wall street & the financial cri - permanent subcommittee on inves

Overview 1 High Risk Lending: Case Study of Washington Mutual Bank 2 Regulatory Failures: Case Study of the Office of Thrift Supervision 3 Inflated Credit Ratings: CaseStudy of Moody’s a

SENATOR CARL LEVIN

Chairman SENATOR TOM COBURN, M.D Ranking Minority Member PERMANENT SUBCOMMITTEE

I EXECUTIVE SUMMARY

A Subcommittee Investigation

B Overview

(1) High Risk Lending: Case Study

of Washington Mutual Bank

(2) Regulatory Failures: Case Study

of the Office of Thrift Supervision

(3) Inflated Credit Ratings: CaseStudy of Moody’s and Standard &Poor’s

(4) Investment Bank Abuses: CaseStudy of Goldman Sachs and Deutsche

B High Risk Mortgage Lending

C Credit Ratings and StructuredFinance

D Investment Banks

E Market Oversight

F Government SponsoredEnterprises

G Administrative and LegislativeActions

H Financial Crisis Timeline

III HIGH RISK LENDING: CASESTUDY OF WASHINGTON MUTUALBANK

A Subcommittee Investigation andFindings of Fact

(3) Definition of High Risk Lending(4) Gain on Sale

(5) Acknowledging UnsustainableHousing Price Increases

(6) Execution of the High RiskLending Strategy

D Shoddy Lending Practices

(1) Long Beach

(2) WaMu Retail Lending

(a) Inadequate Systems and WeakOversight

(b) Risk Layering

(c) Loan Fraud

(d) Steering Borrowers to High RiskOption ARMs

(e) Marginalization of WaMu RiskManagers

E Polluting the Financial System(1) Long Beach and WaMuSecuritizations

(2) Deficient SecuritizationPractices

(3) Securitizing Delinquency-ProneLoans

(4) WaMu Loan Sales to Fannie Maeand Freddie Mac

F Destructive CompensationPractices

(1) Sales Culture

(2) Paying for Speed and Volume(a) Long Beach Account Executives

(b) WaMu Loan Consultants

(c) Loan Processors and QualityAssurance Controllers

(3) WaMu Executive Compensation

G Preventing High Risk Lending(1) New Developments

IV REGULATORY FAILURE:CASE STUDY OF THE OFFICE OFTHRIFT SUPERVISION

A Subcommittee Investigation andFindings of Fact

B Background

(1) Office of Thrift Supervision(2) Federal Deposit InsuranceCorporation

Mutual’s Ratings History and Closure(3) OTS Identification of WaMuDeficiencies

(a) Deficiencies in LendingStandards

(b) Deficiencies in RiskManagement

(c) Deficiencies in Home Appraisals(d) Deficiencies Related to LongBeach

(e) Over 500 Deficiencies in 5Years

(4) OTS Turf War Against the FDIC

D Regulatory Failures

(1) OTS’ Failed Oversight of WaMu(a) Deference to Management

(b) Demoralized Examiners

(c) Narrow Regulatory Focus(d) Inflated CAMELS Ratings(e) Fee Issues

(2) Other Regulatory Failures(a) Countrywide

4 Evaluate Impacts of High RiskLending

V INFLATED CREDIT RATINGS:CASE STUDY OF MOODY’S ANDSTANDARD & POOR’S

A Subcommittee Investigation andFindings of Fact

B Background

(1) Credit Ratings Generally

(2) The Rating Process

(3) Record Revenues

C Mass Credit Rating Downgrades(1) Increasing High Risk Loans andUnaffordable Housing

(2) Mass Downgrades

D Ratings Deficiencies

(1) Awareness of Increasing CreditRisks

(2) CRA Conflicts of Interest

(a) Drive for Market Share

(b) Investment Bank Pressure

(3) Inaccurate Models

(a) Inadequate Data

(b) Unclear and Subjective RatingsProcess

(4) Failure to Retest After ModelChanges

(5) Inadequate Resources

(6) Mortgage Fraud

E Preventing Inflated Credit Ratings(1) Past Credit Rating Agency

3 Strengthen CRA Operations

4 Ensure CRAs Recognize Risk

5 Strengthen Disclosure

6 Reduce Ratings Reliance

VI INVESTMENT BANKABUSES: CASE STUDY OFGOLDMAN SACHS AND DEUTSCHEBANK

A Background

(1) Investment Banks In General(2) Roles and Duties of anInvestment Bank: Market Maker,Underwriter, Placement Agent, Broker-Dealer

