Staff Director and Chief Counsel

Counsel and Chief Investigator

Counsel

Counsel

Counsel

Counsel

Counsel

Professional Staff Member

Detailee

Detailee

Staff Director to the Minority

Counsel to the Minority

Chief Investigator to the Minority

Senior Investigator to the Minority

Law Clerk

Law Clerk

Law Clerk

Law Clerk

Law Clerk

Intern

Intern

Law Clerk

Chief Clerk

199 Russell Senate Office Building – Washington, D.C. 20510

Main Number: 202/224-9505

i

(1) High Risk Lending: Case Study of Washington Mutual Bank. . . . . . . . . . . . . . . . . . 2

(2) Regulatory Failure: Case Study of the Office of Thrift Supervision.. . . . . . . . . . . . . 4

(3) Inflated Credit Ratings: Case Study of Moody’s and Standard & Poor’s. . . . . . . . . . 5

(4) Investment Bank Abuses: Case Study of Goldman Sachs and Deutsche Bank.. . . . . 7

(1) Major Business Lines and Key Personnel. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51

(2) Loan Origination Channels. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52

(3) Long Beach. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54

(4) Securitization.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55

(5) Overview of WaMu’s Rise and Fall. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56

(1) Strategic Direction.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60

(2) Approval of Strategy. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60

(3) Definition of High Risk Lending.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 62

(4) Gain on Sale. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64

(5) Acknowledging Unsustainable Housing Price Increases.. . . . . . . . . . . . . . . . . . . . . . 65

(6) Execution of the High Risk Lending Strategy.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68

(1) Long Beach. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75

ii

(2) WaMu Retail Lending. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86

(a) Inadequate Systems and Weak Oversight. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 86

(b) Risk Layering.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 90

(c) Loan Fraud. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95

(d) Steering Borrowers to High Risk Option ARMs. . . . . . . . . . . . . . . . . . . . . . . . . 104

(e) Marginalization of WaMu Risk Managers.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 109

(1) WaMu and Long Beach Securitizations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116

(2) Deficient Securitization Practices. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 122

(3) Securitizing Delinquency-Prone Loans. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 125

(4) WaMu Loan Sales to Fannie Mae and Freddie Mac. . . . . . . . . . . . . . . . . . . . . . . . . . 136

(1) Sales Culture. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 143

(2) Paying for Speed and Volume. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 147

(a) Long Beach Account Executives. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 148

(b) WaMu Loan Consultants. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 149

(c) Loan Processors and Quality Assurance Controllers. . . . . . . . . . . . . . . . . . . . . . 151

(3) WaMu Executive Compensation.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 153

(1) New Developments. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 155

(2) Recommendations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160

1. Ensure “Qualified Mortgages” Are Low Risk. . . . . . . . . . . . . . . . . . . . . . . . . . . 160

2. Require Meaningful Risk Retention. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160

3. Safeguard Against High Risk Products. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160

4. Require Greater Reserves for Negative Amortization Loans.. . . . . . . . . . . . . . . 160

5. Safeguard Bank Investment Portfolios.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160

(1) Office of Thrift Supervision. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 165

(2) Federal Deposit Insurance Corporation. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 166

(3) Examination Process. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 167

(1) Regulatory Challenges Related to Washington Mutual.. . . . . . . . . . . . . . . . . . . . . . . 169

(2) Overview of Washington Mutual’s Ratings History and Closure.. . . . . . . . . . . . . . . 173

(3) OTS Identification of WaMu Deficiencies. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 177

(a) Deficiencies in Lending Standards.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 177

(b) Deficiencies in Risk Management. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 182

(c) Deficiencies in Home Appraisals.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 187

(d) Deficiencies Related to Long Beach. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 191

(e) Over 500 Deficiencies in 5 Years. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 195

(4) OTS Turf War Against the FDIC. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 196

iii

(1) OTS’ Failed Oversight of WaMu. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 209

(a) Deference to Management. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 209

(b) Demoralized Examiners.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 215

(c) Narrow Regulatory Focus . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 224

(d) Inflated CAMELS Ratings.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 228

(e) Fee Issues. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 230

(2) Other Regulatory Failures. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 231

(a) Countrywide.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 231

(b) IndyMac. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 233

(c) New Century . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 235

(d) Fremont. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 237

(1) New Developments. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 239

(2) Recommendations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 241

1. Complete OTS Dismantling.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 241

2. Strengthen Enforcement.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 241

3. Strengthen CAMELS Ratings. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 242

4. Evaluate Impacts of High Risk Lending. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 242

(1) Credit Ratings Generally. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 247

(2) The Rating Process. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250

(3) Record Revenues.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 256

(1) Increasing High Risk Loans and Unaffordable Housing. . . . . . . . . . . . . . . . . . . . . . . 259

(2) Mass Downgrades. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 263

(1) Awareness of Increasing Credit Risks.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 268

(2) CRA Conflicts of Interest. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 272

(a) Drive for Market Share. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 273

(b) Investment Bank Pressure. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 278

(3) Inaccurate Models. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 288

(a) Inadequate Data. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 288

(b) Unclear and Subjective Ratings Process. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 294

(4) Failure to Retest After Model Changes. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 297

(5) Inadequate Resources. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 304

(6) Mortgage Fraud. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 310

(1) Past Credit Rating Agency Oversight. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 313

iv

(2) New Developments. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 315

(3) Recommendations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 316

1. Rank Credit Rating Agencies by Accuracy. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 316

2. Help Investors Hold CRAs Accountable. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 316

3. Strengthen CRA Operations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 316

4. Ensure CRAs Recognize Risk. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 316

5. Strengthen Disclosure. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 317

6. Reduce Ratings Reliance. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 317

(1) Investment Banks In General.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 321

(2) Roles and Duties of an Investment Bank: Market Maker, Underwriter,

Placement Agent, Broker-Dealer.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 322

(3) Structured Finance Products. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 325

(1) Subcommittee Investigation and Findings of Fact. . . . . . . . . . . . . . . . . . . . . . . . . . . 333

(2) Deutsche Bank Background. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 334

(3) Deutsche Bank’s $5 Billion Short . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 337

(a) Lippmann’s Negative Views of Mortgage Related Assets. . . . . . . . . . . . . . . . . 337

(b) Building and Cashing in the $5 Billion Short. . . . . . . . . . . . . . . . . . . . . . . . . . . 341

(4) The “CDO Machine” . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 346

(5) Gemstone.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 350

(a) Background on Gemstone. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 350

(b) Gemstone Asset Selection. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 353

(c) Gemstone Risks and Poor Quality Assets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 357

(d) Gemstone Sales Effort. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 363

(e) Gemstone Losses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 371

(6) Other Deutsche Bank CDOs. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 372

(7) Analysis. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 374

(1) Subcommittee Investigation and Findings of Fact. . . . . . . . . . . . . . . . . . . . . . . . . . . 376

(2) Goldman Sachs Background. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 378

(3) Overview of Goldman Sachs Case Study. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 382

(a) Overview of How Goldman Shorted the Subprime Mortgage Market. . . . . . . . 382

(b) Overview of Goldman’s CDO Activities.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 388

(4) How Goldman Shorted the Subprime Mortgage Market.. . . . . . . . . . . . . . . . . . . . . . 398

(a) Starting $6 Billion Net Long. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 398

(b) Going Past Home: Goldman’s First Net Short. . . . . . . . . . . . . . . . . . . . . . . . . . 404

(c) Attempted Short Squeeze.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 425

(d) Building the Big Short. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 430

(e) “Get Down Now”.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 440

v

(f) Profiting from the Big Short: Making “Serious Money”. . . . . . . . . . . . . . . . . . . 444

(g) Goldman’s Records Confirm Large Short Position. . . . . . . . . . . . . . . . . . . . . . . 445

(i) Top Sheets. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 446

(ii) Risk Reports.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 455

(h) Profiting From the Big Short. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 466

(5) How Goldman Created and Failed to Manage Conflicts of Interest in its

Securitization Activities. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 474

(a) Background. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 477

(i) Goldman’s Securitization Business. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 477

(ii) Goldman’s Negative Market View. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 478

(iii) Goldman’s Securitization Sell Off. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 481

AA. RMBS Sell Off.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 481

BB. CDO Sell Off. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 492

CC. CDO Marks. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 503

DD. Customer Losses. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 507

(b) Goldman’s Conflicts of Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 513

(i) Conflicts of Interest Involving RMBS Securities. . . . . . . . . . . . . . . . . . . . 513

(ii) Conflicts of Interest Involving Sales of CDO Securities. . . . . . . . . . . . . . 516

AA. Hudson Mezzanine Funding 2006-1. . . . . . . . . . . . . . . . . . . . . . . . . 517

BB. Anderson Mezzanine Funding 2007-1.. . . . . . . . . . . . . . . . . . . . . . . 532

CC. Timberwolf I. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 541

DD. Abacus 2007-AC1. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 560

(iii) Additional CDO Conflicts of Interest. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 574

AA. Liquidation Agent in Hudson 1. . . . . . . . . . . . . . . . . . . . . . . . . . . . . 574

BB. Collateral Put Provider in Timberwolf. . . . . . . . . . . . . . . . . . . . . . . 588

(6) Analysis of Goldman’s Conflicts of Interest. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 602

(a) Securities Laws. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 603

(b) Analysis .. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 609

(i) Claiming Market Maker Status.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 609

(ii) Soliciting Clients and Recommending Investments. . . . . . . . . . . . . . . . . . 613

(iii) Failing to Disclose Material Adverse Information. . . . . . . . . . . . . . . . . . . 615

(iv) Making Unsuitable Investment Recommendations. . . . . . . . . . . . . . . . . . 619

(7) Goldman’s Proprietary Investments. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 624

(1) New Developments. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 636

(2) Recommendations. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 638

1. Review Structured Finance Transactions.. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 639

2. Narrow Proprietary Trading Exceptions. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 639

3. Design Strong Conflict of Interest Prohibitions.. . . . . . . . . . . . . . . . . . . . . . . . . 639

4. Study Bank Use of Structured Finance. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 639

# # #

April 13, 2011

In the fall of 2008, America suffered a devastating economic collapse. Once valuable

securities lost most or all of their value, debt markets froze, stock markets plunged, and storied

financial firms went under. Millions of Americans lost their jobs; millions of families lost their

homes; and good businesses shut down. These events cast the United States into an economic

recession so deep that the country has yet to fully recover.

This Report is the product of a two-year bipartisan investigation by the U.S. Senate

Permanent Subcommittee on Investigations into the origins of the 2008 financial crisis. The

goals of this investigation were to construct a public record of the facts in order to deepen the

understanding of what happened; identify some of the root causes of the crisis; and provide a

factual foundation for the ongoing effort to fortify the country against the recurrence of a similar

crisis in the future.

Using internal documents, communications, and interviews, the Report attempts to

provide the clearest picture yet of what took place inside the walls of some of the financial

institutions and regulatory agencies that contributed to the crisis. The investigation found that

the crisis was not a natural disaster, but the result of high risk, complex financial products;

undisclosed conflicts of interest; and the failure of regulators, the credit rating agencies, and the

market itself to rein in the excesses of Wall Street.

While this Report does not attempt to examine every key moment, or analyze every

important cause of the crisis, it provides new, detailed, and compelling evidence of what

happened. In so doing, we hope the Report leads to solutions that prevent it from happening

again.

In November 2008, the Permanent Subcommittee on Investigations initiated its

investigation into some of the key causes of the financial crisis. Since then, the Subcommittee

has engaged in a wide-ranging inquiry, issuing subpoenas, conducting over 150 interviews and

depositions, and consulting with dozens of government, academic, and private sector experts.

The Subcommittee has accumulated and reviewed tens of millions of pages of documents,

including court pleadings, filings with the Securities and Exchange Commission, trustee reports,

prospectuses for public and private offerings, corporate board and committee minutes, mortgage

transactions and analyses, memoranda, marketing materials, correspondence, and emails. The

Subcommittee has also reviewed documents prepared by or sent to or from banking and

2

securities regulators, including bank examination reports, reviews of securities firms,

enforcement actions, analyses, memoranda, correspondence, and emails.

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.

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

3

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.

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.

4

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.

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

5

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.

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.

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

6

(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.

Between 2004 and 2007, Moody’s and S&P issued credit ratings for tens of thousands of

U.S. residential mortgage backed securities (RMBS) and collateralized debt obligations (CDO).

Taking in increasing revenue from Wall Street firms, Moody’s and S&P issued AAA and other

investment grade credit ratings for the vast majority of those RMBS and CDO securities,

2006, high risk mortgages began incurring delinquencies and defaults at an alarming rate.

Despite signs of a deteriorating mortgage market, Moody’s and S&P continued for six months to

issue investment grade ratings for numerous RMBS and CDO securities.

Then, in July 2007, as mortgage delinquencies intensified and RMBS and CDO securities

began incurring losses, both companies abruptly reversed course and began downgrading at

record numbers hundreds and then thousands of their RMBS and CDO ratings, some less than a

year old. Investors like banks, pension funds, and insurance companies, who are by rule barred

from owning low rated securities, were forced to sell off their downgraded RMBS and CDO

holdings, because they had lost their investment grade status. RMBS and CDO securities held

by financial firms lost much of their value, and new securitizations were unable to find investors.

The subprime RMBS market initially froze and then collapsed, leaving investors and financial

firms around the world holding unmarketable subprime RMBS securities that were plummeting

in value. A few months later, the CDO market collapsed as well.

Traditionally, investments holding AAA ratings have had a less than 1% probability of

incurring defaults. But in 2007, the vast majority of RMBS and CDO securities with AAA

ratings incurred substantial losses; some failed outright. Analysts have determined that over

90% of the AAA ratings given to subprime RMBS securities originated in 2006 and 2007 were

later downgraded by the credit rating agencies to junk status. In the case of Long Beach, 75 out

of 75 AAA rated Long Beach securities issued in 2006, were later downgraded to junk status,

defaulted, or withdrawn. Investors and financial institutions holding the AAA rated securities

lost significant value. Those widespread losses led, in turn, to a loss of investor confidence in

the value of the AAA rating, in the holdings of major U.S. financial institutions, and even in the

viability of U.S. financial markets.

Inaccurate AAA credit ratings introduced risk into the U.S. financial system and

constituted a key cause of the financial crisis. In addition, the July mass downgrades, which

were unprecedented in number and scope, precipitated the collapse of the RMBS and CDO

secondary markets, and perhaps more than any other single event triggered the beginning of the

financial crisis.

Report will refer to both ratings as “AAA.”

7

The Subcommittee’s investigation uncovered a host of factors responsible for the

inaccurate credit ratings issued by Moody’s and S&P. One significant cause was the inherent

conflict of interest arising from the system used to pay for credit ratings. Credit rating agencies

were paid by the Wall Street firms that sought their ratings and profited from the financial

products being rated. Under this “issuer pays” model, the rating agencies were dependent upon

those Wall Street firms to bring them business, and were vulnerable to threats that the firms

would take their business elsewhere if they did not get the ratings they wanted. The rating

agencies weakened their standards as each competed to provide the most favorable rating to win

business and greater market share. The result was a race to the bottom.

Additional factors responsible for the inaccurate ratings include rating models that failed

to include relevant mortgage performance data; unclear and subjective criteria used to produce

ratings; a failure to apply updated rating models to existing rated transactions; and a failure to

provide adequate staffing to perform rating and surveillance services, despite record revenues.

Compounding these problems were federal regulations that required the purchase of investment

grade securities by banks and others, which created pressure on the credit rating agencies to issue

investment grade ratings. While these federal regulations were intended to help investors stay

away from unsafe securities, they had the opposite effect when the AAA ratings proved

inaccurate.

Evidence gathered by the Subcommittee shows that the credit rating agencies were aware

of problems in the mortgage market, including an unsustainable rise in housing prices, the high

risk nature of the loans being issued, lax lending standards, and rampant mortgage fraud. Instead

of using this information to temper their ratings, the firms continued to issue a high volume of

investment grade ratings for mortgage backed securities. If the credit rating agencies had issued

ratings that accurately reflected the increasing risk in the RMBS and CDO markets and

appropriately adjusted existing ratings in those markets, they might have discouraged investors

from purchasing high risk RMBS and CDO securities, and slowed the pace of securitizations.

It was not in the short term economic interest of either Moody’s or S&P, however, to

provide accurate credit ratings for high risk RMBS and CDO securities, because doing so would

have hurt their own revenues. Instead, the credit rating agencies’ profits became increasingly

reliant on the fees generated by issuing a large volume of structured finance ratings. In the end,

Moody’s and S&P provided AAA ratings to tens of thousands of high risk RMBS and CDO

securities and then, when those products began to incur losses, issued mass downgrades that

shocked the financial markets, hammered the value of the mortgage related securities, and helped

trigger the financial crisis.

The final chapter examines how investment banks contributed to the financial crisis,

using as case studies Goldman Sachs and Deutsche Bank, two leading participants in the U.S.

mortgage market.

8

Investment banks can play an important role in the U.S. economy, helping to channel the

nation’s wealth into productive activities that create jobs and increase economic growth. But in

the years leading up to the financial crisis, large investment banks designed and promoted

complex financial instruments, often referred to as structured finance products, that were at the

heart of the crisis. They included RMBS and CDO securities, credit default swaps (CDS), and

CDS contracts linked to the ABX Index. These complex, high risk financial products were

engineered, sold, and traded by the major U.S. investment banks.

From 2004 to 2008, U.S. financial institutions issued nearly $2.5 trillion in RMBS and

over $1.4 trillion in CDO securities, backed primarily by mortgage related products. Investment

banks typically charged fees of $1 to $8 million to act as the underwriter of an RMBS

securitization, and $5 to $10 million to act as the placement agent for a CDO securitization.

Those fees contributed substantial revenues to the investment banks, which established internal

structured finance groups, as well as a variety of RMBS and CDO origination and trading desks

within those groups, to handle mortgage related securitizations. Investment banks sold RMBS

and CDO securities to investors around the world, and helped develop a secondary market where

RMBS and CDO securities could be traded. The investment banks’ trading desks participated in

those secondary markets, buying and selling RMBS and CDO securities either on behalf of their

clients or in connection with their own proprietary transactions.

The financial products developed by investment banks allowed investors to profit, not

only from the success of an RMBS or CDO securitization, but also from its failure. CDS

contracts, for example, allowed counterparties to wager on the rise or fall in the value of a

specific RMBS security or on a collection of RMBS and other assets contained or referenced in a

CDO. Major investment banks developed standardized CDS contracts that could also be traded

on a secondary market. In addition, they established the ABX Index which allowed

counterparties to wager on the rise or fall in the value of a basket of subprime RMBS securities,

which could be used to reflect the status of the subprime mortgage market as a whole. The

investment banks sometimes matched up parties who wanted to take opposite sides in a

transaction and other times took one or the other side of the 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 investment 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 practices that raise conflicts of interest and other concerns involving RMBS, CDO,

CDS, and ABX related financial instruments that contributed to the financial crisis.

The Goldman Sachs case study focuses on how it used net short positions to benefit from

the downturn in the mortgage market, and designed, marketed, and sold CDOs in ways that

the same products that caused substantial losses for its clients.

