policy to encourage this in the Electronic Funds Transfer Act. And yet, the banking agencies have failed to issue appropriate guidance to ensure that the millions of Federal benefit recipients receive the protections they are entitled to under Federal law.J. The Comptroller of the Currency permits banks to manipulate payment order to extract maximum bounced check and overdraft fees, even when overdrafts are permitted. The Comptroller of the Currency permits national banks to rig the order in which debits are processed. This practice increases the number of transactions that trigger an overdrawn account, resulting in higher fee income for banks. When banks began to face challenges in court to the practice of clearing debits according to the size of the debit--from the largest to the smallest--rather than when the debit occurred or from smallest to largest check, the OCC issued guidelines that allow banks to use this dubious practice. The OCC issued an Interpretive Letter allowing high-to-low check clearing when banks follow the OCC's considerations in adopting this policy. Those considerations include: the cost incurred by the bank in providing the service; the deterrence of misuse by customers of banking services; the enhancement of the competitive position of the bank in accordance with the bank's business plan and marketing strategy; and the maintenance of the safety and soundness of the institution. \66\ None of the OCC's considerations relate to consumer protection.--------------------------------------------------------------------------- \66\ 12 C.F.R. 7.4002(b).--------------------------------------------------------------------------- The Office of Thrift Supervision (OTS) addressed manipulation of transaction-clearing rules in the Final Guidance on Thrift Overdraft Programs issued in 2005. The OTS, by contrast, advised thrifts that transaction-clearing rules (including check-clearing and batch debit processing) should not be administered unfairly or manipulated to inflate fees. \67\ The Guidelines issued by the other Federal regulatory agencies merely urged banks and credit unions to explain the impact of their transaction clearing policies. The Interagency ``Best Practices'' State: ``Clearly explain to consumers that transactions may not be processed in the order in which they occurred, and that the order in which transactions are received by the institution and processed can affect the total amount of overdraft fees incurred by the consumers.'' \68\--------------------------------------------------------------------------- \67\ Office of Thrift Supervision, Guidance on Overdraft Protection Programs, February 14, 2005, p. 15. \68\ Department of Treasury, Joint Guidance on Overdraft Protection Programs, February 15, 2005, p. 13.--------------------------------------------------------------------------- CFA and other national consumer groups wrote to the Comptroller and other Federal bank regulators in 2005 regarding the unfair trade practice of banks ordering withdrawals from high-to-low, while at the same time unilaterally permitting overdrafts for a fee. One of the OCC's ``considerations'' is that the overdraft policy should ``deter misuse of bank services.'' Since banks deliberately program their computers to process withdrawals high-to-low and to permit customers to overdraw at the ATM and Point of Sale, there is no ``misuse'' to be deterred. No Federal bank regulator took steps to direct banks to change withdrawal order to benefit low-balance consumers or to stop the unfair practice of deliberately causing more transactions to bounce in order to charge high fees. CFA's survey of the 16 largest banks earlier this year found that all of them either clear transactions largest first or reserve the right to do so. \69\ Since ordering withdrawals largest first is likely to deplete scarce resources and trigger more overdraft and insufficient funds fees for many Americans, banks have no incentive to change this practice absent strong oversight by bank regulators.--------------------------------------------------------------------------- \69\ Consumer Federation of America, Comments to Federal Reserve Board, Docket No. R-1343, Reg. E, submitted March 30, 2009.---------------------------------------------------------------------------K. The regulators have failed to enforce the Truth In Savings Act requirement that banks provide account disclosures to prospective customers. According to a 2008 GAO report \70\ to Rep. Carolyn Maloney, then-chair of the Financial Institutions and Consumer Credit Subcommittee, based on a secret shopper investigation, banks don't give consumers access to the detailed schedule of account fee disclosures as required by the 1991 Truth In Savings Act. From GAO:--------------------------------------------------------------------------- \70\ ``Federal Banking Regulators Could Better Ensure That Consumers Have Required Disclosure Documents Prior to Opening Checking or Savings Accounts'', GAO-08-28I, January 2008, available at http://www.gao.gov/new.items/d08281.pdf (last visited 21 June 2009). Regulation DD, which implements the Truth in Savings Act (TISA), requires depository institutions to disclose (among other things) the amount of any fee that may be imposed in connection with an account and the conditions under which such fees are imposed. [ . . . ] GAO