2008 Financial Crisis Inquiry Report by the Financial Crisis Inquiry Commission

1. The economy was doing well, and poor people were getting houses -- pity the regulator or congressman who stood in front of that bi-partisan political train.

2. Was it really just a coincidence that the only i-banks that failed, Bear Stearns and Lehman Brothers, were the only banks that refused to bank-roll the Long-Term Capital Management bailout ten years earlier?

It's certainly possible that the hidden third variable is low capital -- in the midst of 1998's crisis they didn't have the cash then either. However, regulators' actions were not obviously correct and even-handed, as they should be.

I cannot accept your canon that we are to judge Pope and King unlike other men, with a favourable presumption that they did no wrong. If there is any presumption it is the other way against holders of power, increasing as the power increases. Historic responsibility has to make up for the want of legal responsibility. Power tends to corrupt and absolute power corrupts absolutely.

-- Lord Acton

If anything, the crisis was a crisis in executive control. Congressional oversight had been subverted by the dull fact that they were simply getting what they wanted -- when Democrats and Republicans agree on something, that something is either very good or very bad. Furthermore, none of the more proximal regulators were willing to enforce rules or use their emergency powers because they feared a backlash should they choose poorly.

Just as we demand that banks have living wills which detail their assets and a plan to liquidate them, we should demand that our regulators have privileged, near-sacrosanct mechanisms in place that we slowly refine over time. The the last thing we want in the midst of a crisis is the uncertainty of Ad-hocracy.

We conclude this finnancial crisis was avoidable. The crisis was the result of human action and inaction, not of Mother Nature or computer models gone haywire. The captains of nance and the public stewards of our financial system ignored warnings and failed to question, understand, and manage evolving risks within a system essen- tial to the well-being of the American public. Theirs was a big miss, not a stumble. While the business cycle cannot be repealed, a crisis of this magnitude need not have occurred.

The prime example is the Federal Reserve’s pivotal failure to stem the flow of toxic mortgages, which it could have done by setting prudent mortgage-lending standards. The Federal Reserve was the one entity empowered to do so and it did not.

Soon there were a multitude of different kinds of mortgages available on the market, confounding consumers who didn’t examine the fine print, baffling conscientious borrowers who tried to puzzle out their implications, and opening the door for those who wanted in on the action. Many people chose poorly.

One of the rst places to see the bad lending practices envelop an entire market was Cleveland, Ohio. From 1989 to 1999, home prices in Cleveland rose 66%, climb- ing from a median of $75,200 to $125,100, while home prices nationally rose about 49% in those same years; at the same time, the city’s unemployment rate, ranging from 5.8% in 1990 to 4.2% in 1999, more or less tracked the broader U.S. pattern. James Rokakis, the longtime county treasurer of Cuyahoga County, where Cleveland is located, told the Commission that the region’s housing market was juiced by “ ip- ping on mega-steroids,” with rings of real estate agents, appraisers, and loan origina- tors earning fees on each transaction and feeding the securitized loans to Wall Street. City officials began to hear reports that these activities were being propelled by new kinds of nontraditional loans that enabled investors to buy properties with little or no money down and gave homeowners the ability to re nance their houses, regardless of whether they could afford to repay the loans. Foreclosures shot up in Cuyahoga County from 3,500 a year in 1995 to 7,000 a year in 2000. Rokakis and other public officials watched as families who had lived for years in modest residences lost their homes. After they were gone, many homes were ultimately abandoned, vandalized, and then stripped bare, as scavengers ripped away their copper pipes and aluminum siding to sell for scrap.

Warren Peterson, a home builder in Bakersfield, felt that he could pinpoint when the world changed to the day. Peterson built homes in an upscale neighborhood, and each Monday morning, he would arrive at the office to find a bevy of real estate agents, sales contracts in hand, vying to be the ones chosen to purchase the new homes he was building. The stream of traffic was constant. On one Saturday in No- vember 2005, he was at the sales office and noticed that not a single purchaser had entered the building. He called a friend, also in the home-building business, who said he had noticed the same thing, and asked him what he thought about it. “It’s over,” his friend told Peterson.

The repo market, too, had vulnerabilities, but it, too, had emerged from an early crisis stronger than ever. In 1982, two major borrowers, the securities firms Drysdale and Lombard-Wall, defaulted on their repo obligations, creating large losses for lenders. In the ensuing fallout, the Federal Reserve acted as lender of last resort to support a shadow banking market.