From 2004 to 2008, Goldman was a major player in the U.S. mortgage market. In 2006

and 2007 alone, it designed and underwrote 93 RMBS and 27 mortgage related CDO

9

securitizations totaling about $100 billion, bought and sold RMBS and CDO securities on behalf

of its clients, and amassed its own multi-billion-dollar proprietary mortgage related holdings. In

December 2006, however, when it saw evidence that the high risk mortgages underlying many

RMBS and CDO securities were incurring accelerated rates of delinquency and default,

Goldman quietly and abruptly reversed course.

Over the next two months, it rapidly sold off or wrote down the bulk of its existing

subprime RMBS and CDO inventory, and began building a short position that would allow it to

profit from the decline of the mortgage market. Throughout 2007, Goldman twice built up and

cashed in sizeable mortgage related short positions. At its peak, Goldman’s net short position

totaled $13.9 billion. Overall in 2007, its net short position produced record profits totaling $3.7

billion for Goldman’s Structured Products Group, which when combined with other mortgage

losses, produced record net revenues of $1.1 billion for the Mortgage Department as a whole.

Throughout 2007, Goldman sold RMBS and CDO securities to its clients without

disclosing its own net short position against the subprime market or its purchase of CDS

contracts to gain from the loss in value of some of the very securities it was selling to its clients.

The case study examines in detail four CDOs that Goldman constructed and sold called

Hudson 1, Anderson, Timberwolf, and Abacus 2007-AC1. In some cases, Goldman transferred

risky assets from its own inventory into these CDOs; in others, it included poor quality assets

that were likely to lose value or not perform. In three of the CDOs, Hudson, Anderson and

Timberwolf, Goldman took a substantial portion of the short side of the CDO, essentially betting

that the assets within the CDO would fall in value or not perform. Goldman’s short position was

in direct opposition to the clients to whom it was selling the CDO securities, yet it failed to

disclose the size and nature of its short position while marketing the securities. While Goldman

sometimes included obscure language in its marketing materials about the possibility of its

taking a short position on the CDO securities it was selling, Goldman did not disclose to

potential investors when it had already determined to take or had already taken short investments

that would pay off if the particular security it was selling, or RMBS and CDO securities in

general, performed poorly. In the case of Hudson 1, for example, Goldman took 100% of the

short side of the $2 billion CDO, betting against the assets referenced in the CDO, and sold the

Hudson securities to investors without disclosing its short position. When the securities lost

value, Goldman made a $1.7 billion gain at the direct expense of the clients to whom it had sold

the securities.

In the case of Anderson, Goldman selected a large number of poorly performing assets

for the CDO, took 40% of the short position, and then marketed Anderson securities to its

clients. When a client asked how Goldman “got comfortable” with the New Century loans in the

CDO, Goldman personnel tried to dispel concerns about the loans, and did not disclose the firm’s

own negative view of them or its short position in the CDO.

In the case of Timberwolf, Goldman sold the securities to its clients even as it knew the

securities were falling in value. In some cases, Goldman knowingly sold Timberwolf securities

to clients at prices above its own book values and, within days or weeks of the sale, marked

10

down the value of the sold securities, causing its clients to incur quick losses and requiring some

to post higher margin or cash collateral. Timberwolf securities lost 80% of their value within

five months of being issued and today are worthless. Goldman took 36% of the short position in

the CDO and made money from that investment, but ultimately lost money when it could not sell

all of the Timberwolf securities.

In the case of Abacus, Goldman did not take the short position, but allowed a hedge fund,

Paulson & Co. Inc., that planned on shorting the CDO to play a major but hidden role in

selecting its assets. Goldman marketed Abacus securities to its clients, knowing the CDO was

designed to lose value and without disclosing the hedge fund’s asset selection role or investment

objective to potential investors. Three long investors together lost about $1 billion from their

Abacus investments, while the Paulson hedge fund profited by about the same amount. Today,

the Abacus securities are worthless.

In the Hudson and Timberwolf CDOs, Goldman also used its role as the collateral put

provider or liquidation agent to advance its financial interest to the detriment of the clients to

whom it sold the CDO securities.

The Deutsche Bank case study describes how the bank’s top global 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. He described some of those securities as “crap” and “pigs,” and predicted the assets and

the CDO securities would lose value. 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 at times referred to the industry’s ongoing CDO marketing

efforts as a “CDO machine” or “ponzi scheme.” 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. Despite its positive view of the housing market, the bank

allowed Mr. Lippmann to develop a large proprietary short position for the bank in the RMBS

market, which from 2005 to 2007, totaled $5 billion. The bank cashed in the short position from

2007 to 2008, generating a profit of $1.5 billion, which Mr. Lippmann claims is more money on

a single position than any other trade had ever made for Deutsche Bank in its history. Despite

that gain, due to its large long holdings, Deutsche Bank lost nearly $4.5 billion from its mortgage

related proprietary investments.

The Subcommittee also examined a $1.1 billion CDO underwritten by Deutsche Bank

known as Gemstone CDO VII Ltd. (Gemstone 7), which issued securities in March 2007. It was

one of 47 CDOs totaling $32 billion that Deutsche Bank underwrote from 2004 to 2008.

Deutsche Bank made $4.7 million in fees from Gemstone 7, while the collateral manager, a

hedge fund called HBK Capital Management, was slated to receive $3.3 million. Gemstone 7

concentrated risk by including within a single financial instrument 115 RMBS securities whose

financial success depended upon thousands of high risk, poor quality subprime loans. Many of

those RMBS securities carried BBB, BBB-, or even BB credit ratings, making them among the

highest risk RMBS securities sold to the public. Nearly a third of the RMBS securities contained

11

subprime loans originated by Fremont, Long Beach, and New Century, lenders well known

within the industry for issuing poor quality loans. Deutsche Bank also sold securities directly

from its own inventory to the CDO. Deutsche Bank’s CDO trading desk knew that many of

these RMBS securities were likely to lose value, but did not object to their inclusion in

Gemstone 7, even securities which Mr. Lippmann was calling “crap” or “pigs.” Despite the poor

quality of the underlying assets, Gemstone’s top three tranches received AAA ratings. Deutsche

Bank ultimately sold about $700 million in Gemstone securities, without disclosing to potential

investors that its global head trader of CDOs had extremely negative views of a third of the

assets in the CDO or that the bank’s internal valuations showed that the assets had lost over $19

million in value since their purchase. Within months of being issued, the Gemstone 7 securities

lost value; by November 2007, they began undergoing credit rating downgrades; and by July

2008, they became nearly worthless.

Both Goldman Sachs and Deutsche Bank underwrote securities using loans from

subprime lenders known for issuing high risk, poor quality mortgages, and sold risky securities

to investors across the United States and around the world. They also enabled the lenders to

acquire new funds to originate still more high risk, poor quality loans. Both sold CDO securities

without full disclosure of the negative views of some of their employees regarding the

underlying assets and, in the case of Goldman, without full disclosure that it was shorting the

very CDO securities it was marketing, raising questions about whether Goldman complied with

its obligations to issue suitable investment recommendations and disclose material adverse

interests.

The case studies also illustrate how these two investment banks continued to market new

CDOs in 2007, even as U.S. mortgage delinquencies intensified, RMBS securities lost value, the

U.S. mortgage market as a whole deteriorated, and investors lost confidence. Both kept

producing and selling high risk, poor quality structured finance products in a negative market, in

part because stopping the “CDO machine” would have meant less income for structured finance

units, smaller executive bonuses, and even the disappearance of CDO desks and personnel,

which is what finally happened. The two case studies also illustrate how certain complex

structured finance products, such as synthetic CDOs and naked credit default swaps, amplified

market risk by allowing investors with no ownership interest in the reference obligations to place

unlimited side bets on their performance. Finally, the two case studies demonstrate how

proprietary trading led to dramatic losses in the case of Deutsche Bank and undisclosed conflicts

of interest in the case of Goldman Sachs.

Investment banks were the driving force behind the structured finance products that

provided a steady stream of funding for lenders originating high risk, poor quality loans and that

magnified risk throughout the U.S. financial system. The investment banks that engineered,

sold, traded, and profited from mortgage related structured finance products were a major cause

of the financial crisis.

12

The four causative factors examined in this Report are interconnected. Lenders

introduced new levels of risk into the U.S. financial system by selling and securitizing complex

home loans with high risk features and poor underwriting. The credit rating agencies labeled the

resulting securities as safe investments, facilitating their purchase by institutional investors

around the world. Federal banking regulators failed to ensure safe and sound lending practices

and risk management, and stood on the sidelines as large financial institutions active in U.S.

financial markets purchased billions of dollars in mortgage related securities containing high

risk, poor quality mortgages. Investment banks magnified the risk to the system by engineering

and promoting risky mortgage related structured finance products, and enabling investors to use

naked credit default swaps and synthetic instruments to bet on the failure rather than the success

of U.S. financial instruments. Some investment banks also ignored the conflicts of interest

created by their products, placed their financial interests before those of their clients, and even

bet against the very securities they were recommending and marketing to their clients. Together

these factors produced a mortgage market saturated with high risk, poor quality mortgages and

securities that, when they began incurring losses, caused financial institutions around the world

to lose billions of dollars, produced rampant unemployment and foreclosures, and ruptured faith

in U.S. capital markets.

Nearly three years later, the U.S. economy has yet to recover from the damage caused by

the 2008 financial crisis. This Report is intended to help analysts, market participants,

policymakers, and the public gain a deeper understanding of the origins of the crisis and take the

steps needed to prevent excessive risk taking and conflicts of interest from causing similar

damage in the future. Each of the four chapters in this Report examining a key aspect of the

financial crisis begins with specific findings of fact, details the evidence gathered by the

Subcommittee, and ends with recommendations. For ease of reference, all of the

recommendations are reprinted here. For more information about each recommendation, please

see the relevant chapter.

1. Ensure “Qualified Mortgages” Are Low Risk. Federal regulators should use their

regulatory authority to ensure that all mortgages deemed to be “qualified residential

mortgages” have a low risk of delinquency or default.

2. Require Meaningful Risk Retention. Federal regulators should issue a strong risk

retention requirement under Section 941 by requiring the retention of not less than a

5% credit risk in each, or a representative sample of, an asset backed securitization’s

tranches, and by barring a hedging offset for a reasonable but limited period of time.

3. Safeguard Against High Risk Products. Federal banking regulators should

safeguard taxpayer dollars by requiring banks with high risk structured finance

products, including complex products with little or no reliable performance data, to

meet conservative loss reserve, liquidity, and capital requirements.

13

4. Require Greater Reserves for Negative Amortization Loans. Federal banking

regulators should use their regulatory authority to require banks issuing negatively

amortizing loans that allow borrowers to defer payments of interest and principal, to

maintain more conservative loss, liquidity, and capital reserves.

5. Safeguard Bank Investment Portfolios. Federal banking regulators should use the

Section 620 banking activities study to identify high risk structured finance products

and impose a reasonable limit on the amount of such high risk products that can be

included in a bank’s investment portfolio.

1. Complete OTS Dismantling. The Office of the Comptroller of the Currency (OCC)

should complete the dismantling of the Office of Thrift Supervision (OTS), despite

attempts by some OTS officials to preserve the agency’s identity and influence within

the OCC.

2. Strengthen Enforcement. Federal banking regulators should conduct a review of

their major financial institutions to identify those with ongoing, serious deficiencies,

and review their enforcement approach to those institutions to eliminate any policy of

deference to bank management, inflated CAMELS ratings, or use of short term profits

to excuse high risk activities.

3. Strengthen CAMELS Ratings. Federal banking regulators should undertake a

comprehensive review of the CAMELS ratings system to produce ratings that signal

whether an institution is expected to operate in a safe and sound manner over a

specified period of time, asset quality ratings that reflect embedded risks rather than

short term profits, management ratings that reflect any ongoing failure to correct

identified deficiencies, and composite ratings that discourage systemic risks.

4. Evaluate Impacts of High Risk Lending. The Financial Stability Oversight Council

should undertake a study to identify high risk lending practices at financial

institutions, and evaluate the nature and significance of the impacts that these

practices may have on U.S. financial systems as a whole.

1. Rank Credit Rating Agencies by Accuracy. The SEC should use its regulatory

authority to rank the Nationally Recognized Statistical Rating Organizations in terms

of performance, in particular the accuracy of their ratings.

2. Help Investors Hold CRAs Accountable. The SEC should use its regulatory

authority to facilitate the ability of investors to hold credit rating agencies accountable

in civil lawsuits for inflated credit ratings, when a credit rating agency knowingly or

recklessly fails to conduct a reasonable investigation of the rated security.

14

3. Strengthen CRA Operations. The SEC should use its inspection, examination, and

regulatory authority to ensure credit rating agencies institute internal controls, credit

rating methodologies, and employee conflict of interest safeguards that advance

rating accuracy.

4. Ensure CRAs Recognize Risk. The SEC should use its inspection, examination, and

regulatory authority to ensure credit rating agencies assign higher risk to financial

instruments whose performance cannot be reliably predicted due to their novelty or

complexity, or that rely on assets from parties with a record for issuing poor quality

assets.

5. Strengthen Disclosure. The SEC should exercise its authority under the new Section

78o-7(s) of Title 15 to ensure that the credit rating agencies complete the required

new ratings forms by the end of the year and that the new forms provide

comprehensible, consistent, and useful ratings information to investors, including by

testing the proposed forms with actual investors.

6. Reduce Ratings Reliance. Federal regulators should reduce the federal government’s

reliance on privately issued credit ratings.

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 marketmaking

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.

15

Understanding the recent financial crisis requires examining how U.S. financial markets

have changed in fundamental ways over the past 15 years. The following provides a brief

historical overview of some of those changes; explains some of the new financial products and

trading strategies in the mortgage area; and provides background on credit ratings, investment

banks, government sponsored enterprises, and financial regulators. It also provides a brief

timeline of key events in the financial crisis. Two recurrent themes are the increasing amount of

risk and conflicts of interest in U.S. financial markets.

Until relatively recently, federal and state laws limited federally-chartered banks from

thousands of modest-sized banks tied to local communities. Since 1990, the United States has

witnessed the number of regional and local banks and thrifts shrink from just over 15,000 to

suffered losses, the United States could quickly close its doors, protect its depositors, and avoid

significant damage to the U.S. banking system or economy. Decentralized banking also

promoted competition, diffused credit in the marketplace, and prevented undue concentrations of

financial power.

In the mid 1990s, the United States initiated substantial changes to the banking industry,

some of which relaxed the rules under which banks operated, while others imposed new

regulations, and still others encouraged increased risk-taking. In 1994, for the first time,

Congress explicitly authorized interstate banking, which allowed federally-chartered banks to

Steagall Act of 1933, which had generally required banks, investment banks, securities firms,

Bank Holding Company Act of 1956, P.L. 84-511 (prohibiting banking company companies from owning branches

in multiple states). See also “Going Interstate: A New Dawn for U.S. Banking,” The Regional Economist, a

publication of the Federal Reserve Bank of St. Louis (7/1994).

and exempted investment bank holding companies from direct federal

http://www.census.gov/compendia/statab/2011/tables/11s1175.pdf.

(showing that, as of 12/31/1993, the United States had 12,317 federal and state credit unions).

prohibitions on interstate banking).

banks had already begun to engage in securities and insurance activities, with the most prominent example at the

time being Citicorp’s 1998 merger with the Travelers insurance group.

16

federal regulation of swaps and the trillion-dollar swap markets, and which allowed U.S. banks,

broker-dealers, and other financial institutions to develop, market, and trade these unregulated

financial products, including credit default swaps, foreign currency swaps, interest rate swaps,

In 2002, the Treasury Department, along with other federal bank regulatory agencies,

altered the way capital reserves were calculated for banks, and encouraged the retention of

securitized mortgages with investment grade credit ratings by allowing banks to hold less capital

2004, the SEC relaxed the capital requirements for large broker-dealers, allowing them to grow

control over the growing hedge fund industry, by requiring certain hedge funds to register with

the agency, a federal Court of Appeals issued a 2006 opinion that invalidated the SEC

These and other steps paved the way, over the course of little more than the last decade,

for a relatively small number of U.S. banks and broker-dealers to become giant financial

conglomerates involved in collecting deposits; financing loans; trading equities, swaps and

commodities; and issuing, underwriting, and marketing billions of dollars in stock, debt

instruments, insurance policies, and derivatives. As these financial institutions grew in size and

complexity, and began playing an increasingly important role in the U.S. economy, policymakers

began to ask whether the failure of one of these financial institutions could damage not only the

U.S. financial system, but the U.S. economy as a whole. In a little over ten years, the creation of

also prepared statement of SEC Chairman Christopher Cox, “Role of Federal Regulators: Lessons from the Credit

Crisis for the Future of Regulation,” October 23, 2008 House Committee on Oversight and Government Reform

Hearing, (“It was a fateful mistake in the Gramm-Leach-Bliley Act that neither the SEC nor any regulator was given

the statutory authority to regulate investment bank holding companies other than on a voluntary basis.”).

Appropriations Act of 2001, P.L. 106-554.

guidelines-capital-adequacy-guidelines-capital-maintenance-capital-treatment-of.

Entities,” RIN 3235-AI96, 17 CFR Parts 200 and 240 (8/20/2004) (“amended the net capital rule under the

Securities Exchange Act of 1934 to establish a voluntary alternative method of computing net capital for certain

broker-dealers”). The Consolidated Supervised Entities (CSE) program, which provided SEC oversight of

investment bank holding companies that joined the CSE program on a voluntarily basis, was established by the SEC

in 2004, and terminated by the SEC in 2008, after the financial crisis. The alternative net capital rules for brokerdealers

were terminated at the same time.

purchased Countrywide and Merrill Lynch; Wells Fargo had acquired Wachovia Bank; and JPMorgan Chase had

purchased Washington Mutual and Bear Stearns, creating the largest banks in U.S. history. By early 2009, each

controlled more than 10% of all U.S. deposits. See, e.g., “Banks ‘Too Big To Fail’ Have Grown Even Bigger:

Behemoths Born of the Bailout Reduce Consumer Choice, Tempt Corporate Moral Hazard,” Washington Post

17

Over the last ten years, some U.S. financial institutions have not only grown larger and

more complex, but have also engaged in higher risk activities. The last decade has witnessed an

explosion of so-called “innovative” financial products with embedded risks that are difficult to

analyze and predict, including collateralized debt obligations, credit default swaps, exchange

traded funds, commodity and swap indices, and more. Financial engineering produced these

financial instruments which typically had little or no performance record to use for risk

management purposes. Some U.S. financial institutions became major participants in the

development of these financial products, designing, selling, and trading them in U.S. and global

markets.

In addition, most major U.S. financial institutions began devoting increasing resources to

so-called “proprietary trading,” in which the firm’s personnel used the firm’s capital to gain

investment returns for the firm itself rather than for its clients. Traditionally, U.S. banks, brokerdealers,

and investment banks had offered investment advice and services to their clients, and did

well when their clients did well. Over the last ten years, however, some firms began referring to

their clients, not as customers, but as counterparties. In addition, some firms at times developed

and used financial products in transactions in which the firm did well only when its clients, or

counterparties, lost money. Some U.S. banks also sponsored affiliated hedge funds, provided

them with billions of dollars in client and bank funds, and allowed the hedge funds to make high

risk investments on the bank’s behalf, seeking greater returns.

By 2005, as U.S. financial institutions reached unprecedented size and made increasing

use of complex, high risk financial products, government oversight and regulation was

increasingly incoherent and misguided.