(3) Structured Finance Products

B Running the CDO Machine: CaseStudy of Deutsche Bank

(1) Subcommittee Investigation andFindings of Fact

(2) Deutsche Bank Background

(3) Deutsche Bank’s $5 BillionShort

(a) Lippmann’s Negative Views ofMortgage Related Assets

(b) Building and Cashing in the $5

Billion Short

(4) The “CDO Machine”

(5) Gemstone

(a) Background on Gemstone

(b) Gemstone Asset Selection

(c) Gemstone Risks and PoorQuality Assets

(d) Gemstone Sales Effort

(e) Gemstone Losses

(6) Other Deutsche Bank CDOs(7) Analysis

C Failing to Manage Conflicts ofInterest: Case Study of Goldman Sachs

(1) Subcommittee Investigation andFindings of Fact

(2) Goldman Sachs Background(3) Overview of Goldman SachsCase Study

(a) Overview of How GoldmanShorted the Subprime Mortgage Market

(b) Overview of Goldman’s CDOActivities

(4) How Goldman Shorted theSubprime Mortgage Market

(a) Starting $6 Billion Net Long(b) Going Past Home: Goldman’sFirst Net Short

(c) Attempted Short Squeeze

(d) Building the Big Short

(e) “Get Down Now”

(f) Profiting from the Big Short:

Making “Serious Money”

(g) Goldman’s Records ConfirmLarge Short Position

(i) TopSheets

(ii)Risk Reports

(h) Profiting From the Big Short(5) How Goldman Created andFailed to Manage Conflicts of Interest inits Securitization Activities

AA RMBS Sell Off

BB CDO Sell Off

CC CDO Marks

DD Customer Losses

(b) Goldman’s Conflicts of Interest(i) Conflicts of Interest InvolvingRMBS Securities

(ii) Conflicts of Interest InvolvingSales of CDO Securities

AA Hudson Mezzanine Funding2006-1

BB Anderson Mezzanine Funding2007-1

CC Timberwolf I

DD Abacus 2007-AC1

(iii) Additional CDO Conflicts ofInterest

AA Liquidation Agent in Hudson 1

BB Collateral Put Provider inTimberwolf

(6) Analysis of Goldman’s Conflicts

(iii) Failing to Disclose MaterialAdverse Information

(iv) Making Unsuitable InvestmentRecommendations

(7) Goldman’s ProprietaryInvestments

D Preventing Investment BankAbuses

Wall Street and The Financial Crisis:

lost their jobs; millions of families losttheir homes; and good businesses shutdown These events cast the UnitedStates into an economic recession sodeep that the country has yet to fullyrecover.

This Report is the product of a year, bipartisan investigation by the U.S.Senate Permanent Subcommittee onInvestigations into the origins of the

two-2008 financial crisis The goals of thisinvestigation were to construct a publicrecord of the facts in order to deepen theunderstanding of what happened; identifysome of the root causes of the crisis; andprovide a factual foundation for theongoing effort to fortify the countryagainst the recurrence of a similar crisis

in the future.

communications, and interviews, theReport attempts to provide the clearestpicture yet of what took place inside thewalls of some of the financialinstitutions and regulatory agencies that

investigation found that the crisis wasnot a natural disaster, but the result ofhigh risk, complex financial products;undisclosed conflicts of interest; and thefailure of regulators, the credit ratingagencies, and the market itself to rein inthe excesses of Wall Street

While this Report does not attempt toexamine every key moment, or analyzeevery important cause of the crisis, it

provides new, detailed, and compellingevidence of what happened In so doing,

we hope the Report leads to solutionsthat prevent it from happening again

of government, academic, and private

sector experts The Subcommittee hasaccumulated and reviewed tens ofmillions of pages of documents,including court pleadings, filings with

prospectuses for public and private

transactions and analyses, memoranda,marketing materials, correspondence,and email The Subcommittee has alsoreviewed documents prepared by or sent

to or from banking and securitiesregulators, including bank examinationreports, reviews of securities firms,

memoranda, correspondence, and email

In April 2010, the Subcommittee heldfour hearings examining four root causes

of the financial crisis Using case studiesdetailed in thousands of pages ofdocuments released at the hearings, theSubcommittee presented and examinedevidence showing how high risk lending

by U.S financial institutions; regulatoryfailures; inflated credit ratings; and highrisk, poor quality financial productsdesigned and sold by some investmentbanks, contributed to the financial crisis.This Report expands on those hearingsand the case studies they featured Thecase studies are Washington MutualBank, the largest bank failure in U.S.history; the federal Office of ThriftSupervision which oversaw Washington