employees posed as consumers shopping for checking and savings accounts [ . . . ] Our visits to 185 branches of depository institutions nationwide suggest that consumers shopping for accounts may find it difficult to obtain account terms and conditions and disclosures of fees upon request prior to opening an account. Similarly, our review of the Web sites of the banks, thrifts, and credit unions we visited suggests that this information may also not be readily available on the Internet We were unable to obtain, upon request, a comprehensive list of all checking and savings account foes at 40 of the branches (22 percent) that we visited. [ . . . ] The results are consistent with those reported by a consumer group [U.S. PIRG] that conducted a --------------------------------------------------------------------------- similar exercise in 2001. This, of course, keeps consumers from being able to shop around and compare prices. As cited by GAO, U.S. PIRG then complained of these concerns in a 2001 letter to then Federal Reserve Board Chairman Alan Greenspan. \71\ No action was taken. The problem is exacerbated by a 2001 Congressional decision to eliminate consumers' private rights olfaction for Truth In Savings violations.--------------------------------------------------------------------------- \71\ The 1 November 2001 letter from Edmund Mierzwinski, U.S. PIRG, to Greenspan is available at http://static.uspirg.org/reports/bigbanks2001/greenspanltr.pdf (last visited 21 June 2009). In that letter, we also urged the regulators to extend Truth In Savings disclosure requirements to the Internet. No action was taken.---------------------------------------------------------------------------L. The Federal Reserve actively campaigned to eliminate a Congressional requirement that it publish an annual survey of bank account fees. One of the consumer protections included in the 1989 savings and loan bailout law known as the Financial Institutions Reform, Recovery and Enforcement Act was Section 1002, which required the Federal Reserve to publish an annual report to Congress on fees and services of depository institutions. The Fed actively campaigned in opposition to the requirement and succeeded in convincing Congress to sunset the survey in 2003. \72\ Most likely, the Fed was unhappy with the report's continued findings that each year bank fees increased, and that each year, bigger banks imposed the biggest fees.--------------------------------------------------------------------------- \72\ The final 2003 report to Congress is available here http://www.federalreserve.gov/boarddocs/rptcongress/2003fees.pdf (last visited 21 June 2009). The 1997-2003 reports can all be accessed from this page, http://www.federalreserve.gov/pubs/reports_other.htm (last visited 21 June 2009).---------------------------------------------------------------------------SECTION 4. STRUCTURE AND JURISDICTION OF A CONSUMER FINANCIAL CHRG-111shrg53085--46 Mr. Attridge," Their operating earnings are fine. Where they have been damaged is in the hits they have been taking to capital and those hits are coming from government-sponsored enterprises. A lot of them invested in Fannie Mae or Freddie Mac preferred stock over the years. They were encouraged to do so, and how could it be a bad investment? It was a government-sponsored enterprise. Fannie and Freddie, when you mention mortgages that are made by Fannie and Freddie, that is basically the gold seal. If you are buying Fannie and Freddie mortgages, they are appropriately underwritten and loan-to-values are good, people are rated to determine whether they can pay them back, and that is all fine. But someplace along the line, that failed, and for whatever reasons, Fannie Mae and Freddie Mac went out and bought private securities that didn't fit their own standards for underwriting. The same thing has happened with the Federal Home Loan Bank, where banks are now concerned about the investment they have in the Federal Home Loan Bank, and most banks have basically said, well, we are not going to continue to borrow from the Federal Home Loan Bank until that gets resolved because we don't want to have any exposure. When is the other shoe going to drop with the Federal Home Loan Bank? They have cut their dividend. They said they are not going to buy back stock for those that are repaying off their loans and in the past would have had the right to offer their stock back. The Federal Home Loan Bank is not doing that for the same reason. They went out and bought so-called toxic securities. So whatever the regulator is has to look at not just the banks, they have to look at the kind of financial instruments that are basically everywhere and are being purchased by banks, others, insurance companies, et cetera. They are not being rated right by the rating agencies. I don't know whose job that is, whether it is the Fed or a council, as you mentioned, Senator. Someone has to look at all the instruments that are involved in our system. And someplace back in Economics 101, Wall Street was there to allow the average citizen to participate in the capitalistic society, a place where you could purchase stocks. I think a majority of Wall Street now, or a good part of it, is basically a casino, and the financial instruments are nothing more than gambling, in my opinion, and I am not sure that is---- "