The U.S. mortgage market reflected many of the trends affecting the U.S. financial

system as a whole. Prior to the early 1970s, families wishing to buy a home typically went to a

local bank or mortgage company, applied for a loan and, after providing detailed financial

information and a down payment, qualified for a 30-year fixed rate mortgage. The local bank or

mortgage company then typically kept that mortgage until the homeowner paid it off, earning its

profit from the interest rates and fees paid by the borrower.

Lenders were required to keep a certain amount of capital for each loan they issued,

which effectively limited the number of loans one bank could have on its books. To increase

their capital, some lenders began selling the loans on their books to other financial institutions

that wanted to service the loans over time, and then used the profits to make new loans to

prospective borrowers. Lenders began to make money, not from holding onto the loans they

originated and collecting mortgage payments over the years, but from the relatively short term

fees associated with originating and selling the loans.

(8/28/2009). Those banks plus Citigroup also issued one out of every two mortgages and two out of every three

credit cards. Id.

18

By 2003, many lenders began using higher risk lending strategies involving the

origination and sale of complex mortgages that differed substantially from the traditional 30-year

fixed rate home loan. The following describes some of the securitization practices and higher

risk mortgage products that came to dominate the mortgage market in the years leading up to the

financial crisis.

Securitization. To make home loans sales more efficient and profitable, banks began

making increasing use of a mechanism now called “securitization.” In a securitization, a

financial institution bundles a large number of home loans into a loan pool, and calculates the

amount of mortgage payments that will be paid into that pool by the borrowers. The securitizer

then forms a shell corporation or trust, often offshore, to hold the loan pool and use the mortgage

revenue stream to support the creation of bonds that make payments to investors over time.

Those bonds, which are registered with the SEC, are called residential mortgage backed

securities (RMBS) and are typically sold in a public offering to investors. Investors typically

make a payment up front, and then hold onto the RMBS securities which repay the principal plus

interest over time. The amount of money paid periodically to the RMBS holders is often referred

to as the RMBS “coupon rate.”

For years, securitization worked well. Borrowers paid their 30-year, fixed rate mortgages

with few defaults, and mortgage backed securities built up a reputation as a safe investment.

Lenders earned fees for bundling the home loans into pools and either selling the pools or

securitizing them into mortgage backed securities. Investment banks also earned fees from

working with the lenders to assemble the pools, design the mortgage backed securities, obtain

credit ratings for them, and sell the resulting securities to investors. Investors like pension funds,

insurance companies, municipalities, university endowments, and hedge funds earned a

reasonable rate of return on the RMBS securities they purchased.

Due to the 2002 Treasury rule that reduced capital reserves for securitized mortgages,

RMBS holdings also became increasingly attractive to banks, which could determine how much

capital they needed to hold based on the credit ratings their RMBS securities received from the

credit ratings agencies. According to economist Arnold Kling, among other problems, the 2002

rule “created opportunities for banks to lower their ratio of capital to assets through structured

financing” and “created the incentive for rating agencies to provide overly optimistic assessment

High Risk Mortgages. The resulting increased demand for mortgage backed securities,

joined with Wall Street’s growing appetite for securitization fees, prompted lenders to issue

mortgages not only to well qualified borrowers, but also higher risk borrowers. Higher risk

borrowers were often referred to as “subprime” borrowers to distinguish them from the more

creditworthy “prime” borrowers who traditionally qualified for home loans. Some lenders began

2009, Mercatus Center, http://mercatus.org/sites/default/files/publication/NotWhatTheyHadInMind(1).pdf.

19

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.

Subprime loans provided new fuel for the securitization engines on Wall Street.

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

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

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.

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.

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.

Calif.), Complaint (June 4, 2009), at ¶¶ 20-21.

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.

20

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.

These practices were used to qualify borrowers for larger loans than they could have

otherwise obtained. When borrowers took out larger loans, the mortgage broker typically

profited from higher fees and commissions; the lender profited from higher fees and a better

price for the loan on the secondary market; and Wall Street firms profited from a larger revenue

stream to support bigger pools of mortgage backed securities.

The securitization of higher risk loans led to increased profits, but also injected greater

risks into U.S. mortgage markets. Some U.S. lenders, like Washington Mutual and Countrywide,

made wholesale shifts in their loan programs, reducing their sale of low risk, 30-year, fixed rate

After 2000, the number of high risk loans increased rapidly, from about $125 billion in

dollar value or 12% of all U.S. loan originations in 2000, to about $1 trillion in dollar value or

34% of all loan originations in 2006.

Because higher risk loans required

borrowers to pay higher fees and a higher rate of interest, they produced greater initial profits for

lenders than lower risk loans. In addition, Wall Street firms were willing to pay more for the

higher risk loans, because once securitized, the AAA securities relying on those loans typically

paid investors a higher rate of return than other AAA investments, due to the higher risk

involved. As a result, investors were willing to pay more, and mortgaged backed securities

relying on higher risk loans typically fetched a better price than those relying on lower risk loans.

Lenders also incurred little risk from issuing the higher risk loans, since they quickly sold the

loans and kept the risk off their books.

JPM_WM00690894, Hearing Exhibit 4/13-3 (featuring discussion of the larger “gain on sale” produced by higher

risk home loans); “WaMu Product Originations and Purchases By Percentage - 2003-2007,” chart prepared by the

Subcommittee, Hearing Exhibit 4/13-1i (showing how higher risk loans grew from about 19% to about 55% of

WaMu’s loan originations); SEC v. Mozilo, Case No. CV09-03994 (USDC CD Calif.), Complaint (June 4, 2009), at

¶¶ 17-19 (alleging that higher risk loans doubled at Countrywide, increasing from about 31% to about 64% of its

loan originations).

The majority of those loans, 59%, were used to refinance

Sources,” Government Accountability Office (GAO), Report No. GAO-10-805 at 1. These figures include subprime

loans, Alt A, and option payment loans, but not home equity loans, which means the totals for high risk loans are

understated.

21

“refinanced their mortgages at a higher amount than the loan balance to convert their

home equity into money for personal use (known as ‘cash-out refinancing’). Of the

subprime mortgages originated from 2000 through 2007, 55 percent were for cash-out

refinancing, 9 percent were for no-cash-out refinancing, and 36 percent were for a home

purchase.”

In addition, according to research performed by

GAO, many of these borrowers:

25

Some lenders became known inside the industry for issuing high risk, poor quality loans,

yet during the years leading up to the financial crisis were able to securitize and sell their home

loans with few problems. Subprime lenders like Long Beach Mortgage Corporation, New

Century Financial Corporation, and Fremont Loan & Investment, for example, were known for

These three lenders and others issued a variety of nontraditional, high risk loans whose

subsequent delinquencies and defaults later contributed to the financial crisis. They included

hybrid adjustable rate mortgages, pick-a-payment or option ARM loans, interest-only loans,

home equity loans, and Alt A and stated income loans. Although some of these loans had been

in existence for years, they had previously been restricted to a relatively small group of

borrowers who were generally able to repay their debts. In the years leading up to the financial

crisis, however, lenders issued these higher risk loans to a wide variety of borrowers, including

subprime borrowers, who often used them to purchase more expensive homes than they would

have been able to buy using traditional fixed rate, 30-year loans.

Despite their reputations for poor quality loans, leading

investment banks continued to do business with them and helped them sell or securitize hundreds

of billions of dollars in home mortgages.

Hybrid ARMs. One common high risk loan used by lenders in the years leading up to

the financial crisis was the short term hybrid adjustable rate mortgage (Hybrid ARM), which was

offered primarily to subprime borrowers. From 2000 to 2007, about 70% of subprime loans

Table 3.

Hybrid ARMs were often referred to “2/28,” “3/27,” or “5/25” loans.

These 30-year mortgages typically had a low fixed teaser rate, which then reset to a higher

floating interest rate, after two years for the 2/28, three years for the 3/27, or five years for the

5/25. The initial loan payment was typically calculated by assuming the initial low, fixed

interest rate would be used to pay down the loan. In some cases, the loan used payments that

initially covered only the interest due on the loan and not any principal; these loans were called

“interest only” loans. After the fixed period for the teaser rate expired, the monthly payment was

typically recalculated using the higher floating rate to pay off the remaining principal and interest

owing over the course of the remaining loan period. The resulting monthly payment was much

Century and Fremont, see section (D)(2)(c)-(d) of Chapter IV.

Sources,” GAO, Report No. GAO-10-805 at 5, 11.

22

larger and sometimes caused borrowers to experience “payment shock” and default on their

loans. To avoid the higher interest rate and the larger loan payment, many of the borrowers

routinely refinanced their loans; when those borrowers were unable to refinance, many were

unable to afford the higher mortgage payment and defaulted.

Pick-A-Payment or Option ARMs. Another common high risk loan, offered to both

prime and subprime borrowers during the years leading up to the financial crisis, was known as

the “pick-a-payment” or “option adjustable rate mortgage” (Option ARM). According to a 2009

GAO report:

“[P]ayment-option ARMs were once specialized products for financially sophisticated

borrowers but ultimately became more widespread. According to federal banking

regulators and a range of industry participants, as home prices increased rapidly in some

areas of the country, lenders began marketing payment-option ARMs as affordability

Option ARMs typically allowed the borrower to pay an initial low teaser rate, sometimes

as low as a 1% annual rate for the first month, and then imposed a much higher interest rate

linked to an index, while also giving the borrower a choice each month of how much to pay

down the outstanding loan balance. These loans were called “pick-a-payment” or “option”

ARMs, because borrowers were typically allowed to choose among four alternatives: (1) paying

the fully amortizing amount needed to pay off the loan in 30 years; (2) paying an even higher

amount to pay off the loan in 15 years; (3) paying only the interest owed that month and no

principal; or (4) making a “minimum” payment that covered only a portion of the interest owed

and none of the principal. If the minimum payment option were selected, the unpaid interest

would be added to the loan principal. If, each month, the borrower made only the minimum

payment, the loan principal would increase rather than decrease over time, creating a negatively

amortizing loan.

Typically, after five years or when the loan principal reached a designated threshold, such

as 110%, 115%, or 125% of the original loan amount, the loan would “recast.” The borrower

would then be required to make the fully amortizing payment needed to pay off the remaining

loan amount within the remaining loan period. The new monthly payment amount was typically

much greater, causing payment shock and increasing loan defaults. For example, a borrower

taking out a $400,000 loan, with a teaser rate of 1.5% and subsequent interest rate of 6%, might

have a minimum payment of $1,333. If the borrower then made only the minimum payments

until the loan recast, the new payment using the 6% rate would be $2,786, an increase of more

than 100%. What began as a 30-year loan for $400,000 became a 25-year loan for $432,000. To

avoid having the loan recast, option ARM borrowers typically sought to refinance their loans. At

some lenders, a significant portion of their option ARM business consisted of refinancing

existing loans.

Home Equity Loans. A third type of high risk loan that became popular during the

years leading up to the financial crisis was the home equity loan (HEL). HELs provided loans

23

secured by the borrower’s equity in his or her home, which served as the loan collateral. HELs

typically provided a lump sum loan amount that had to be repaid over a fixed period of time,

such as 5, 10, or 30 years, using a fixed interest rate, although adjustable rates could also be

used. A related loan, the Home Equity Line of Credit (HELOC), created a revolving line of

credit, secured by the borrower’s home, that the borrower could use at will, to take out and repay

various levels of debt over time, typically using an adjustable rate of interest. Both HELs and

HELOCs created liens against the borrower’s house which, in the event of a default, could be

sold to repay any outstanding loan amounts.

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

HEL and the mortgage often provided the borrower with financing equal to 85%, 90%, or even

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.

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.

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

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

including both first and second home liens, of 100%, but by 2006, the percentage had climbed tenfold to 29.3%.

Option ARMs as a separate loan category.

24

Stated Income Loans. Stated income loans were a more extreme form of low doc Alt A

loans, in that they imposed no documentation requirements and required little effort by the lender

to verify the borrower’s income. These loans allowed borrowers simply to “state” their income,

with no verification by the lender of the borrower’s income or assets other than to consider the

income’s “reasonableness.” They were sometimes called “NINA” loans, because “No Income”

and “No Assets” of the borrower were verified by the lender. They were also referred to as “liar

loans,” since borrowers could lie about their incomes, and the lender would make little effort to

substantiate the claimed income. Many lenders believed they could simply rely on the other

underwriting tools, such as the borrower’s credit score and the property appraisal, to ensure the

loans would be repaid. Once rare and reserved only for wealthier borrowers, stated income loans

became commonplace in the years leading up to the financial crisis. For example, at Washington

Mutual Bank, one of the case studies in this Report, by the end of 2007, stated income loans

made up 50% of its subprime loans, 73% of its Option ARMs, and 90% of its home equity

Nationwide, the percentage of high risk loans issued with low or no documentation of

borrower income or assets was less dramatic. According to GAO, for example, from 2000 to

2006, the nationwide percentage of subprime loans with low or no documentation of borrower

Volume and Speed. When lenders kept on their books the loans they issued, the

creditworthiness of those loans determined whether the lender would turn a profit. Once lenders

began to sell or securitize most of their loans, volume and speed, as opposed to creditworthiness,

became the keys to a profitable securitization business.

In addition, in the years leading up to the financial crisis, investors that might normally

insist on purchasing only high quality securities, purchased billions of dollars in RMBS

securities containing poor quality, high risk loans, in part because those securities bore AAA

ratings from the credit rating agencies, and in part because the securities offered higher returns

compared to other AAA rated investments. Banks also bought investment grade RMBS

securities to take advantage of their lower capital requirements. Increasingly, the buyers of

RMBS securities began to forego detailed due diligence of the RMBS securities they purchased.

Instead, they, like the lenders issuing the mortgages, operated in a mortgage market that came to

be dominated by volume and speed, as opposed to credit risk.

Lenders that produced a high volume of loans could sell pools of the loans to Wall Street

or to government sponsored entities like Fannie Mae and Freddie Mac. Likewise, they could

securitize the loans and work with Wall Street investment banks to sell the securities to investors.

These lenders passed on the risk of nonpayment to third parties, and so lost interest in whether

the sold loans would, in fact, be repaid. Investment banks that securitized the loans garnered

fees for their services and also typically passed on the risk of nonpayment to the investors who

Inspector General at the Department of the Treasury and Federal Deposit Insurance Corporation, at 10, Hearing

Exhibit 4/16-82.

25

bought the mortgage backed securities. The investment banks were typically interested in loan

repayment rates only to the extent needed to ensure defaulting loans did not cause losses to the

mortgage backed securities they sold. Even some of the investors who purchased the mortgage

backed securities lost interest in their creditworthiness, so long as they could buy “insurance” in

the form of credit default swaps that paid off if a mortgage backed security defaulted.

To ensure an ongoing supply of loans for sale, lenders created compensation incentives

that encouraged their personnel to quickly produce a high volume of loans. They also

encouraged their staffs to issue or purchase higher risk loans, because those loans produced

higher sale prices on Wall Street. Loan officers, for example, 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, often called yield

spread premiums, if they charged borrowers higher interest rates or points than required in the

lender’s rate sheets specifying loan prices, or included prepayment penalties in the loan

agreements. The Subcommittee’s investigation found that lenders employed few compensation

incentives to encourage loan officers or loan processors to produce high quality, creditworthy

loans in line with the lender’s credit requirements.

As long as home prices kept rising, the high risk loans fueling the securitization markets

produced few problems. Borrowers who could not make their loan payments could refinance

their loans or sell their homes and use the sale proceeds to pay off their mortgages. As this chart

shows, over the ten years before the crisis hit, housing prices shot up faster than they had in

Paulson & Co. Inc., Hearing Exhibit 4/13-1j.

26

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.

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

27

Credit ratings are issued by private firms that have been officially designated by the SEC

as Nationally Recognized Statistical Rating Organizations (NRSROs). NRSROs are usually

referred to as “credit rating agencies.” While there are ten registered credit rating agencies in the

United States, the market is dominated by just three: Moody’s Investors Service, Inc.

(Moody’s); Standard & Poor’s Financial Services LLC (S&P); and Fitch Ratings Ltd. (Fitch).

A high credit rating indicates that a debt instrument is expected to be

repaid and so qualifies as a safe investment.

38

By some accounts, these firms issue about 98% of the total credit ratings and collect 90% of total

Credit ratings use a scale of letter grades to indicate credit risk, ranging from AAA to D,

with AAA ratings designating the safest investments. Investments with AAA ratings have

historically had low default rates. For example, S&P reported that its cumulative RMBS default

rate by original rating class (through September 15, 2007) was 0.04% for AAA initial ratings and

Investors often rely on credit ratings to gauge the safety of a particular investment. Some

institutional investors design an investment strategy that calls for acquiring assets with specified

credit ratings. State and federal law also restricts the amount of below investment grade bonds

that certain investors can hold, such as pension funds and insurance companies.

Financial instruments bearing AAA through BBB- ratings are generally

referred to as “investment grade,” while those with ratings below BBB- (or Baa3) are referred to

as “below investment grade” or sometimes as having “junk” status. Financial instruments that

default receive a D rating from Standard & Poor’s, but no rating at all from Moody’s.

41

Although the SEC has generally overseen the credit rating industry for many years, it had

no statutory basis to exercise regulatory authority until enactment of the Credit Rating Agency

Reform Act in September 2006. Concerned by the inflated credit ratings that had been issued for

Banks are also

limited by law in the amount of noninvestment grade bonds they can hold, and are typically

federal and state statutes and regulations required financial institutions to hold securities with

investment grade ratings, the credit rating agencies were not only guaranteed a steady business,

but were encouraged to issue AAA and other investment grade ratings. Issuers of securities and

other financial instruments also worked hard to obtain favorable credit ratings to ensure more

investors could buy their products.

Report No. R40613 (revised report issued 4/9/2010). For more information about the credit rating process and the

credit rating agencies, see Chapter V, below.

Report No. R40613 (revised report issued 4/9/2010).

“The Role of Credit Rating Agencies in the Structured Finance Market,” before the U.S. House of Representatives

Subcommittee on Capital Markets, Insurance and Government Sponsored Enterprises of the Committee on Financial

Services, Serial No. 110-62 (9/27/2007), S&P SEC-PSI 0001945-71, at 51. (See Chapter V below.) See also 1/2007

“Annual 2006 Global Corporate Default Study and Ratings Transitions,” S&P.

28

bonds from Enron Corporation and other troubled corporations, Congress strengthened the

SEC’s authority over the credit rating industry. Among other provisions, the law established

criteria for the NRSRO designation and authorized the SEC to conduct examinations of credit

rating agencies. The law also, however, prohibited the SEC from regulating credit rating criteria

or methodologies used in credit rating models. In June 2007, the SEC issued implementing

regulations, which were essentially too late to affect the ratings already provided for mortgage

related securities. One month later, in July 2007, the credit rating agencies issued the first of

several mass downgrades of the ratings earlier issued for mortgage related securities.

Structured Finance. In recent years, Wall Street firms have devised increasingly

complex financial instruments for sale to investors. These instruments are often referred to as

structured finance. Because structured finance products are so complicated and opaque,

investors often place particular reliance on credit ratings to determine whether they should buy

them.

Among the oldest types of structured finance products are RMBS securities. To create

loans into a loan pool, and calculate the revenue stream coming into the loan pool from the

individual mortgages. They then design a “waterfall” that delivers a stream of revenues in

sequential order to specified “tranches.” The first tranche is at the top of the waterfall and is

typically the first to receive revenues from the mortgage pool. Since that tranche is guaranteed

to be paid first, it is the safest investment in the pool. The issuer creates a security, often called a

bond, linked to that first tranche. That security typically receives a AAA credit rating since its

revenue stream is the most secure.