The other loophole (in the 1991 FDIC Improvement Act) addressed a concern raised by some Wall Street investment banks, Goldman Sachs in particular: the reluctance of commercial banks to help securities firms during previ- ous market disruptions, such as Drexel’s failure. Wall Street firms successfully lobbied for an amendment to FDICIA to authorize the Fed to act as lender of last resort to in- vestment banks by extending loans collateralized by the investment banks’ securities.

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 2005 to 2007 and found 13% 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 $1 trillion of the loans made during the period were fraudulent. Fulmer further estimated $160 billion worth of fraudu- lent loans from 2005 to 2007 resulted in foreclosures, leading to losses of $112 bil- lion for the holders.

An employee of Paulson & Co., the hedge fund that was taking the short side of the deal, bluntly said that “real money” investors such as IKB were outgunned. “The market is not pricing the sub- prime [residential mortgage–backed securities] wipeout scenario,” the Paulson em- ployee wrote in an email. “In my opinion this situation is due to the fact that rating agencies, CDO managers and underwriters have all the incentives to keep the game going, while ‘real money’ investors have neither the analytical tools nor the institu- tional framework to take action before the losses that one could anticipate based [on] the ‘news’ available everywhere are actually realized.”

Pricewaterhouse Coopers, which served as auditor for both AIG and Gold- man during this period, knew full well that AIG had never before marked these positions to market. In the third quarter of 2007, with the collateral demands piling up, PwC prompted AIG to begin developing a model of its own. Prior to the Gold- man margin call, PwC had concluded that “compensating controls” made up for AIG’s not having a model. Among those was notice from counterparties that collat- eral was due. In other words, one of AIG’s risk management tools was to learn of its own problems from counterparties who did have the ability to mark their own posi- tions to market prices and then demand collateral from AIG.

As of December 13, 2007, state and local governments had issued $165 billion in ARS, accounting for half of the $330 billion market. The other half were primarily bundles of student loans and debt of nonprofits such as museums and hospitals.

The key point: these entities wanted to borrow long-term but get the bene t of lower short-term rates, and investors wanted to get the safety of investing in these se- curities without tying up their money for a long time. Unlike commercial paper, this market had no explicit liquidity backstop from a bank, but there was an implicit backstop: often, if there were not enough new buyers to replace the previous in- vestors, the dealers running these auctions, including firms like UBS, Citigroup, and Merrill Lynch, would step in and pick up the shortfall. Because of these interven- tions, there were only 13 failures between 1984 and early 2007in more than 100,000 auctions. Dealers highlighted those minuscule failure rates to convince clients that ARS were very liquid, short-term instruments, even in times of stress.

However, if an auction did fail, the previous ARS investors would be obligated to retain their investments. In compensation, the interest rates on the debt would reset, often much higher, but investors’ funds would be trapped until new investors or the dealer stepped up or the borrower paid off the loan. ARS investors were typically very risk averse and valued liquidity, and so they were willing to pay a premium for guarantees on the ARS investments from monolines. It necessarily followed that the monolines’ growing problems in the latter half of 2007 affected the ARS market. Fearing that the monolines would not be able to perform on their guarantees, in- vestors fled. The dealers’ interventions were all that kept the market going, but the stress became too great. With their own problems to contend with, the dealers were unable to step in and ensure successful auctions. In February, en masse, they pulled up stakes. The market collapsed almost instantaneously. On February 14, in one of the starkest market dislocations of the financial crisis, 80% of the ARS auctions failed; the following week, 67% failed.

Hundreds of billions of dollars were trapped by ARS instruments as investors were obligated to retain their investments. And retail investors—individuals invest- ing less than $1 million, small businesses, and charities—constituted more than $110 billion of this $330 billion market. Moreover, investors who chose to re- main in the market demanded a premium to take on the risk. Between investor de- mands and interest rate resets, countless governments, infrastructure projects, and nonprofits on tight budgets were slammed with interest rates of 10% or higher. Problems in the ARS market cost Georgetown University, a borrower, 6 million. New York State was stuck with interest rates that soared from about 3.5% to more than 14% on $4 billion of its debt. The Port Authority of New York and New Jersey saw the interest rate on its debt jump from 4.3% to 20% in a single week in Febru- ary.