The security created from the next tranche receives the same or a lower credit rating and

so on until the waterfall reaches the “equity” tranche at the bottom. The equity tranche typically

receives no rating since it is the last to be paid, and therefore the first to incur losses if mortgages

in the loan pool default. Since virtually every mortgage pool has at least some mortgages that

default, equity tranches are intended to provide loss protection for the tranches above it. Because

equity tranches are riskier, however, they are often assigned and receive a higher rate of interest

and can be profitable if losses are minimal. One mortgage pool might produce five to a dozen or

more tranches, each of which is used to create a residential mortgage backed security that is rated

and then sold to investors.

Cash CDOs. Collateralized debt obligations (CDOs) are another type of structured

finance product whose securities receive credit ratings and are sold to investors. CDOs are a

more complex financial product that involves the re-securitization of existing income-producing

assets. From 2004 through 2007, many CDOs included RMBS securities from multiple

mortgage pools. For example, a CDO might contain BBB rated securities from 100 different

RMBS securitizations. CDOs can also contain other types of assets, such as commercial

mortgage backed securities, corporate bonds, or other CDO securities. These CDOs are often

called “cash CDOs,” because they receive cash revenues from the underlying RMBS bonds and

other assets. If a CDO is designed so that it contains a specific list of assets that do not change, it

is often called a “static” CDO; if the CDO’s assets are allowed to change over time, it is often

29

referred to as a “managed” CDO. Like an RMBS securitization, the CDO arranger calculates the

revenue stream coming into the pool of assets, designs a waterfall to divide those incoming

revenues among a hierarchy of tranches, and uses each tranche to issue securities that can then be

marketed to investors. The most senior tranches of a CDO may receive AAA ratings, even if all

of its underlying assets have BBB ratings.

Synthetic CDOs. Some investment banks also created “synthetic CDOs” which

mimicked cash CDOs, but did not contain actual mortgages or other assets that produced income.

Instead, they simply “referenced” existing assets and then allowed investors to use credit default

swaps to place bets on the performance of those referenced assets. Investors who bet that the

referenced assets would maintain or increase in value bought the CDO’s securities and, in

exchange, received periodic coupon payments to recoup their principal investment plus interest.

Investors who bet that the referenced assets would lose value or incur a specified negative credit

event purchased one or more credit default swap contracts referencing the CDO’s assets, and

paid monthly premiums to the CDO in exchange for obtaining a large lump sum payment if the

loss or other negative credit event actually occurred. Investors in synthetic CDOs who bet the

referenced assets would maintain or increase in value were said to be on the “long” side, while

investors who bet the assets would lose value or fail were said to be on the “short” side. Some

investment banks also created “hybrid CDOs” which contained some cash assets as well as credit

default swaps referencing other assets. Others created financial instruments called CDO squared

or cubed, which contained or referenced tranches from other CDOs.

Like RMBS mortgage pools and cash CDOs, synthetic and hybrid CDOs pooled the

payments they received, designed a waterfall assigning portions of the revenues to tranches set

up in a certain order, created securities linked to the various tranches, and then sold the CDO

securities to investors. Some CDOs employed a “portfolio selection agent” to select the initial

assets for the CDO. In addition, some CDOs employed a “collateral manager” to select both the

initial and subsequent assets that went into the CDO.

Ratings Used to Market RMBS and CDOs. Wall Street firms helped design RMBS

and CDO securities, worked with the credit rating agencies to obtain ratings for the securities,

and sold the securities to investors like pension funds, insurance companies, university

endowments, municipalities, and hedge funds. Without investment grade ratings, Wall Street

firms would have had a more difficult time selling structured finance products to investors,

because each investor would have had to perform its own due diligence review of the product. In

addition, their sales would have been restricted by federal and state regulations limiting certain

institutional investors to the purchase of instruments carrying investment grade credit ratings.

Still other regulations conditioned capital reserve requirements on the credit ratings assigned to a

bank’s investments. Investment grade credit ratings, thus, purported to simplify the investors’

due diligence review, ensured some investors could make a purchase, reduced banks’ capital

calls, and otherwise enhanced the sales of the structured finance products. Here’s how one

federal bank regulator’s handbook put it:

quality of the transactions. Such agencies are considered credible because they possess

30

the expertise to evaluate various underlying asset types, and because they do not have a

financial interest in a security’s cost or yield. Ratings are important because investors

generally accept ratings by the major public rating agencies in lieu of conducting a due

The more complex and opaque the structured finance instruments became, the more reliant

investors were on high credit ratings for the instruments to be marketable.

In addition to making structured finance products easier to sell to investors, Wall Street

firms used financial engineering to combine AAA ratings – normally reserved for ultra-safe

investments with low rates of return – with high risk assets, such as the AAA tranche from a

subprime RMBS paying a relatively high rate of return. Higher rates of return, combined with

Record Ratings and Revenues. From 2004 to 2007, Moody’s and S&P produced a record

number of ratings and a record amount of revenues for rating structured finance products. A

2008 S&P submission to the SEC indicates, for example, that from 2004 to 2007, S&P issued

to a 2008 Moody’s submission to the SEC, from 2004 to 2007, Moody’s issued over 4,000

Revenues increased dramatically over the same time period. The credit rating agencies

charged substantial fees to rate a product. To obtain a rating during the height of the market, for

example, S&P generally charged from $40,000 to $135,000 to rate tranches of an RMBS and

Moody’s gross revenues from RMBS and CDO ratings more than tripled, going from over $61

Securitization,” at 11.

S&P’s revenue also increased. S&P’s gross

revenues for RMBS and mortgage related CDO ratings quadrupled, from over $64 million in

RMBS or CDO pools that were presented to S&P which then issued ratings for multiple tranches per RMBS or

CDO pool. (See Chapter V below.)

These numbers represent the RMBS or CDO pools that were presented to Moody’s which then issued ratings for

multiple tranches per RMBS or CDO pool. The data Moody’s provided to the SEC on CDOs represented ABS

CDOs, some of which may not be mortgage related. However, by 2004, most, but not all, CDOs relied primarily on

mortgage related assets such as RMBS securities. Subcommittee interview of Gary Witt, former Managing Director

of Moody’s RMBS Group (10/29/2009). (See Chapter V below.)

Evaluations,” prepared by S&P, S&P-PSI 0000028-35; and “U.S. Structured Ratings Fee Schedule Collateralized

Debt Obligations Amended 3/7/2007,” prepared by S&P, S&P-PSI 0000036-50. (See Chapter V below.)

The 2002 figure does not include gross revenue from CDO ratings as this figure was not readily available due to the

transition of Moody’s accounting systems. (See Chapter V below.)

31

Conflicts of Interest. Credit rating agencies are paid by the issuers seeking ratings for

the products they sell. Issuers and the investment banks want high ratings, whether to help

market their products or ensure they comply with federal regulations. Because credit rating

agencies issue ratings to issuers and investment banks who bring them business, they are subject

to an inherent conflict of interest that can create pressure on the credit rating agencies to issue

favorable ratings to attract business. The issuers and investment banks engage in “ratings

shopping,” choosing the credit rating agency that offers the highest ratings. Ratings shopping

weakens rating standards as the rating agencies who provide the most favorable ratings win more

business. In September 2007, Moody’s CEO described the problem this way: “What happened

in ’04 and ’05 with respect to subordinated tranches is that our competition, Fitch and S&P, went

conflicts of interest faced by credit rating agencies have increased in recent years, particularly

given the expansion of large credit rating agencies into ancillary advisory and other businesses,

Mass Downgrades. The credit ratings assigned to RMBS and CDO securities are

designed to last the lifetime of the securities. Because circumstances can change, however,

credit rating agencies conduct ongoing surveillance of each rated financial product to evaluate

the rating and determine whether it should be upgraded or downgraded. Prior to the financial

crisis, the numbers of downgrades and upgrades for structured finance ratings were substantially

From 2004 through the first half of 2007, Moody’s and S&P provided AAA ratings to a

AAA ratings to as much as 95% of a securitization.

Beginning in July 2007, however, Moody’s and S&P issued hundreds and then

thousands of downgrades of RMBS and CDO ratings, the first mass downgrades in U.S. history.

over 90% of the AAA ratings issued to RMBS securities originated in 2006 and 2007 had been

http://thismatter.com/money, Hearing Exhibit 4/23-1g.

prepared by the SEC, at 40. The report continued: “[C]oncerns had been expressed that a rating agency might be

tempted to give a more favorable rating to a large issue because of the large fee, and to encourage the issuer to

submit future large issues to the rating agency.” Id. at 40 n.109.

Fitch.

May 2010, at 1.

BlackRock Solutions, Hearing Exhibit 4/23-1i. See also 3/2008 “Understanding the Securitization of Subprime

Moody’s and S&P began downgrading RMBS and CDO products in late 2006, when

residential mortgage delinquency rates and losses began increasing. Then, in July 2007, both

S&P and Moody’s initiated the first of several mass downgrades that shocked the financial

markets. On July 10, S&P placed on credit watch the ratings of 612 subprime RMBS with an

original value of $7.35 billion. Later that day, Moody’s downgraded 399 subprime RMBS with

an original value of $5.2 billion. Two days later, S&P downgraded 498 of the ratings it had

placed on credit watch.

In October 2007, Moody’s began downgrading CDOs on a daily basis, downgrading

more than 270 CDO securities with an original value of $10 billion. In December 2007,

Moody’s downgraded another $14 billion in CDOs, and placed another $105 billion on credit

watch. Moody’s calculated that, overall in 2007, “8725 ratings from 2116 deals were

over four times more ratings than it upgraded. On January 30, 2008, S&P either downgraded or

placed on credit watch over 8,200 ratings of subprime RMBS and CDO securities, representing

These downgrades created significant turmoil in the securitization markets, as investors

were required by regulations to sell off assets that had lost their investment grade status, holdings

at financial firms plummeted in value, and new securitizations were unable to find investors. As

a result, the subprime RMBS and CDO secondary markets slowed and then collapsed, and

financial firms around the world were left holding billions of dollars in suddenly unmarketable

RMBS and CDO securities.

Historically, investment banks helped raise capital for business and other endeavors by

helping to design, finance, and sell financial products like stocks or bonds. When a corporation

needed capital to fund a large construction project, for example, it often hired an investment

bank either to help it arrange a bank loan or raise capital by helping to market a new issue of

shares or corporate bonds to investors. Investment banks also helped with corporate mergers and

acquisitions. Today, investment banks also participate in a wide range of other financial

activities, including offering broker-dealer and investment advisory services, and trading

derivatives and commodities. Many have also been active in the mortgage market and have

worked with lenders or mortgage brokers to package and sell mortgage loans and mortgage

backed securities. Investment banks have traditionally performed these services in exchange for

fees.

lien subprime deals originated in 2006 as well as … 91.8 percent of 2nd-lien deals originated in 2006 have been

downgraded.”).

Moody’s, at 4.

(1/30/2008 “S&P Takes Action on 6,389 U.S. Subprime RMBS Ratings and 1,953 CDO Ratings,” S&P’s

RatingsDirect). Ratings may appear on CreditWatch when events or deviations from an expected trend occur and

additional information is needed to evaluate the rating.

33

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

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

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

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

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.

and Rule 10b-5 thereunder.

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)).

34

This inventory or portfolio of long-term assets is typically designated as “held for investment,”

and is not used in day-to-day transactions.

Investment banks that carry out market-making and proprietary trading activities are

requirements typically vary based on how the positions are held and how they are classified. For

example, assets that are “held for sale” or are in the “trading account” typically have lower

capital requirements than those that are “held for investment,” because of the expected lower

risks associated with what are expected to be shorter term holdings.

Many investment banks use complex automated systems to analyze the “Value at Risk”

(VaR) associated with their holdings. To reduce the VaR attached to their holdings, investment

banks employ a variety of methods to offset or “hedge” their risk. These methods can include

diversifying their assets, taking a short position on related financial products, purchasing loss

protection through insurance or credit default swaps, or taking positions in derivatives whose

values move inversely to the value of the assets being hedged.

Shorting the Mortgage Market. Prior to the financial crisis, investors commonly

purchased RMBS or CDO securities as long-term investments that produced a steady income. In

2006, however, the high risk mortgages underlying these securities began to incur record levels

of delinquencies. Some investors, worried about the value of their holdings, sought to sell their

RMBS or CDO securities, but had a difficult time doing so due to the lack of an active market.

Some managed to sell their high risk RMBS securities to investment banks assembling cash

CDOs.

Some investors, instead of selling their RMBS or CDO securities, purchased “insurance”

against a loss by buying a credit default swap (CDS) that would pay off if the specified securities

incurred losses or other negative credit events. By 2005, investment banks had standardized

CDS contracts for RMBS and CDO securities, making this a practical alternative.

Much like insurance, the buyer of a CDS contract paid a periodic premium to the CDS

seller, who guaranteed the referenced security against loss. CDS contracts referencing a single

security or corporate bond became known as “single name” CDS contracts. If the referenced

security later incurred a loss, the CDS seller had to pay an agreed-upon amount to the CDS buyer

to cover the loss. Some investors began to purchase single name CDS contracts, not as a hedge

to offset losses from RMBS or CDO securities they owned, but as a way to profit from particular

RMBS or CDO securities they predicted would lose money. CDS contracts that paid off on

securities that were not owned by the CDS buyer were known as “naked credit default swaps.”

Appendix A and 12 CFR part 225, Appendix A (for the Federal Reserve Board of Governors) and 12 CFR part 325,

Appendix A (for the Federal Deposit Insurance Corporation).

35

Some investors purchased large numbers of these CDS contracts in a concerted strategy to profit

from mortgage backed securities they believed would fail.

Some investment banks took the CDS approach a step further. In 2006, a consortium of

investment banks led by Goldman Sachs and Deutsche Bank launched the ABX Index, which

created five indices that tracked the aggregate performance of a basket of 20 designated

markets, investors could buy and sell contracts linked to the value of one of the ABX indices.

Each contract consisted of a credit default swap agreement in which the parties could essentially

wager on the rise or fall of the index value. According to a Goldman Sachs employee, the ABX

Index “introduced a standardized tool that allow[ed] clients to quickly gain exposure to the asset

class,” in this case subprime RMBS securities. An investor – or investment bank – taking a short

position in an ABX contract was, in effect, placing a bet that the basket of subprime RMBS

securities would lose value.

Synthetic CDOs provided still another vehicle for shorting the mortgage market. In this

approach, an investment bank created a synthetic CDO that referenced a variety of RMBS

securities. One or more investors could take the “short” position by paying premiums to the

CDO in exchange for a promise that the CDO would pay a specified amount if the referenced

assets incurred a negative credit event, such as a default or credit rating downgrade. If that event

took place, the CDO would have to pay an agreed-upon amount to the short investors to cover

the loss, removing income from the CDO and causing losses for the long investors. Synthetic

CDOs became a way for investors to short multiple specific RMBS securities that they expected

would incur losses.

Proprietary Trading. Financial institutions also built increasingly large proprietary

holdings of mortgage related assets. Numerous financial firms, including investment banks,

bought RMBS and CDO securities, and retained these securities in their investment portfolios.

Others retained these securities in their trading accounts to be used as inventory for short term

trading activity, market making on behalf of clients, hedging, providing collateral for short term

loans, or maintaining lower capital requirements. Deutsche Bank’s RMBS Group in New York,

for example, built up a $102 billion portfolio of RMBS and CDO securities, while the portfolio

securitizations. One index tracked AAA rated securities from the 20 subprime RMBS securities; the second tracked

AA rated securities from the 20 RMBS securitizations; and the remaining indices tracked baskets of A, BBB, and

BBB rated RMBS securities. Every six months, a new set of RMBS securitizations was selected for a new ABX

index. See 3/2008 “Understanding the Securitization of Subprime Mortgage Credit,” prepared by Federal Reserve

Bank of New York, Report No. 318, at 26. Markit Group Ltd. administered the ABX Index which issued indices in

2006 and 2007, but has not issued any new indices since then.

Other financial firms,

including Bear Stearns, Citibank, JPMorgan Chase, Lehman Brothers, Merrill Lynch, Morgan

Stanley, and UBS also accumulated enormous propriety holdings in mortgage related products.

When the value of these holdings dropped, some of these financial institutions lost tens of

36

One investment bank, Goldman Sachs, built a large number of proprietary positions to

the United States and had accumulated a huge portfolio of mortgage related products. In late

2006, Goldman Sachs decided to reverse course, using a variety of means to bet against the

mortgage market. In some cases, Goldman Sachs took proprietary positions that paid off only

when some of its clients lost money on the very securities that Goldman Sachs had sold to them

and then shorted. Altogether in 2007, Goldman’s mortgage department made $1.1 billion in net

to ensure its continued existence.

U.S. financial regulators failed to stop financial firms from engaging in high risk,

conflict-ridden activities. Those regulatory failures arose, in part, from the fragmented nature of

U.S. financial oversight as well as statutory barriers to regulating high risk financial products.

positions in a number of [its] businesses. These positions are accounted for at fair value, and the declines in the

values of assets have had a direct and large negative impact on [its] earnings in fiscal 2008.”); see also, Viral V.

Acharya and Matthew Richardson, “Causes of the Financial Crisis,” 21 Critical Review 195, 199-204 (2009) (citing

proprietary holdings of asset backed securities as one of the primary drivers of accumulated risks causing the

financial crisis); “Prop Trading Losses Ain’t Peanuts,” The Street (1/27/2010),

http://www.thestreet.com/story/10668047/prop-trading-losses-aint-peanuts.html.

Chapter III of Washington Mutual Bank which was sold to JPMorgan Chase.

the Treasury, at http://www.treasury.gov/initiatives/financial-stability/investmentprograms/

cpp/Pages/capitalpurchaseprogram.aspx.

losses on other desks within the mortgage department, resulting in the $1.1 billion in total net revenues.

the Treasury, available at http://www.treasury.gov/initiatives/financial-stability/investmentprograms/

cpp/Pages/capitalpurchaseprogram.aspx and an example of a transactions report at

http://www.treasury.gov/initiatives/financial-stability/briefing-room/reports/tarptransactions/

DocumentsTARPTransactions/transactions-report-062309.pdf.

the Primary Dealer Credit Facility 85 times in 2008.

“The Federal Bailout of AIG,” before the House Committee on Oversight and Government Reform (1/27/2010),

http://oversight.house.gov/images/stories/Hearings/pdfs/20100127barofsky.pdf (noting that some firms, including

Goldman Sachs, disproportionately benefited from the federal government’s bailout of AIG).

37

Oversight of Lenders. At the end of 2005, the United States had about 8,800 federally

overseen by five agencies: the Federal Reserve which oversaw state-chartered banks that were

part of the Federal Reserve System as well as foreign banks and others; the Office of the

Comptroller of the Currency (OCC) which oversaw banks with national charters; the Office of

Thrift Supervision (OTS) which oversaw federally-chartered thrifts; the National Credit Union

Administration which oversaw federal credit unions; and the Federal Deposit Insurance

Corporation (FDIC) which oversaw financial institutions that have federal deposit insurance

oversaw the state-chartered institutions and at times took action to require federally-chartered

financial institutions to comply with certain state laws.

The primary responsibility of the federal bank regulators was to ensure the safety and

soundness of the financial institutions they oversaw. One key mechanism they used to carry out

that responsibility was to conduct examinations on a periodic basis of the financial institutions

within their jurisdiction and provide the results in an annual Report of Examination (ROE) given

to the Board of Directors at each entity. The largest U.S. financial institutions typically operated

under a “continuous exam” program, which required federal bank examiners to conduct a series

of specialized examinations during the year with the results from all of those examinations

included in the annual ROE.

Federal examination activities were typically led by an Examiner in Charge and were

organized around a rating system called CAMELS that was used by all federal bank regulators.

The CAMELS rating system evaluated a financial institution’s: (C) capital adequacy, (A) asset

quality, (M) management, (E) earnings, (L) liquidity, and (S) sensitivity to market risk.

CAMELS ratings are on a scale of 1 to 5, in which 1 signifies a safe and secure bank with no

cause for supervisory concern, 3 signifies an institution with supervisory concerns in one or more

areas, and 5 signifies an unsafe and unsound bank with severe supervisory concerns. In the

annual ROE, regulators typically provided a financial institution with a rating for each CAMELS

component, as well as an overall composite rating on its safety and soundness.

In addition, the FDIC conducted its own examinations of financial institutions with

federal deposit insurance. The FDIC reviews relied heavily on the examination findings and

ROEs developed by the primary regulator of the financial institution, but the FDIC assigned its

own CAMELS ratings to each institution. In addition, for institutions with assets of $10 billion

or more, the FDIC established a Large Insured Depository Institutions (LIDI) Program to assess

and report on emerging risks that may pose a threat to the federal Deposit Insurance Fund.

Under this program, the FDIC performed an ongoing analysis of emerging risks within each

had 8,832 federal and state chartered insured banks and thrifts).

(showing that, as of 12/31/2005, the United States had 8,695 federal and state credit unions).

duties to the OCC. See Chapter IV.

38

insured institution and assigned a quarterly risk rating, using a scale of A to E, with A being the

best rating and E the worst.

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

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

U.S. Financial Regulatory System,” prepared by the Government Accountability Office, Report No. GAO-09-216, at

26-27.

39

securities world, including securities exchanges, securities brokers and dealers, investment

advisors, and mutual funds,” primarily for the purpose of “promoting the disclosure of important

The securities firms central to the financial crisis were subject to a variety of SEC

regulations in their roles as broker-dealers, investment advisors, market makers, underwriters,

securities firms were required to submit a variety of public filings with the SEC about their

operations and in connection with the issuance of new securities. The SEC’s Office of

Compliance Inspections and Examinations (OCIE) conducted inspections of broker-dealers,

among others, to understand industry practices, encourage compliance, evaluate risk

management, and detect violations of the securities laws. In addition, under the voluntary

Consolidated Supervised Entities program, the SEC’s Division of Trading and Markets

monitored the investment activities of the largest broker-dealers, including Bear Stearns,

Goldman Sachs, Lehman Brothers, Merrill Lynch, Morgan Stanley, Citigroup, and JPMorgan

Like bank regulators, if the SEC became concerned about a particular securities firm, it

could choose from a range of informal and formal enforcement actions. Informal actions could

include issuing a “deficiency letter” identifying problems and requiring the securities firm to take

corrective action by a certain date. Formal enforcement actions, undertaken by the SEC’s

Division of Enforcement, could include civil proceedings before an administrative law judge; a

civil complaint filed in federal district court; civil fines; an order to suspend or remove personnel

from a firm or bar them from the brokerage industry; or a referral for criminal prosecution.

Common securities violations included selling unregistered securities, misrepresenting

Statutory and Regulatory Barriers. Federal and state financial regulators responsible

for oversight of banks, securities firms, and other financial institutions in the years leading to the

financial crisis operated under a number of statutory and regulatory constraints.

One key constraint was the sweeping statutory prohibition on the federal regulation of

any type of swap, including credit default swaps. This prohibition took effect in 2000, with

The key statutory section

explicitly prohibited federal regulators from requiring the registration of swaps as securities;

issuing or enforcing any regulations or orders related to swaps; or imposing any recordkeeping

www.sec.gov.

federal oversight by taking advantage of exemptions in the Investment Company Act of 1940.

40

rate swap,’ including a rate floor, rate cap, rate collar, cross-currency rate swap, basis swap,

currency swap, equity index swap, equity swap, debt index swap, debt swap, credit spread, credit

federal regulators could not even ask U.S. financial institutions to report on their swaps trades or

holdings, much less regulate swap dealers or examine how swaps were affecting the mortgage

market or other U.S. financial markets.

As a result, the multi-trillion-dollar U.S. swaps markets operated with virtually no

disclosure requirements, no restrictions, and no oversight by any federal agency, including the

market for credit default swaps which played a prominent role in the financial crisis. On

September 23, 2008, in a hearing before the Senate Committee on Banking, Housing, and Urban

Affairs, then SEC Chairman Christopher Cox testified that, as a result of the statutory

prohibition, the credit default swap market “is completely lacking in transparency,” “is regulated

discussed regulatory gaps impeding his agency and again raised the issue of swaps:

“Unfortunately, as I reported to Congress this week, a massive hole remains: the approximately

$60 trillion credit default swap market, which is regulated by no agency of government. Neither

A second significant obstacle for financial regulators was the patchwork of federal and

state laws and regulations applicable to high risk mortgages and mortgage brokers. Federal bank

regulators took until October 2006, to provide guidance to federal banks on acceptable lending

whose standards were not enforceable in court and failed to address such key issues as the

Reserve, in 1994, to issue regulations to prohibit deceptive or abusive mortgage practices –

regulations that could have applied across the board to all types of lenders and mortgage brokers

– the Federal Reserve failed to issue any until July 2008, after the financial crisis had already

Government Sponsored Entities, Investment Banks and Other Financial Institutions,” before the U.S. Senate

Committee on Banking, Housing and Urban Affairs, S.Hrg. 110-1012 (9/23/2008).

http://www.sec.gov/news/press/2008/2008-230.htm.

192 at 58609.

Equity Protection Act of 1994 (HOEPA), P.L. 103-325. The Federal Reserve did not issue any regulations under

HOEPA, however, until July 2008, when it amended Regulation Z. The new rules primarily strengthened consumer

protections for “higher priced loans,” which included many types of subprime loans. See “New Regulation Z Rules

Enhance Protections for Mortgage Borrowers,” Consumer Compliance Outlook (Fourth Quarter 2008) (Among

41

A third problem, exclusive to state regulators, was a 2005 regulation issued by the OCC

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

effectively unable to enforce state laws prohibiting abusive mortgage practices against federallychartered

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.

Between 1990 and 2004, homeownership rates in the United States increased rapidly

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.”).

http://www.census.gov/hhes/www/housing/hvs/annual09/ann09t14.xls.

42

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.

Over time, however, Fannie Mae and Freddie Mac began to purchase larger quantities of

higher risk loans, providing a secondary market for those loans and encouraging their

proliferation. Between 2005 and 2007, Fannie Mae alone purchased billions of dollars in high

risk home loans, including Option ARM, Alt A, and loans with subprime characteristics. For

example, data from Fannie Mae shows that, in mid 2008, 62% of the Option ARM loans on its

were purchased in that time frame, as were 57% of those with FICO scores less than 620; 62% of

loans constituted only a small percentage of Fannie Mae’s purchases at the time, they came to

account for some its most significant losses. By the middle of 2009, Fannie Mae reported an

unpaid principal balance of $878 billion for its loans with subprime characteristics, nearly a third

According to economist Arnold Kling, Fannie Mae and Freddie Mac purchased these

loans after “lowering their own credit standards in order to maintain a presence in the market and

Throughout their history, Fannie Mae and Freddie Mac were able to bundle the

mortgages they purchased into securities that were popular with investors, because many

believed the securities carried the implicit support of the federal government. The Congressional

Budget Office found the following:

“Because of their [Fannie Mae and Freddie Mac] size and interconnectedness with other

financial institutions, they posed substantial systemic risk—the risk that their failure

could impose very high costs on the financial system and the economy. The GSEs’

market power also allowed them to use their profits partly to benefit their other stakeholders

rather than exclusively to benefit mortgage borrowers. The implicit guarantee

created an incentive for the GSEs to take excessive risks: Stakeholders would benefit

when gambles paid off, but taxpayers would absorb the losses when they did not. …

One way that Fannie Mae and Freddie Mac increased risk was by expanding the volume

of mortgages and MBSs held in their portfolios, which exposed them to the risk of losses

http://www.fanniemae.com/media/pdf/newsreleases/2008_Q2_10Q_Investor_Summary.pdf.

http://www.fanniemae.com/ir/pdf/sec/2009/q2credit_summary.pdf.

2009, Mercatus Center, http://mercatus.org/sites/default/files/publication/NotWhatTheyHadInMind(1).pdf.

43

from changes in interest or prepayment rates. Over the past decade, the two GSEs also

increased their exposure to default losses by investing in lower-quality mortgages, such

The risks embedded in their mortgage portfolios finally overwhelmed the GSEs in

September 2008, and both Fannie Mae and Freddie Mac were taken into conservatorship by the

federal government. Since that time, the Treasury Department has spent nearly $150 billion to

Ginnie Mae. Additional housing policies that allowed borrowers with less than adequate

credit to obtain traditional mortgages included programs at the Federal Housing Administration

(FHA) and the Department of Veterans Affairs (VA). Both agencies provided loan guarantees to

lenders that originated loans for borrowers that qualified under the agencies’ rules. Many of the

loans guaranteed by the FHA and VA, some of which required down payments as low as 3%,

were bundled and sold as mortgage backed securities guaranteed by the Government National

Mortgage Association (Ginnie Mae), a government corporation. Ginnie Mae guaranteed

investors the timely payment of principal and interest on mortgage backed securities backed by

federally insured or guaranteed loans.

In the years leading up to the financial crisis, FHA guaranteed millions of home loans

FHA loans originated in 2008 were seriously delinquent, meaning borrowers had missed three or

more payments, while loans originated in 2007 had a serious delinquency rate of over 22%. The

2007 and 2008 loans, which currently make up about 15% of FHA’s active loan portfolio,

remain the worst performing in that portfolio. In 2009 and 2010, FHA tightened its underwriting

guidelines, and the loans it guaranteed performed substantially better. By early 2011, the serious

delinquency rate for all FHA borrowers was about 8.8%, down from over 9.4% the prior year.

In response to the financial crisis, Congress and the Executive Branch have taken a

number of actions. Three that have brought significant changes are the Troubled Asset Relief

Program, Federal Reserve assistance programs, and the Dodd-Frank Wall Street and Consumer

Protection Act.

Troubled Asset Relief Program (TARP). On October 3, 2008, Congress passed and

President Bush signed into law the Emergency Economic Stabilization Act of 2008, P.L. 110-

343. This law, which passed both Houses with bipartisan majorities, established the Troubled

Market,” December 2010, at x, http://www.cbo.gov/ftpdocs/120xx/doc12032/12-23-FannieFreddie.pdf.

Draws for Fannie Mae and Freddie Mac,” October 21, 2010, http://fhfa.gov/webfiles/19409/Projections_102110.pdf.

“FHA Single-Family Mutual Mortgage Insurance Fund Programs, Quarterly Report to Congress, FY 2011 Q1,”

March 17, 2011, at 4 and 19, http://www.hud.gov/offices/hsg/rmra/oe/rpts/rtc/fhartc_q1_2011.pdf.

44

Asset Relief Program (TARP) and authorized the expenditure of up to $700 billion to stop

financial institutions from collapsing and further damaging the U.S. economy. Administered by

the Department of the Treasury, with support from the Federal Reserve, TARP funds have been

used to inject capital into or purchase or insure assets at hundreds of large and small banks.

The largest recipients of TARP funds were AIG, Ally Financial (formerly GMAC

Financial Services), Bank of America, Citigroup, Goldman Sachs, JPMorgan Chase, Morgan

Stanley, PNC Financial Services, U.S. Bancorp, and Wells Fargo, as well as Chrysler, and

General Motors. Most have repaid all or a substantial portion of the TARP funds they received.

Although initially expected to cost U.S. taxpayers more than $350 billion, the

Congressional Budget Office estimated in November 2010, that the final cost of the TARP

Federal Reserve Emergency Support Programs. In addition, as the financial crisis

began to unfold, the Federal Reserve aggressively expanded its balance sheet from about $900

billion at the beginning of 2008, to more than $2.4 trillion in December 2010, to provide support

to the U.S. financial system and economy. Using more than a dozen programs, through more

than 21,000 individual transactions, the Federal Reserve provided trillions of dollars in assistance

to U.S. and foreign financial institutions in an effort to promote liquidity and prevent a financial

Mortgage Backed Securities Purchase Program which purchased more than $1.25 trillion in

Dodd-Frank Act. On July 21, 2010, Congress passed and President Obama signed into

law the Dodd-Frank Wall Street Reform and Consumer Protection Act, P.L. 111-203. This law,

which passed both Houses with bipartisan majorities, expanded the authority of regulatory

agencies to try to prevent future financial crises. Among other provisions, the law:

In other

instances, it modified and significantly expanded existing programs, such as by lowering the

quality of collateral it accepted and increasing lending by the discount window.

– established a Financial Stability Oversight Council, made up of federal financial

regulators and others, to identify and respond to emerging financial risks;

– established a Consumer Financial Protection Bureau to strengthen protection of

American consumers from abusive financial products and practices;

– restricted proprietary trading and investments in hedge funds by banks and other large

financial institutions;

http://www.cbo.gov/ftpdocs/119xx/doc11980/11-29-TARP.pdf.

http://www.federalreserve.gov/newsevents/reform_transaction.htm.

http://www.federalreserve.gov/newsevents/reform_mbs.htm.

45

– prohibited sponsors of asset backed securities from engaging in transactions that would

involve or result in a material conflict of interest with investors in those securities;

– established procedures to require nonbank firms whose failure would threaten U.S.

financial stability to divest some holdings or undergo an orderly liquidation;

– strengthened regulation of credit rating agencies;

– strengthened mortgage regulation, including by clamping down on high cost mortgages,

requiring securitizers to retain limited liability for securities reliant on high risk

mortgages, banning stated income loans, and restricting negative amortization loans;

– required better federal regulation of mortgage brokers;

– directed regulators to require greater capital and liquidity reserves;

– required regulation of derivatives and derivative dealers;

– required registration of certain hedge funds and private equity funds;

– authorized regulators to impose standards of conduct that are the same as those

applicable to investment advisers on broker-dealers who provide personalized

investment advice to retail customers; and

– abolished the Office of Thrift Supervision.

This Report reviews events from the period 2004 to 2008, in an effort to identify and

explain four significant causes of the financial crisis. A variety of events could be identified as

the start of the crisis. Candidates include the record number of home loan defaults that began in

December 2006; the FDIC’s March 2007 cease and desist order against Fremont Investment &

Loan which exposed the existence of unsafe and unsound subprime lending practices; or the

collapse of the Bear Stearns hedge funds in June 2007. Still another candidate is the two-week

period in September 2008, when half a dozen major U.S. financial institutions failed, were

forcibly sold, or were bailed out by U.S. taxpayers seeking to prevent a collapse of the U.S.

economy.

This Report concludes, however, that the most immediate trigger to the financial crisis

was the July 2007 decision by Moody’s and S&P to downgrade hundreds of RMBS and CDO

securities. The firms took this action because, in the words of one S&P senior analyst, the

investment grade ratings could not “hold.” By acknowledging that RMBS and CDO securities

containing high risk, poor quality mortgages were not safe investments and were going to incur

losses, the credit rating agencies admitted the emperor had no clothes. Investors stopped buying,

the value of the RMBS and CDO securities fell, and financial institutions around the world were

46

suddenly left with unmarketable securities whose value was plummeting. The financial crisis

was on.

Because of the complex nature of the financial crisis, this chapter concludes with a brief

timeline of some key events from 2006 through 2008. The succeeding chapters provide more

detailed examinations of the roles of high risk lending, federal regulators, credit ratings agencies,

and investment banks in causing the financial crisis.

47

Crisis: A Timeline of Events and Policy Actions,” http://timeline.stlouisfed.org/index.cfm?p=timeline.

Ownit Mortgage Solutions bankruptcy

Freddie Mac announces it will no longer buy the

most risky subprime mortgages

FDIC issues cease and desist order against Fremont

for unsafe and unsound banking

New Century bankruptcy

Two Bear Stearns subprime hedge funds collapse

Credit rating agencies issue first mass ratings

downgrades of hundreds of RMBS and CDO

securities

American Home Mortgage bankruptcy

Federal Reserve: “[M]arket conditions have

deteriorated… downside risks to growth have

increased appreciably.”

Ameriquest Mortgage ceases operations

Federal Reserve establishes Term Auction Facility

to provide bank funding

ABX Index stops issuing new subprime indices

Countrywide announces sale to Bank of America

S&P downgrades or places on credit watch over

8,000 RMBS and CDO securities

Federal Reserve Bank of New York forms Maiden

Lane I to help JPMorgan Chase acquire Bear Stearns

Bear Stearns shareholders approve sale

IndyMac Bank fails and is seized by FDIC

SEC restricts naked short selling of some financial

stocks

U.S. takes control of Fannie Mae and Freddie Mac

Lehman Brothers bankruptcy

Merrill Lynch announces its sale to Bank of America

Federal Reserve offers $85 billion credit line to AIG;

Reserve Primary Money Fund NAV falls below $1

Goldman Sachs and Morgan Stanley convert to bank

holding companies

WaMu fails, is seized by FDIC, and is sold to

JPMorgan Chase

Congress and President Bush establish TARP

Wachovia is sold to Wells Fargo

U.S. uses TARP to buy $125 billion in preferred

stock at nine banks

Federal Reserve buys Fannie and Freddie assets

48

Washington Mutual Bank, known also as WaMu, rose out the ashes of the great Seattle

fire to make its first home loan in 1890. By 2004, WaMu had become one of the nation’s largest

financial institutions and a leading mortgage lender. Its demise just four years later provides a

case history that traces not only the rise of high risk lending in the mortgage field, but also how

those high risk mortgages led to the failure of a leading bank and contributed to the financial

crisis of 2008.

For many years, WaMu was a mid-sized thrift, specializing in home mortgages. In the

1990s, WaMu initiated a period of growth and acquisition, expanding until it became the nation’s

largest thrift and sixth largest bank, with $300 billion in assets, $188 billion in deposits, 2,300

branches in 15 states, and over 43,000 employees. In 2003, its longtime CEO, Kerry Killinger,

said he wanted to do for the lending industry what Wal-Mart and others did for their industries,

Soon after, WaMu embarked on a strategy of high risk lending. By 2006, its high risk loans

began incurring record rates of delinquency and default, and its securitizations saw ratings

downgrades and losses. In 2007, the bank itself began incurring losses. Its shareholders lost

confidence, and depositors began withdrawing funds, eventually causing a liquidity crisis. On

September 25, 2008, 119 years to the day of its founding, WaMu was seized by its regulator, the

Office of Thrift Supervision (OTS), and sold to JPMorgan Chase for $1.9 billion. Had the sale

not gone through, WaMu’s failure might have exhausted the $45 billion Deposit Insurance Fund.

Washington Mutual is the largest bank failure in U.S. history.