On Tuesday (2007-03-11), the Fed announced it would lend to investment banks and other “primary dealers.” The Term Securities Lending Facility (TSLF) would make avail- able up to 200 billion in Treasury securities, accepting as collateral GSE mortgage– backed securities and non-GSE mortgage–backed securities rated triple-A. The hope was that lenders would lend to investment banks if the collateral was Treasuries rather than other highly rated but now suspect assets such as mortgage-backed secu- rities.
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With the TSLF, the Fed would be setting a new precedent by extending emergency credit to institutions other than commercial banks. To do so, the Federal Reserve Board was required under section 13(3) of the Federal Reserve Act to determine that there were “unusual and exigent circumstances.” The Fed had not invoked its section 13(3) authority since the Great Depression; it was the Fed’s rst use of the authority since Congress had expanded the language of the act in 1991 to allow the Fed to lend to investment banks. The Fed was taking the unusual step of declaring its willing- ness to soon open its checkbook to institutions it did not regulate and whose nan- cial condition it had never examined.

But the Fed would not launch the TSLF until March 27, more than two weeks later...

By the fall of 2007, signs of strain were beginning to emerge among the commercial banks. In the fourth quarter of 2007, commercial banks’ earnings declined to a 16 year low, driven by write-downs on mortgage-backed securities and CDOs and by record provisions for future loan losses, as borrowers had increasing difficulty meet- ing their mortgage payments—and even greater di culty was anticipated. The net charge-off rate—the ratio of failed loans to total loans—rose to its highest level since 2002, when the economy was coming out of the post-9/11 recession.

William Isaac, who was chairman of the FDIC from 1981 until 1985, 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.”

In early October, Senator Charles Schumer and Representative Barney Frank in- troduced similar bills to temporarily lift portfolio limits on the GSEs by 10 percent, or approximately 150 billion, most of which would be designated for refinancing subprime loans. The measures, which Federal Reserve Chairman Ben Bernanke called “ill advised,” were not enacted.

That day (2008-09-10), New York Fed Senior Vice President Patricia Mosser circulated her opinion on Dudley’s request for “thoughts on how to resolve Lehman.” She laid out three options: (1) Find a buyer at any price, (2) wind down Lehman’s affairs, or (3) force it into bankruptcy. Regarding option 1, Mosser said it “should be done in a way that requires minimal temporary support. . . . No more Maiden Lane LLCs and no equity position by [the] Fed. Moral hazard and reputation cost is too high. If the Fed agrees to another equity investment, it signals that everything [the Fed] did in March in terms of temporary liquidity backstops is useless. Horrible precedent; in the long run MUCH worse than option 3.”

Fed General Counsel Alvarez and New York Fed General Counsel Baxter told the FCIC that there would have been questions either way. As Baxter put it, “I think that if the Federal Reserve had lent to Lehman that Monday in a way that some people think—without adequate collateral and without other security to ensure repay- ment—this hearing and other hearings would have only been about how we wasted the taxpayers’ money.”

The majority says the crisis was avoidable if only the United States had adopted across-the-board more restrictive regulations, in conjunction with more aggressive regulators and supervisors. This conclusion by the majority largely ignores the global nature of the crisis.

Although there were many contributing factors, the housing bubble of 1997- 2007 would not have reached its dizzying heights or lasted as long, nor would the financial crisis of 2008 have ensued, but for the role played by the housing policies of the United States government over the course of two administrations. As a result of these policies, by the middle of 2007, there were approximately 27 million subprime and Alt-A mortgages in the U.S. financial system — half of all mortgages outstanding — with an aggregate value of over $4.5 trillion. These were unprecedented numbers, far higher than at any time in the past, and the losses associated with the delinquency and default of these mortgages fully account for the weakness and disruption of the financial system that has become known as the financial crisis.

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.

The mortgage market is studied constantly by thousands of analysts, academics, regulators, traders and investors. How could all these people have missed something as important as the actual number of NTMs (non-traditional mortgage) outstanding? Most market participants appear to have assumed in the bubble years that Fannie and Freddie continued to adhere to the same conservative underwriting policies they had previously pursued. Until Fannie and Freddie were required to meet HUD’s AH (affordable housing) goals, they rarely acquired subprime or other low quality mortgages. Indeed, the very definition of a traditional prime mortgage was a loan that Fannie and Freddie would buy.

HUD made clear in numerous statements that its policy—in order to make credit available to low-income borrowers—was speci cally 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.”

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, both of which could be adjusted in the future.