This case study examines how one bank’s strategy for growth and profit led to the

origination and securitization of hundreds of billions of dollars in poor quality mortgages that

undermined the U.S. financial system. WaMu had held itself out as a prudent lender, but in

reality, the bank turned increasingly to higher risk loans. Its fixed rate mortgage originations fell

from 64% of its loan originations in 2003, to 25% in 2006, while subprime, Option ARM, and

home equity originations jumped from 19% of the originations to 55%. Using primarily loans

from its subprime lender, Long Beach Mortgage Corporation, WaMu’s subprime securitizations

grew sixfold, increasing from about $4.5 billion in 2003, to $29 billion in securitizations in 2006.

From 2000 to 2007, WaMu and Long Beach together securitized at least $77 billion in subprime

loans. WaMu also increased its origination of Option ARMs, its flagship product, which from

2003 to 2007, represented as much as half of all of WaMu’s loan originations. In 2006 alone,

Washington Mutual originated more than $42.6 billion in Option ARM loans and sold or

securitized at least $115 billion, including sales to the Federal National Mortgage Association

(Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac). In addition, WaMu

dramatically increased its origination and securitization of home equity loan products. By 2007,

http://www.nytimes.com/2008/12/28/business/28wamu.html?_r=1 (quoting Mr. Killinger: “We hope to do to this

industry what Wal-Mart did to theirs, Starbucks did to theirs, Costco did to theirs and Lowe’s-Home Depot did to

their industry. And I think if we’ve done our job, five years from now you’re not going to call us a bank.”).

49

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 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

50

becoming a major Wall Street player.

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.

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

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.

Subcommittee on Investigations, S.Hrg. 111-67 (April 13, 2010) (hereinafter “April 13, 2010 Subcommittee

Hearing”).

51

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.

Washington Mutual Bank was a federally chartered thrift whose primary federal regulator

was the Office of Thrift Supervision (OTS). As an insured depository institution, it was also

overseen by the Federal Deposit Insurance Corporation (FDIC). Washington Mutual was a full

service consumer and business bank. This Report focuses only on WaMu’s home lending and

securitization business. As part of that business, WaMu originated home loans, acquired home

loans for investment and securitization, sold pools of loans, and also securitized pools of home

loans that it had originated or acquired. It was also a leading servicer of residential mortgages.

The Home Loans Group

handled WaMu’s home mortgage originations, securitizations, and servicing operations. The

Commercial Group handled apartment buildings and other commercial properties. The Retail

Banking Group provided retail banking services to consumers and businesses across the country.

The Card Services Group handled a credit card business purchased from Providian Financial

Corporation.

52

For most of the five-year period reviewed by the Subcommittee, WaMu was led by its

longtime Chairman of the Board and Chief Executive Officer (CEO) Kerry Killinger who joined

the bank in 1982, became bank president in 1988, and was appointed CEO in 1990. Mr.

Killinger was the moving force behind WaMu’s acquisitions and growth strategy during the

1990s, and made the fateful decision to embark upon its High Risk Lending Strategy in 2005.

Mr. Killinger stepped down as Chairman of the Board in June 2008, after shareholders opposed

having the same person occupy the bank’s two top positions. He was dismissed from the bank

on September 8, 2008, the same day WaMu was required by its regulator, OTS, to sign a public

Memorandum of Understanding to address its lending and securitization deficiencies. Two

weeks later the bank failed.

Other key members of the bank’s senior management included President Steve Rotella

who joined the bank in January 2005; Chief Financial Officer Tom Casey; President of the Home

Loans Division David Schneider who joined the bank in July 2005; and General Counsel Faye

Chapman. David Beck served as Executive Vice President in charge of the bank’s Capital

Markets Division, oversaw its securitization efforts, and reported to the head of Home Loans.

Anthony Meola headed up the Home Loans Sales effort. Jim Vanasek was WaMu’s Chief Credit

Officer from 1999 until 2004, and was then appointed its Chief Risk Officer, a new position,

from 2004-2005. After Mr. Vanasek’s retirement, Ronald Cathcart took his place as Chief Risk

Officer, and headed the bank’s newly organized Enterprise Risk Management Division, serving

in that post from 2005 to 2007.

and acquired residential mortgages through several methods, which it referred to as loan

origination channels. WaMu referred to them as its retail, wholesale, subprime, correspondent,

and conduit channels.

Retail Channel. In WaMu’s parlance, “retail channel” loans were loans originated by

WaMu employees, typically loan officers or sales associates operating out of WaMu branded

loan centers. The prospective borrower typically communicated directly with the WaMu loan

officer, who was often called a “loan consultant.” WaMu considered all retail channel loans to

be “prime” loans, regardless of the characteristics of the loan or the creditworthiness of the

borrower, and sometimes referred to the retail channel as the “prime” channel. The retail

channel originated significant numbers of Option ARM loans, which WaMu treated as prime

loans, despite their inherent risks. According to the Inspectors General of the U.S. Treasury

Department and the FDIC, who prepared a report on WaMu’s failure (hereinafter “IG Report”),

“Option ARMs represented as much as half of all loan originations from 2003 to 2007 and

approximately $59 billion, or 47 percent, of the home loans on WaMu’s balance sheet at the end

(indicating WaMu was one of the top three issuers of U.S. residential mortgages from 2003 to 2005); “Washington

Mutual to Acquire PNC’s Residential Mortgage Business,” Business Wire (10/2/2000),

http://findarticles.com/p/articles/mi_m0EIN/is_2000_Oct_2/ai_65635032.

53

loans and home equity lines of credit.

Wholesale Channel. According to WaMu, its “wholesale channel” loans were loans that

the bank acquired from third party mortgage brokers. These brokers, who were not WaMu

employees, located borrowers interested in purchasing a home or refinancing an existing

mortgage, and explained available loans that could be underwritten by WaMu. The borrower’s

primary, and sometimes sole, contact was with the mortgage broker. The mortgage broker

would then provide the borrower’s information to a WaMu loan officer who would determine

whether the bank would finance the loan. If the bank decided to finance the loan, the broker

would receive a commission for its efforts. Third party mortgage brokers typically received little

guidance or training from WaMu, aside from receiving daily “rate sheets” explaining the terms

of the loans that WaMu was willing to accept and the available commissions. WaMu treated

wholesale loans issued under the WaMu brand as prime loans.

Subprime Channel. WaMu also originated wholesale loans through its subprime

affiliate and later subsidiary, Long Beach Mortgage Company (Long Beach). Long Beach was a

purely wholesale lender, and employed no loan officers that worked directly with borrowers.

Instead, its account executives developed relationships with third party mortgage brokers who

brought prospective loans to the company, and if Long Beach accepted those loans, received a

commission for their efforts. WaMu typically referred to Long Beach as its “subprime channel.”

Later, in 2007, when the bank decided to eliminate Long Beach as a separate entity, it rebranded

Long Beach as its “Wholesale Specialty Lending” channel.

At times, WaMu also acquired subprime loans through “correspondent” or “conduit”

other lenders for investment or securitization. For example, WaMu at times operated a

correspondent channel that it referred to as “Specialty Mortgage Finance” and used to purchase

subprime loans from other lenders, especially Ameriquest, for inclusion in its investment

portfolio. In addition, in 2005, its New York securitization arm, Washington Mutual Capital

Corporation, established a “subprime conduit” to purchase closed subprime loans in bulk from

other lenders for use in securitizations. At the end of 2006, WaMu reported that its investment

portfolio included $4 billion in subprime loans from Long Beach and about $16 billion in

Other Channels. At times, WaMu also originated or acquired loans in other ways. Its

“Consumer Direct” channel, for example, originated loans over the phone or internet; borrowers

did not need to meet in person with a WaMu loan officer. In addition, in 2004, Washington

Mutual Capital Corporation (WCC) set up a conduit to purchase closed Alt A loans in bulk from

Offices of Inspector General at the Department of the Treasury and Federal Deposit Insurance Corporation, Hearing

Exhibit 4/16-82 (hereinafter “IG Report”).

54

other lenders and use them in securitizations. WCC shut down both the Alt A and subprime

The Treasury and the FDIC IG report examining the failure of WaMu found that, from

employees overseeing 34,000 third party brokers doing business with the bank nationwide, and

WaMu had traditionally originated mortgages to well qualified prime borrowers. But in

Long Beach was located in Anaheim, California, had a network of loan centers across the

country, and at its height had as many as 1,000 employees.

Long Beach made loans for the express purpose of securitizing them and profiting from

the gain on sale; it did not hold loans for its own investment. It had no loan officers of its own,

but relied entirely on third party mortgage brokers bringing proposed subprime loans to its

doors. In 2000, the year after it was purchased by WaMu, Long Beach made and securitized

approximately $2.5 billion in home loans. By 2006, its loan operations had increased more than

tenfold, and Long Beach securitized nearly $30 billion in subprime home loans and sold the

Long Beach’s most common subprime loans were short term, hybrid adjustable rate

mortgages, known as “2/28,” “3/27,” or “5/25” loans. These 30-year mortgages typically had a

low fixed “teaser” rate, which then reset to a higher floating rate after two years for the 2/28,

47c.

Long Beach typically qualified borrowers

according to whether they could afford to pay the initial, low interest rate rather than the later,

Regulators,” before the U.S. Senate Permanent Subcommittee on Investigations, S.Hrg. 111-672 (April 16, 2010)

(hereinafter “April 16, 2010 Subcommittee Hearing”), at 5.

Mortgage Corporation, for about $350 million.

Hearing Exhibit 4/16-31 (“LBMC was acquired … as a vehicle for WMI to access the subprime loan market.

LBMC’s core business is the origination of subprime mortgage loans through a nationwide network of mortgage

brokers.”).

Exhibit 4/13-1c.

55

cover only the interest due on the loan and not any principal. After the fixed interest rate period

expired, the monthly payment was typically recalculated to pay off the entire remaining loan

within the remaining loan period at the higher floating rate. Unless borrowers could refinance,

the suddenly increased monthly payments caused some borrowers to experience “payment

shock” and default on their loans.

From 1999 to 2006, Long Beach operated as a subsidiary of Washington Mutual Inc., the

parent of Washington Mutual Bank. Long Beach’s loans repeatedly experienced early payment

defaults, high delinquency rates, and losses, and its securitizations were among the worst

received permission from its regulator, OTS, to purchase the company from its parent and make

it a wholly owned subsidiary of the bank. WaMu installed new management, required the head

of Long Beach to report to its Home Loans Division President, and promised OTS that it would

improve Long Beach. When Long Beach’s loans continued to perform poorly, in June 2007,

WaMu shut down Long Beach as a separate entity, and took over its subprime lending

operations, rebranding Long Beach as its “Wholesale Specialty Lending” channel. WaMu

continued to issue and securitize subprime loans. After the subprime market essentially shut

down a few months later in September 2007, WaMu ended all of its subprime lending.

From 2000 to 2007, Long Beach and WaMu together securitized tens of billions of

dollars in subprime loans, creating mortgage backed securities that frequently received AAA or

investments with low default rates of one to two percent, of the 75 Long Beach mortgage backed

security tranches rated AAA by Standard and Poor’s in 2006, all 75 have been downgraded to

Washington Mutual depended on the securitization process to generate profit, manage

risk, and obtain capital to originate new loans. Washington Mutual and Long Beach sold or

securitized most of the subprime home loans they acquired. Initially, Washington Mutual kept

most of its Option ARMs in its proprietary investment portfolio, but eventually began selling or

securitizing those loans as well. From 2000 to 2007, Washington Mutual and Long Beach

(discussing findings by Fitch, a credit rating agency, highlighting poor performance of Long Beach securities).

Exhibit 4/13-1c.

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%).

56

securitized at least $77 billion in subprime home loans. Washington Mutual sold or securitized

at least $115 billion of Option ARM loans, as well as billions more of other types of high risk

loans, including hybrid adjustable rate mortgages, Alt A, and home equity loans.

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

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.

securitization market, WCC had over 200 employees and offices in Seattle, New York, Los

in December 2007, after the securitization markets collapsed.

Washington Mutual Bank (WaMu) was a wholly owned subsidiary of its parent holding

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.

Mutual Inc. also owned a second, much smaller thrift, Washington Mutual Bank, FSB. Id.

57

In 2006, WaMu took several major actions that reduced the size of its Home Loans

Group. It sold $140 billion in mortgage servicing rights to Wells Fargo; sold a $22 billion

In July 2007, after the Bear Stearns hedge funds collapsed and the credit rating agencies

downgraded the ratings of hundreds of mortgaged backed securities, including over 40 Long

Beach securities, the secondary market for subprime loans dried up. In September 2007, due to

the difficulty of finding investors willing to purchase subprime loans or mortgage backed

securities, Washington Mutual discontinued its subprime lending. It also became increasingly

difficult for Washington Mutual to sell other types of high risk loans and related mortgage

backed securities, including its Option ARMs and home equity products. Instead, WaMu

retained these loans in its portfolios. By the end of the year, as the value of its loans and

mortgage backed securities continued to drop, Washington Mutual began to incur significant

losses, reporting a $1 billion loss in the fourth quarter of 2007, and another $1 billion loss in the

first quarter of 2008.

In February 2008, based upon increasing deterioration in the bank’s asset quality,

earnings, and liquidity, OTS and the FDIC lowered the bank’s safety and soundness rating to a 3

OTS and the FDIC, Washington Mutual allowed several potential buyers of the bank to review

In July 2008, a $30 billion subprime mortgage lender, IndyMac, failed and was placed

into receivership by the government. In response, depositors became concerned about

Washington Mutual and withdrew over $10 billion in deposits, putting pressure on the bank’s

liquidity. After the bank disclosed a $3.2 billion loss for the second quarter, its stock price

continued to drop, and more deposits left.

with the SEC, at 1 (Washington Mutual reduced its workforce from 60,789 to 49,824 from December 31, 2005 to

December 31, 2006.); “Washington Mutual to cut 2,500 jobs,” MarketWatch (2/15/2006), available at

http://www.marketwatch.com/story/washington-mutual-cutting-2500-mortgage-jobs.

Office Director Darrel Dochow (3/3/2010); 4/2010 “Washington Mutual Regulators Timeline,” prepared by the

Subcommittee, Hearing Exhibit 4/16-1j.

http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aNUz6NmbYZCQ.

58

On September 8, 2008, Washington Mutual signed a public Memorandum of

Understanding that it had negotiated with OTS and the FDIC to address the problems affecting

the bank. Longtime CEO Kerry Killinger was forced to leave the bank, accepting a $15 million

On September 15, 2008, Lehman Brothers declared bankruptcy. Three days later, on

September 18, OTS and the FDIC lowered Washington Mutual’s rating to a “4,” indicating that a

bank failure was a possibility. The credit rating agencies also downgraded the credit ratings of

the bank and its parent holding company. Over the span of eight days starting on September 15,

nearly $17 billion in deposits left the bank. At that time, the Deposit Insurance Fund contained

about $45 billion, an amount which could have been exhausted by the failure of a $300 billion

institution like Washington Mutual. As the financial crisis worsened each day, regulatory

concerns about the bank’s liquidity and viability intensified.

Because of its liquidity problems and poor quality assets, OTS and the FDIC decided to

close the bank. Unable to wait for a Friday, the day on which most banks are closed, the

WaMu’s founding. That day, OTS seized Washington Mutual Bank, placed it into receivership,

and appointed the FDIC as the receiver. The FDIC facilitated its immediate sale to JPMorgan

Chase for $1.9 billion. The sale eliminated the need to draw upon the Deposit Insurance Fund.

WaMu’s parent, Washington Mutual, Inc., declared bankruptcy soon after.

In 2004, Washington Mutual ramped up high risk home loan originations to borrowers

that had not traditionally qualified for them. The following year, Washington Mutual adopted a

high risk strategy to issue high risk mortgages, and then mitigate some of that risk by selling or

securitizing many of the loans. When housing prices stopped climbing in late 2006, a large

number of those risky loans began incurring extraordinary rates of delinquency as did the

securities that relied on those loans for cash flow. In 2007, the problems with WaMu’s High

Risk Lending Strategy worsened, as delinquencies increased, the securitization market dried up,

and the bank was unable to find buyers for its high risk loans or related securities.

The formal initiation of WaMu’s High Risk Lending Strategy can be dated to January

Subcommittee, Hearing Exhibit 4/13-1h.

WaMu adopted this strategy because its executives calculated that high risk home loans were

more profitable than low risk loans, not only because the bank could charge borrowers higher

interest rates and fees, but also because higher risk loans received higher prices when securitized

and sold to investors. They garnered higher prices because, due to their higher risk, the

securities paid a higher coupon rate than other comparably rated securities.

of Directors Finance Committee Discussion, JPM_WM00302975-93, Hearing Exhibit 4/13-2a.

59

Over a five-year period from 2003 to 2008, Washington Mutual Bank shifted its loan

originations from primarily traditional 30-year fixed and government backed loans to primarily

higher risk home loans. This shift included increased subprime loan activity at Long Beach,

more subprime loans purchased through its Specialty Mortgage Finance correspondent channel,

and more bulk purchases of subprime loans through its conduit channel for use in securitizations.

WaMu also increased its originations and acquisitions of Option ARM, Alt A, and home equity

loans. While the shift began earlier, the strategic decision to move toward higher risk loans was

not fully articulated to regulators or the Board of Directors until the end of 2004 and the

In about three years, from 2005 to 2007, WaMu issued hundreds of billions of higher risk

compiled by the Treasury and the FDIC Inspectors General showed that, by the end of 2007,

Option ARMs constituted about 47% of all home loans on WaMu’s balance sheet and home

equity loans made up $63.5 billion or 27% of its home loan portfolio, a 130% increase from

from 1999 until 2006, Option ARM borrowers selected the minimum monthly payment more

the Option ARMs was negatively amortizing, meaning that the borrowers were going into deeper

also originated numerous loans with high loan-to-value (LTV) ratios, in which the loan amount

exceeded 80% of the value of the underlying property. The Treasury and the FDIC Inspectors

General determined, for example, that 44% of WaMu’s subprime loans and 35% of its home

geographic concentrations of its home loans in California and Florida, states that ended up

Management,” Washington Mutual Board of Directors Discussion, JPM_WM04107995-8008, Hearing Exhibit 4/13-

2b; 1/2005 “Higher Risk Lending Strategy ‘Asset Allocation Initiative,’” submitted to Washington Mutual Board of

Directors Finance Committee Discussion, JPM_WM00302975-93, Hearing Exhibit 4/13-2a.

Exhibit 4/13-1c.

Payment Behavior,” at 7, Hearing Exhibit 4/13-37. The WaMu report also stated: “Almost all Option ARM

borrowers select the minimum payment every month with very high persistency, regardless of changes in the interest

rates or payment adjustments.” Id. at 2.

60

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

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

Mr. Killinger identified residential nonprime and adjustable rate mortgage loans as one of the

memorandum: “Wholesale and correspondent will be nationwide and retooled to deliver higher

After 2002, Washington Mutual stopped acquiring lenders specializing in residential

increasing its issuance and purchase of higher risk home loans. OTS took note of this strategy in

WaMu’s 2004 Report on Examination:

Direction,” JPM_WM05385579 at 581.

61

“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

OTS directed the bank to spell out its new lending strategy in a written document that had to be

In response, in January 2005, WaMu management developed a document entitled,

“Higher Risk Lending Strategy” and presented it to its Board of Directors for approval to shift

the bank’s focus from originating low risk fixed rate and government backed loans to higher risk

to increase both its issuance of higher risk loans and its offering of loans to higher risk

borrowers. The explicit reasoning for the shift was the increased profitability of the higher risk

loans, measured by actual bank data showing that those loans produced a higher “gain on sale”

or profit for the bank compared to lower risk loans. For example, one chart supporting the

Strategy showed that selling subprime loans garnered more than eight times the gain on sale as

The WaMu submission to the Board noted that, in order for the plan to be successful,

WaMu would need to carefully manage its residential mortgage business as well as its credit risk,

Exhibit].

These documents show that WaMu knew that, even if loan losses did not immediately come to

pass after initiating the High Risk Lending Strategy, it did not mean the strategy was free of

problems.

- Subprime Lending Strategy”); 3/15/2004 OTS Report of Examination, at OTSWMS04-0000001483, Hearing

Exhibit 4/16-94 [Sealed Exhibit]. See also 1/2005 “Higher Risk Lending Strategy Presentation,” submitted to

Washington Mutual Board of Directors, at JPM_WM00302978, Hearing Exhibit 4/13-2a (“As we implement our

Strategic Plan, we need to address OTS/FDIC 2004 Safety and Soundness Exam Joint Memos 8 & 9 . . . Joint Memo

9: Develop and present a SubPrime/Higher Risk Lending Strategy to the Board.”).

JPM_WM00302978, Hearing Exhibit 4/13-2a; see also 4/2010 “WaMu Product Originations and Purchases by

Percentage – 2003-2007,” chart prepared by the Subcommittee, Hearing Exhibit 4/13-1i.

Hearing Exhibit 4/13-3 (see chart showing gain on sale for government loans was 13 basis points; for 30-year, fixed

rate loans was 19; for option loans was 109; for home equity loans was 113; and for subprime loans was 150.).

Hearing Exhibit 4/13-3 (acknowledging that the risks of the High Risk Lending Strategy included managing credit

risk, implementing lending technology and enacting organizational changes).

JPM_WM06293964; see also 1/2005 “Higher Risk Lending Strategy Presentation,” submitted to Washington

Mutual Board of Directors, at JPM_WM00302987, Hearing Exhibit 4/13-2a (“Lags in Effects of Expansion,” chart

showing peak loss rates in 2007).

62

As part of the 2005 presentation to the Board of Directors outlining the strategy, OTS

contained a slide defining “Higher Risk Lending”:

“For the purpose of establishing concentration limits, Higher Risk Lending

strategies will be implemented in a ‘phased’ approach. Later in 2005 an

“The initial definition is ‘Consumer Loans to Higher Risk Borrowers’,

which at 11/30/04 totaled $32 Billion or 151% of total risk-based capital,

comprised of:

-Subprime loans, or all loans originated by Long Beach Mortgage

or purchased through our Specialty Mortgage Finance program

-SFR [Single Family Residential] and Consumer Loans to

A footnote on the slide defined “low credit scores” as less than a 620 FICO score for first lien

single family residence mortgages, home equity loans, and home equity lines of credit. It

defined low credit scores as less than 660 for second lien home equity loans (HEL) and home

While the January 2005 presentation promised to present a fuller definition of higher risk

loans for Board approval at some future date, a more complete definition had already been

provided to the Board a few weeks earlier in a December 21, 2004 presentation entitled, “Asset

This presentation contained the same basic definition of higher risk borrowers, but also provided

a definition of higher risk loans.

Higher risk loans were defined as single family residence mortgages with a loan-to-value

(LTV) ratio of equal to or greater than 90% if not credit enhanced, or a combined-loan-to-value

(CLTV) ratio of 95%. These numbers are a notable departure from the 80% LTV ratio

Borrowers’”), OTSWME04-0000005357 at 61.

JPM_WM00302979, Hearing Exhibit 4/13-2a.

Washington Mutual Board of Directors Presentation, at JPM_WM04107995-8008, Hearing Exhibit 4/13-2b.

63

considered a first lien to be high risk if it had a greater than 90% LTV ratio, and considered a

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 …

-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

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.

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.

http://www.federalreserve.gov/boarddocs/srletters/1993/SR9301.htm, and discussion of high LTV loans in section

D(2)(b), below.

Washington Mutual Board of Directors Presentation, JPM_WM04107995-8008 at 7999, Hearing Exhibit 4/13-2b.

following.”

$16.05 billion in subprime mortgage loans”).

64

WaMu’s internal documents indicate that the primary motivation behind its High Risk

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

Positioning,” and stated: “Home Loans is accelerating significant business model changes to

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:

Government 13

Fixed 19

Hybrid/ARM 25

Alt A 40

Option ARM 109

Home Equity 113

Subprime 150

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

Hearing Exhibit 4/13-3.

65

Mr. Schneider told the Subcommittee that the numbers listed on the chart were not

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,

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.

66

“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

Mr. Vanasek was the senior-most risk officer at WaMu, and had frequent interactions with Mr.

Killinger and the Board of Directors. While his concerns may have been heard, they were not

heeded.

Mr. Vanasek told the Subcommittee that, because of his predictions of a collapse in the

bubble was overwhelming by 2005. Over the prior ten years, housing prices had skyrocketed in

an unprecedented fashion, as the following chart prepared by Paulson & Co. Inc., based on data

from the Bureau of Economic Analysis and the Office of Federal Housing Enterprise Oversight,

67

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

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

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

68

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.”

Mr. Vanasek agreed:

“I could not agree more. All the classic signs are there and the likely outcome is

probably not great. We would all like to think the air can come out of the balloon slowly

but history would not lean you in that direction. Over the next month or so I am going to

work hard on what I hope can be a lasting mechanism (legacy) for determining how

much risk we can afford to take ….”

Despite Mr. Killinger’s awareness that housing prices were unsustainable, could drop suddenly,

and could make it difficult for borrowers to refinance or sell their homes, Mr. Killinger

continued to push forward with WaMu’s High Risk Lending Strategy.

following two years, management significantly shifted the bank’s loan originations towards

riskier loans as called for in the plan, but had to slow down the pace of implementation in the

face of worsening market conditions. In retrospect, WaMu executives tried to portray their

inability to fully execute the plan as a strategic choice rather than the result of a failed strategy.

For example, Mr. Killinger testified at the Subcommittee hearing that the bank’s High Risk

Lending Strategy was only contemplated, but not really executed:

“First, we had an adjustment in our strategy that started in about 2004 to gradually

increase the amount of home equity, subprime, commercial real estate, and multi-family

loans that we could hold on the balance sheet. We had that long-term strategy, but … we

quickly determined that the housing market was increasing in its risk, and we put most of

Mr. Killinger’s claim that the High Risk Lending Strategy was put “on hold” is contradicted,

however, by WaMu’s SEC filings, its internal documents, and the testimony of other WaMu

executives.

Washington Mutual’s SEC filings contain loan origination and acquisition data showing

that the bank did implement its High Risk Lending Strategy. Although rising defaults and the

2007 collapse of the subprime secondary market prevented WaMu from fully executing its plans,

WaMu dramatically shifted the composition of the loans it originated and purchased, nearly

Exhibit].

69

doubling the percentage of higher risk home loans from 36% to 67%. The following chart,

In 2003, 64% of WaMu’s mortgage originations and purchases were fixed rate loans, and

only 19% were subprime, Option ARM, or home equity loans. In 2004, 31% of WaMu’s

mortgage originations and purchases were fixed rate loans, and 55% were subprime, Option

ARM, or home equity loans. In 2005, 31% of WaMu’s mortgage originations and purchases

were fixed rate loans, and 56% were subprime, Option ARM, or equity loans. By 2006, only

25% of WaMu’s mortgage originations and purchases were fixed rate loans, and 55% were

toll in 2007, and WaMu ended all subprime lending in the fall of that year, its higher risk

Subcommittee, Hearing Exhibit 4/13-1i.

70

Mr. Killinger’s annual “Strategic Direction” memoranda to the Board in 2005, 2006, and

2007, also contradict his testimony that the strategy of expanding high risk lending was put on

hold. On the first page of his 2005 memorandum, Mr. Killinger wrote: “We continue to see

excellent long-term growth opportunities for our key business lines of retail banking, mortgage

WaMu’s stated strategy of risk expansion, Mr. Killinger told the Board that WaMu should

accelerate it:

“In order to reduce the impact of interest rate changes on our business, we have

accelerated development of Alt-A, government and sub-prime loan products, as well as

hybrid ARMs and other prime products, specifically for delivery through retail,

The 2005 strategic direction memorandum also targeted Long Beach for expansion:

“Long Beach is expected to originate $30 billion of loans this year, growing to $36

billion in 2006. To facilitate this growth, we plan to increase account managers by 100.

We expect Long Beach to have 5% of the sub-prime market in 2005, growing to [a] 6%

Despite warning against unsustainable housing prices in March 2005, Mr. Killinger’s

2006 “Strategic Direction” memorandum to the Board put even more emphasis on growth than

the 2005 memorandum. After reviewing the financial targets set in the five-year plan adopted in

2004, Mr. Killinger wrote: “To achieve these targets, we developed aggressive business plans

around the themes of growth, productivity, innovation, risk management and people

high risk home lending strategy was still operative in 2006. The memorandum stated:

“Finally, our Home Loan Group should complete its repositioning within the next twelve

months and it should then be in position to grow its market share of Option ARM, home

equity, sub prime and Alt. A loans. We should be able to increase our share of these

Contrary to Mr. Killinger’s hearing testimony, the 2006 memorandum indicates an expansion of

WaMu’s high risk home lending, rather than any curtailment:

“We are refining our home loans business model to significantly curtail low margin

Government and conventional fixed rate originations and servicing, and to significantly

Direction,” JPMC/WM - 0636-49 at 36, Hearing Exhibit 4/13-6c.

Direction,” JPM_00808312-324 at 314, Hearing Exhibit 4/13-6d.

71

increase our origination and servicing of high margin home equity, Alt. A, sub prime and

option ARMs. Action steps include merging Longbeach sub prime and the prime

business under common management, merging correspondent activities into our

correspondent channel, getting out of Government lending, curtailing conventional fixed

rate production, expanding distribution of targeted high margin products through all

distribution channels and potentially selling MSRs [Mortgage Servicing Rights] of low

margin products. We expect these actions to result in significantly higher profitability

The April 16, 2006 “Home Loans Discussion” presentation by Home Loans President

David Schneider, discussed above, also confirms WaMu’s ongoing efforts to shift its loan

business toward high risk lending. Page four of that presentation, entitled, “Shift to Higher

One chart depicts loan volume for 2005, and the second chart depicts projected loan volume for

2008:

These charts demonstrate WaMu’s intention to increase its loan originations over three

years by almost $30 billion, focusing on increases in high risk loan products. Subprime

originations, for example, were expected to grow from $34 billion in 2005 to $70 billion in 2008;

Alt A originations were projected to grow from $1 billion in 2005 to $24 billion in 2008; and

JPM_WM00690890-901 at 894, Hearing Exhibit 4/13-3.

72

Home Equity originations were projected to grow from $4 billion in 2005 to $30 billion in 2008.

On the other hand, WaMu’s low risk originations were expected to be curtailed dramatically.

Government backed loan originations, which totaled $8 billion in 2005, were projected to be

eliminated by 2008. Fixed rate loan originations were projected to decline from $69 billion in

2005 to $4 billion in 2008.

The 2007 “Strategic Direction” memorandum to the Board is dated June 18, 2007, well

after U.S. housing prices had begun to decline, as Mr. Killinger acknowledged:

“For the past two years, we have been predicting the bursting of the housing bubble and

the likelihood of a slowing housing market. This scenario has now turned into a reality.

Housing prices are declining in many areas of the country and sales are rapidly slowing.

This is leading to an increase in delinquencies and loan losses. The sub-prime market

was especially rocked as many sub-prime borrowers bought houses at the peak of the

cycle and now find their houses are worth less and they are having difficulties refinancing

While the memorandum’s section on home loan strategy no longer focused on overall growth, it

continued to push the shift to high risk lending, despite problems in the subprime market:

“Home Loans is a large and important business, but at this point in the cycle, it is

unprofitable. The key strategy for 2008 is to execute on the revised strategy adopted in

2006. … We need to optimize the sub-prime and prime distribution channels with

particular emphasis on growing the retail banking, home loan center and consumer direct

channels. We also expect to portfolio more of Home Loans’ originations in 2008,

including the new Mortgage Plus product. We will continue to emphasize higher-risk

adjusted return products such as home equity, sub-prime first mortgages, Alt A

The testimony of other WaMu executives further confirms the bank’s implementation of

its High Risk Lending Strategy. Ronald Cathcart, who joined WaMu in 2006, to become the

company’s Chief Risk Officer, testified:

“The company’s strategic plan to shift its portfolios towards higher margin products was

already underway when I arrived at WaMu. Basically, this strategy involved moving

away from traditional mortgage lending into alternative lending programs involving

adjustable-rate mortgages as well as into subprime products. The strategic shift to

Direction,” JPM_WM03227058-67 at 60, Hearing Exhibit 4/13-6a.

Program,” JPM_WM02551400, Hearing Exhibit 4/13-5 (informing potential investors in its subprime RMBS

securities that: “WaMu is focusing on higher margin products”).

73

higher-margin products resulted in the bank taking on a higher degree of credit risk

Likewise, Steven Rotella, WaMu’s President and Chief Operating Officer, who began with the

bank in January 2005, testified before the Subcommittee:

“In particular, I want to be very clear on the topic of high-risk lending, this

Subcommittee’s focus today. High-risk mortgage lending in WaMu’s case, primarily

Option ARMs and subprime loans through Long Beach Mortgage, a subsidiary of WaMu,

were expanded and accelerated at explosive rates starting in the early 2000s, prior to my

hiring in 2005…. In 2004 alone, the year before I joined, Option ARMs were up 124

In his testimony, Mr. Rotella took credit for curtailing WaMu’s growth and high risk

Strategy. On October 15, 2005, Mr. Rotella emailed Mr. Killinger about WaMu’s 2006 strategic

plan: “I think our focus needs to be on organic growth of home eq, and subprime, and greater

utilization of [the Home Loans division] as we know it today to facilitate that at lower

Mr. Killinger replied by email the next day: “Regarding Longbeach, I think there is a

good opportunity to be a low cost provider and gain significant share when the industry

wrote: “It makes sense to leverage the home loans distribution channels with home equity, sub

contemplate reducing prime lending, not subprime. Mr. Killinger wrote: “If we can’t make a

Mr. Rotella replied to Mr. Killinger’s email later on October 16, 2005. He continued to

emphasize the importance of focusing on high risk lending, referring to his previous experience

as a mortgage banker at JPMorgan Chase:

“We did these kinds of analyses all the time at Chase which led us to run as fast as we

could into home eq, alt a, subprime (our investment banking brethren stopped us from

going too far here). We viewed prime as a source of scale benefits in servicing for the

other areas and a conduit of higher margin product and aimed to hold our prime servicing

74

flat to down. I feel strongly that where we need to land is a new home loan unit that

In July 2008, just two months before the collapse of WaMu, Home Loans President

David Schneider prepared an internal presentation entitled, “Home Loans Story, External &

strategy, policy, and personnel changes. The first substantive page of the presentation bears the

heading, “Three fundamental business shifts occurred in Home Loans this millennium which

shaped its performance and position in a volatile competitive landscape”:

‘Mono-line’ business model focused on generating high volume of low-margin, prime

products ….

Targeted production franchise toward higher margin products to become a market leader

in specific product segments ….

Subprime mortgage implosion fuels credit and liquidity crisis and the non-agency

secondary market disappears[.]”

Mr. Scheider’s retrospective presentation of the changes that occurred at WaMu is

unambiguous: by 2006, WaMu had “[t]argeted production franchise toward higher margin

more detail. A quarterly timeline is presented with the heading: “In an environment of internal

and external large-scale change, Home Loans took bold actions to redefine its business into a

sustainable model.” In the strategy section for the second quarter of 2006, Mr. Schneider wrote:

Despite warnings by some within its management about unsustainable housing prices,

WaMu pursued a High Risk Lending Strategy to generate short term profits from the favorable

gain-on-sale margins offered by Wall Street for high risk loans and securitizations, for which the

credit rating agencies continued to award AAA ratings. To succeed, the strategy was premised

upon borrowers being able to refinance or sell their homes to pay off their loans in the event of a

default. Stagnant or declining house prices made refinancing and home sales more difficult.

Exhibit 4/13-80.

75

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.

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.

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

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.

showing Long Beach Annual Origination Volume).

76

The problems with Long Beach’s loans and securitizations predated the company’s

purchase by WaMu in 1999, but continued after the purchase. An internal email at WaMu’s

primary federal regulator, the Office of Thrift Supervision (OTS), observed the following with

respect to Long Beach’s mortgage backed securities:

“Performance data for 2003 and 2004 vintages appear to approximate industry average

while issues prior to 2003 have horrible performance. LBMC finished in the top 12 worst

annualized NCLs [net credit losses] in 1997 and 1999 thru 2003. LBMC nailed down the

In 2003, Long Beach’s performance deteriorated to the point that WaMu’s legal

department put a stop to all Long Beach securitizations until the company improved its

40% (109 of 271) of loans reviewed were considered unacceptable due to one or more critical

State: “This raised concerns over LBMC’s ability to meet the representations and warrant[ies]

A Long Beach corporate credit review in August 2003 confirmed that “credit management and

As a result of the halt in securitizations, Long Beach had to hold loans on its warehouse

balance sheet, which increased by approximately $1 billion per month and reached nearly $5

billion by the end of November 2003. Long Beach had to borrow money from WaMu and other

evaluated the loans that had accumulated during the halt in securitizations. The joint visitation

report noted that of 4,000 Long Beach loans reviewed by WaMu by the end of November 2003,

less than one quarter, about 950, could be sold to investors, another 800 were unsaleable, and the

memorandum, “Long Beach Mortgage Corporation (LBMC),” OTSWMS06-007 0001010, Hearing Exhibit 4/16-31.

Washington Department of Financial Institutions, FDIC-E_00102515, at 3, Hearing Exhibit 4/13-8b (citing a Long

Beach quality assurance report).

Washington Department of Financial Institutions, FDIC-E_00102515, at 3, Hearing Exhibit 4/13-8b.

77

After a short hiatus, WaMu allowed Long Beach to resume securitizing subprime loans in

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

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

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.

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.”).

early 2007, JPM_WM02095572.

HFI,” JPM_WM01407692.

78

To analyze what happened, WaMu conducted a “post mortem” review of 213 Long

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

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

Due to the early payment defaults, Long Beach was forced to repurchase loans totaling

Exhibit 4/13-9.

This

Committee, “Long Beach Mortgage Company - Repurchase Reserve Root Cause Analysis,” prepared by WaMu

General Auditor, JPM_WM02533760-61, Hearing Exhibit 4/13-10.

2005 [which] … led to a large volume of required loan repurchases. The unpaid principal balance repurchased as a

79

loss overwhelmed Long Beach’s repurchase reserves, leading to a reserve shortfall of nearly $75

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

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

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

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

also filed a formal application, requiring OTS approval, to purchase Long Beach from its parent

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.”).

WaMu told OTS

that making Long Beach a subsidiary would give the bank greater control over Long Beach’s

0001009, Hearing Exhibit 4/16-31.

80

operations and allow it to strengthen Long Beach’s lending practices and risk management, as

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

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

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

OTSWMS06-007 0002683, Hearing Exhibit 4/16-28.

Hearing Exhibit 4/16-31.

81

Again, he expressed hope that the situation would improve: “The good news is David and his

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

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

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

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

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

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

Steve Funaro, “WaMu – Long Beach Mortgage Company (LMC) Repurchases,” at 1, FDIC_WAMU_000012348,

Hearing Exhibit 4/13-13b.

82

On December 22, 2006, the FDIC Dedicated Examiner at WaMu, Steve Funaro, sent an

email to Mr. Schneider, the Home Loans President, raising questions about the unexpected loan

defaults and repurchase demands. He wrote that Long Beach had the “[s]ame issues as FPD last

quarter … Current forecast of 35 to 50m [million] risk.” His email also noted potentially

insufficient loss reserves related to WaMu’s own subprime conduit that purchased subprime

loans from other lenders and mortgage brokers, some of which were going out of business and

would be unable to shoulder any liability for defaulting loans. His email noted forecasts of early

payment defaults totaling $15.6 million and loan delinquencies totaling $10.7 million, in addition

Mr. Schneider forwarded the email to his team and expressed frustration at Long Beach’s

continuing problems:

“Short story is this is not good. … There is [a] growing potential issue around Long

Beach repurchases …. [W]e have a large potential risk from what appears to be a recent

increase in repurchase requests. … We are all rapidly losing credibility as a management

Performance in 2007 Worsens. The following year, 2007, was no better as the

performance of WaMu’s loan portfolio continued to deteriorate. WaMu’s chief risk officer, Ron

Cathcart, asked WaMu’s Corporate Credit Review team to assess the quality of Long Beach

In January 2007, he forwarded an email with the results of the review, which identified “key risk

issues” related to recent loans and described deteriorating loan performance at Long Beach. The

“top five priority issues” were:

“Appraisal deficiencies that could impact value and were not addressed[;]

Material misrepresentations relating to credit evaluation were confirmed[;]

Legal documents were missing or contained errors or discrepancies[;]

Credit evaluation or loan decision errors[; and]

The review also found: “[D]eterioration was accelerating in recent vintages with each vintage

since 2002 having performed worse than the prior vintage.” Mr. Cathcart also expressed concern

that problems were not being reported to senior management. He wrote: “Long Beach

represents a real problem for WaMu. … I am concerned that Credit Review may seem to have

been standing on the sidelines while problems continue. For instance, why have Cathcart,

83

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

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

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

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

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

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

2007), Hearing Exhibit 4/13-18.

84

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

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,

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

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

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

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:

Exhibit 4/13-21.

Hearing Exhibit 4/13-19.

85

“[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

In response, Mr. Rotella wrote to WaMu’s General Auditor: “This seems to me to be the

Subprime Lending Ends. In September 2007, with investors no longer interested in

During the prior year, which was their peak, Long Beach and WaMu had securitized $29 billion

in subprime loans; by 2007, due to the collapse of the subprime secondary market, WaMu’s

volume for the year dropped to $5.5 billion. Altogether, from 2000 to 2007, Long Beach and

When asked about Long Beach at the Subcommittee’s hearing, all of the WaMu former

managers who testified remembered its operations as being problematic, and could not explain

why WaMu failed to strengthen its operations. Mr. Vanasek, former Chief Risk Officer, testified

that Long Beach did not have an effective risk management regime when he arrived at WaMu in

1999, and that it had not developed an effective risk management regime by the time he retired at

testified that Long Beach never developed effective risk management during the course of his

At the April 13 Subcommittee hearing, Senator Levin asked Mr. Vanasek: “Is it fair to

say that WaMu is not particularly worried about the risk associated with Long Beach subprime

mortgages because it sold those loans and passed the risk on to investors?” Mr. Vanasek replied:

Home Loans President David Schneider, who had direct responsibility for addressing the

problems at Long Beach, testified that he tried to improve Long Beach, but “ultimately decided

WaMu President Steve Rotella

also acknowledged the inability of WaMu management to resolve the problems at Long Beach:

Exhibit 4/13-1c.

86

“We did bring the volume in Long Beach down substantially every quarter starting in the

first quarter of 2006. As we went through that process, it became increasingly clear, as I

have indicated in here, that the problems in Long Beach were deep and the only way we

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

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

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.

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

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

http://www.occ.treas.gov/news-issuances/news-releases/2009/nr-occ-2009-112b.pdf, Hearing Exhibit 4/13-58.

87

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.

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

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

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

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

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

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.”).

88

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

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

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

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

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

OTSWMEF-0000047591, Hearing Exhibit 4/16-94 [Sealed Exhibit]. See the Regulator Chapter of this Report for

more information.

0000392, Hearing Exhibit 4/16-26. For more information, see Chapter IV, below.

(Examination findings were issued to WaMu on August 28, 2005.)

0001299, Hearing Exhibit 4/16-33; and 8/29/2006 OTS Report of Examination, OTSWMS06-008 0001690, Hearing

Exhibit 4/16-94 [Sealed Exhibit].

00020408_001, Hearing Exhibit 4/16-9.

89

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

2003 WaMu quality assurance review found an “error rate of 29 percent for wholesale mortgage

OTS examination noted that 20,000 brokers and lenders had submitted loans to WaMu for

investigation of two high volume loan centers in Southern California that accepted loans from

brokers found that “78% of the funded retail broker loans reviewed were found to contain

conduit were experiencing high delinquency rates found the bank had securitized broker loans

OTS examinations in 2006 and 2007 also identified deficiencies in WaMu’s oversight

only 14 full-time employees overseeing more than 34,000 third party brokers submitting loans to

brokers. The OTS examination not only questioned the staffing level, but also criticized the

scorecard WaMu used to rate the mortgage brokers, which did not include the rates at which

significant lending or documentation deficiencies were attributed to the broker, the rate at which

the broker’s loans were denied or produced unsaleable loans, or any indication of whether the

broker was included on industry watch lists for prior or suspected misconduct.

In 2006, federal regulators issued Interagency Guidance on Nontraditional Mortgage

Product Risks (NTM Guidance) providing standards on how banks “can offer nontraditional

“have strong systems and controls in place for establishing and maintaining relationships” with

third party lenders and brokers submitting high risk loans for approval. It instructed banks to

monitor the quality of the submitted loans to detect problems such as “early payment defaults,

incomplete documentation, and fraud.” If problems arose, the NTM Guidance directed banks to

“take immediate action”:

Hearing Exhibit 4/13-22b.

Exhibit 4/16-10.

192 at 58609.

90

“Oversight of third party brokers and correspondents who originate nontraditional

mortgage loans should involve monitoring the quality of originations so that they reflect

the institution’s lending standards and compliance with applicable laws and regulations.

… If appraisal, loan documentation, credit problems or consumer complaints are

WaMu did, at times, exercise oversight of its third party brokers. A 2006 credit review of

their loans had experienced high rates of first payment defaults requiring Long Beach 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

WaMu closed down its wholesale and subprime channels in 2007, and its Alt A and

subprime securitization conduits in 2008.

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

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

The bank’s acceptance of

unverified income information came on top of its use of loans with other high risk features, such

14.

91

as borrowers with low credit scores or the use of low initial teaser interest rates followed by

much higher rates.

Stated income loans were originally developed to assist self employed individuals that

had good credit and high net worth to obtain loans they could afford. But from 2004 to 2008,

stated income loans became much more widespread, including with respect to a wide variety of

“[Stated income loans] originated as a product for self-employed individuals who didn’t

have pay stubs and whose financial statements didn’t necessarily reflect what they made.

It was intended to be available for only the most creditworthy borrowers and it was

supposed to be tested for reasonableness so that a person who said that they were a waiter

or a lower-paid individual couldn’t say that they had an income of $100,000.

“I think that the standards eroded over time. At least I have become aware, reading all

that has happened … standards eroded over time and that it became a competitive tool

that was used by banks to gather business, so that if a loan consultant could send his loan

to Bank A or Bank B, the consultant would say, well, why don’t you go to Bank B? You

don’t have to state your income.

“I do think, thinking it through, that there was a certain amount of coaxing that was

possible between the loan consultant and the individual, which would be something

which would be invisible to a bank that received the application and the only test for that

would be reasonableness, which as you have heard there were some issues within the

WaMu required its loan personnel to determine whether a loan applicant’s stated income

was reasonable, but evidence obtained by the Subcommittee indicates that requirement was not

effectively implemented. A 2008 press report about a WaMu stated income loan is illustrative:

“As a supervisor at a Washington Mutual mortgage processing center, John D. Parsons

was accustomed to seeing baby sitters claiming salaries worthy of college presidents, and

schoolteachers with incomes rivaling stockbrokers. He rarely questioned them. A real

estate frenzy was under way and WaMu, as his bank was known, was all about saying

yes.

“Yet even by WaMu’s relaxed standards, one mortgage four years ago raised eyebrows.

The borrower was claiming a six-figure income and an unusual profession: mariachi

singer.

unverified income, to qualify borrowers for nontraditional mortgage loans.”). The NTM Guidance directed banks to

use stated income loans “with caution,” but did not prohibit them or even issue guidance limiting their use. Id. at

58611.

92

“Mr. Parsons could not verify the singer’s income, so he had him photographed in front

of his home dressed in his mariachi outfit. The photo went into a WaMu file.

Instead of verifying borrower income, WaMu loan personnel apparently focused instead

on borrower credit scores, as a proxy measure of a borrower’s creditworthiness. The problem

the mortgage amount being requested.

High LTV Ratios. A second risk-layering practice at WaMu involved loan-to-value

(LTV) ratios. LTV ratios are a critical risk management tool, because they compare the loan

amount to the estimated dollar value of the property. If an LTV ratio is too high and the

borrower defaults, the sale of the property may not produce sufficient proceeds to pay off the

loan. In interagency guidance, federal banking regulators noted that banks should generally

avoid issuing loans with LTV ratios over 80%, and directed banks to ensure that loans with LTV

ratios of 90% or more have additional credit support such as mortgage insurance or added

These loans were the result of explicit WaMu policies allowing high LTV ratios to be

used in loans that already had other high risk features. In February 2005, for example, WaMu set

up automated loan approval parameters to approve loans with a 90% LTV in Option ARM and

added to these loans by permitting the borrowers to have credit scores as low as 620.

The Treasury and the FDIC IG report determined that 44% of WaMu’s subprime loans

part from a 2006 WaMu decision to combine home equity loans bearing high LTV ratios with

borrowers bearing low credit scores. That initiative was discussed in a June 2006 email sent to

Mr. Rotella, after he inquired about the project. He was informed:

report, WaMu told the Subcommittee that it had no record of this loan, but could not deny that the incident took

place as reported. See also, in the following subsection, a WaMu loan issued to a “Sign Designer” who claimed

earnings of $34,000 per month.

the SEC, at 52 (showing that, as of 12/31/2006, WaMu held $7.4 billion in home mortgages without private

mortgage insurance or government guarantees with LTV ratios in excess of 80%, and $15 billion in home equity

loans and lines of credit with LTV ratios in excess of 80%).

93

“$4 billion home equity investment program [was] approved … last Friday. High CLTVs

[Combined Loan-to-Value ratios] (up to 100%) and lower FICOs (down to 600)

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

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

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

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

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

JPM_WM01311922-23.

In addition, in 2005, WaMu

personnel informed OTS that, since 2004, the bank had not been qualifying its Option ARM

Mr. Schneider, among others, JPM_WM01311922.

JPM_WM01311922-23.

(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.”).

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).

94

Borrowers, loan officers, and WaMu executives often assumed that hybrid and Option

eventually proved to be unfounded. In a November 30, 2007 email discussing loan

modifications from Mr. Schneider to Mr. Killinger, Mr. Rotella and other senior executives, Mr.

Schneider described WaMu’s faulty assumptions about the “start rate” and life span of these

loans:

“I also think it is clear that the economic benefit of providing modifications for these

borrowers is compelling for the following reasons:

- None of these borrowers ever expected that they would have to pay at a rate

greater than the start rate. In fact, for the most part they were qualified at the start

rate

- We need to provide incentive to these borrowers to maintain the home –

especially if the home value has declined

- When we booked these loans, we anticipated an average life of 2 years and

Qualifying borrowers using the lower initial interest rate enabled banks to qualify more

borrowers for those loans and enabled them to issue loans for larger amounts. Concerned that

more banks were beginning to use this risky practice, federal banking regulators addressed it in

the October 2006 NTM Guidance, which cautioned banks to use the fully indexed rate when

Guidance provided that for negatively amortizing loans, banks should consider not only the

“initial loan amount” but also “any balance increase that may accrue from the negative

that applying the new requirement to all of its loans would cause a 33% drop in its loan volume

due to borrowers who would no longer qualify for its loans:

“Implementing the NTM change for Purchase only drops additional 2.5% of volume …

If we implement the NTM changes to all loans, then we’ll see additional drop of 33% of

Hearing Exhibit 4/16-6. The “fully indexed rate” is the prevailing interest rate in the published index to which an

adjustable rate mortgage is tied, plus the additional percentage points that the lender adds to the index value to

calculate the loan’s interest rate. See NTM Guidance at 58614, n.5.

95

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

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

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

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.

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.”).

96

Downey and Montebello Fraud Investigations. The most significant example involves

an internal WaMu investigation that, in 2005, uncovered substantial evidence of loan fraud

involving two top producing loan offices in Southern California. WaMu management was

presented with the findings, but failed to respond, leading to the same fraud allegations erupting

again in 2007. According to the WaMu Home Loans Credit Risk Mitigation Team that

conducted the 2005 internal investigation, it was initiated in response to “a sustained history of

confirmed fraud findings over the past three years” involving the two offices, known as Downey

a loan officer who had won repeated WaMu awards for high volume loan production.

To conduct its inquiry, the WaMu Risk Mitigation Team reviewed all of the loans

produced by the two offices over a two-month period from August to September 2005, which

totaled 751 loans. Analysts scored the loans using a standard electronic fraud detection program,

and then reviewed all of the loans flagged for possible fraud, as well as ten percent of the

found an “extensive level of loan fraud” caused primarily by employees “circumventing” bank

policies:

“[A]n extensive level of loan fraud exists in the Emerging Markets [loan processing

centers], virtually all of it stemming from employees in these areas circumventing bank

policy surrounding loan verification and review. Of the 129 detailed loan review[s] …

conducted to date, 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. In terms of employee activity enabling this perpetration of fraud, the

following categories of activity appeared most frequently: inconsistent application of

credit policy, errors or negligence, process design flaws, intentional circumvention of

established processes, and overriding automated decisioning recommendations. …

Based on the consistent and pervasive pattern of activity among these employees, we are

recommending firm action be taken to address these particular willful behaviors on the

that, out of the 751 loans produced, the Risk Mitigation Team had selected 180 loans for detailed

JPM_WM01083051, Hearing Exhibit 4/13-22a.

It also stated that the

fraud findings did not differ between loans originated by WaMu’s own loan officers and loans

Exhibit 4/13-22b.

97

that the fraud uncovered by the review was found to be “preventable with improved processes

and controls.”

The presentation indicated that the loan fraud involved primarily “misrepresentation of

loan qualifying data,” including misrepresentations of income and employment, false credit

including:

“Loan #0694256827[:] Misrepresentation [of] the borrower’s identification and

qualifying information were confirmed in every aspect of this file, including: – Income –

SSN – Assets – Alternative credit reference letters – 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, and exceptions

The presentation noted that the loan delinquency rate for Luis Fragoso, the loan officer

heading the Montebello loan office, was “289% worse than the delinquency performance for the

entire open/active retail channel book of business,” while the delinquency rate for Thomas

from the Risk Mitigation Team was clear that the two head loan officers were willfully flouting

bank policy, issuing poor quality loans, and needed to be the subject of “firm action” by the

bank.

Three months prior to its formal presentation on the fraud, the Risk Mitigation Team

supplied a lengthy email with its fraud findings to colleagues in the credit risk department. The

August 2005 email provided spreadsheets containing data collected on the loans from the two

information, it indicated that at the Downey office, 83 loans had been reviewed, including 28

originated by the WaMu loan officer Thomas Ramirez, and 54 submitted to him by third party

brokers; while at the Montebello office, 48 loans had been reviewed, including 19 originated by

the WaMu loan officer Luis Fragoso and 29 submitted to him by third party brokers. The email

was forwarded by a credit risk officer to WaMu’s Chief Risk Officer Jim Vanasek, with the

following comment:

“As you requested in our Enterprise Fraud Committee meeting last Friday, the attached

email contains a high-level summary of the investigations the Home Loans Risk Mit team

has conducted on [the two offices] over the past year and a half, based on loans that were

referred to them. … As you can see, among the referred cases there is an extremely high

98

incidence of confirmed fraud (58% for Ramirez, 83% for Fragoso) …. [Additional

analysis] will allow us to substantially validate what we suspect, which is that the

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

“The good news is that people are taking this very seriously. They requested some additional

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.

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

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

JPM_WM03535695, Hearing Exhibit 4/13-23a.

two offices per year. April 13, 2010 Subcommittee Hearing at 27.

99

no one responded to its concerns, in September 2007, AIG filed a Suspected Fraud Claim with

Examiner-in-Charge at WaMu at the time, Benjamin Franklin, asked the bank to conduct an

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

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

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,

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

redacted],” at 1, Hearing Exhibit 4/13-24.

The memorandum reported that one individual

believed that David Schneider “was made aware of these findings” and wanted Risk Mitigation

redacted],” at 1, Hearing Exhibit 4/13-24.

100

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

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

After the memorandum was issued, WaMu initially resisted providing a copy to OTS,

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.

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

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

25.

redacted],” at 4, Hearing Exhibit 4/13-24.

101

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.

Other Fraud Problems. The loan fraud problems at the Downey and Montebello offices

were not the only fraud problems plaguing WaMu. The Subcommittee uncovered three

additional examples that demonstrate the problem was not isolated.

The first example involves the Westlake Village loan office outside of Los Angeles. On

April 1, 2008, WaMu’s Risk Mitigation Team sent 13 home loans with early payment defaults to

unpaid loan balances totaled about $14.3 million, had been issued in 2007, by the Westlake

Village loan office which was one of WaMu’s top loan producers. Two loan officers, Chris

O’Brien and Brian Minkow, who worked in tandem, had won multiple awards for their loan

loans which contained a variety of fraud indicators, including “fabricated asset statements,

altered statements, income misrepresentation and one altered statement that is believed to have

personnel at the WaMu “loan fulfillment center” (LFC) that processed Westlake Village loan

applications.

In one egregious example of document “manufacturing,” a sales associate confessed that

if “it was too late to call the borrower,” the “sales associates would take [bank] statements from

other [loan] files and cut and paste the current borrower’s name and address” onto the old bank

Associates would ‘manufacture’ asset statements from previous loan docs,” because end-ofmonth

loans would often get funded without full documentation. The pressure to get the

necessary documentation was “tremendous” and they had been told to get the loans funded “with

The LFC loan processor in charge of handling Westlake Village’s loan applications was

fired, as was the sales associate who confessed to manufacturing false documents. The rest of

the employees were also let go, when the office itself was closed on April 30, 2008, in

Home Loan Center, JPM_WM03171384, Hearing Exhibit 4/13-31. See also “Washington Mutual Exits Wholesale

Lending Business, Will Close Home-Loan Centers,” Mercury News, 4/7/2008,

http://blogs.mercurynews.com/realestate/2008/04/07/washington-mutual-exits-wholesale-lending-business-willclose-

home-loan-centers.

Night Show Script,” Washington Mutual, Home Loans Group, Hearing Exhibit 4/13-63a (stating Mr. O’Brien and

Mr. Minkow had produced $1.2 billion in loans in 2005).