Mutual’s demise; Moody’s and Standard

& Poor’s, the country’s two largestcredit rating agencies; and GoldmanSachs and Deutsche Bank, two leaders

in the design, marketing, and sale ofmortgage related securities This Reportdevotes a chapter to how each of thefour causative factors, as illustrated bythe case studies, fueled the 2008financial crisis, providing findings offact, analysis of the issues, andrecommendations for next steps

B Overview

(1) High Risk Lending:

Washington Mutual Bank

The first chapter focuses on how highrisk mortgage lending contributed to thefinancial crisis, using as a case studyWashington Mutual Bank (WaMu) Atthe time of its failure, WaMu was thenation’s largest thrift and sixth largestbank, with $300 billion in assets, $188billion in deposits, 2,300 branches in 15states, and over 43,000 employees.Beginning in 2004, it embarked upon alending strategy to pursue higher profits

by emphasizing high risk loans By 2006,WaMu’s high risk loans began incurringhigh rates of delinquency and default,and in 2007, its mortgage backed

securities began incurring ratingsdowngrades and losses Also in 2007,the bank itself began incurring lossesdue to a portfolio that contained poorquality and fraudulent loans andsecurities Its stock price dropped asshareholders lost confidence, anddepositors began withdrawing funds,eventually causing a liquidity crisis atthe bank On September 25, 2008,WaMu was seized by its regulator, theOffice of Thrift Supervision, placed inreceivership with the Federal DepositInsurance Corporation (FDIC), and sold

to JPMorgan Chase for $1.9 billion Hadthe sale not gone through, WaMu’sfailure might have exhausted the entire

$45 billion Deposit Insurance Fund

This case study focuses on how onebank’s search for increased growth andprofit led to the origination andsecuritization of hundreds of billions ofdollars in high risk, poor qualitymortgages that ultimately plummeted invalue, hurting investors, the bank, andthe U.S financial system WaMu hadheld itself out as a prudent lender, but inreality, the bank turned increasingly tohigher risk loans Over a four-yearperiod, those higher risk loans grewfrom 19% of WaMu’s loan originations

in 2003, to 55% in 2006, while its lowerrisk, fixed rate loans fell from 64% to25% of its originations At the sametime, WaMu increased its securitization

of subprime loans sixfold, primarily

through its subprime lender, Long BeachMortgage Corporation, increasing suchloans from nearly $4.5 billion in 2003,

to $29 billion in 2006 From 2000 to

2007, WaMu and Long Beach togethersecuritized at least $77 billion insubprime loans

WaMu also originated an increasingnumber of its flagship product, OptionAdjustable Rate Mortgages (OptionARMs), which created high risk,negatively amortizing mortgages and,from 2003 to 2007, represented as much

as half of all of WaMu’s loanoriginations In 2006 alone, WashingtonMutual originated more than $42.6billion in Option ARM loans and sold orsecuritized at least $115 billion to

investors, including sales to the FederalNational Mortgage Association (FannieMae) and Federal Home Loan MortgageCorporation (Freddie Mac) In addition,WaMu greatly increased its originationand securitization of high risk homeequity loan products By 2007, homeequity loans made up $63.5 billion or27% of its home loan portfolio, a 130%increase from 2003.

At the same time that WaMu wasimplementing its high risk lendingstrategy, WaMu and Long Beachengaged in a host of shoddy lendingpractices that produced billions ofdollars in high risk, poor quality

securities Those practices included

qualifying high risk borrowers for largerloans than they could afford; steeringborrowers from conventional mortgages

to higher risk loan products; acceptingloan applications without verifying theborrower’s income; using loans withlow, short term “teaser” rates that couldlead to payment shock when higherinterest rates took effect later on;promoting negatively amortizing loans inwhich many borrowers increased ratherthan paid down their debt; andauthorizing loans with multiple layers ofrisk In addition, WaMu and Long Beachfailed to enforce compliance with their

excessive loan error and exception rates;exercised weak oversight over the third

party mortgage brokers who suppliedhalf or more of their loans; and toleratedthe issuance of loans with fraudulent orerroneous borrower information Theyalso designed compensation incentivesthat rewarded loan personnel for issuing

a large volume of higher risk loans,valuing speed and volume over loanquality

As a result, WaMu, and particularly itsLong Beach subsidiary, became known

by industry insiders for its failedmortgages and poorly performing RMBS

investors, its securitizations wereunderstood to be some of the worstperforming in the marketplace Inside thebank, WaMu’s President Steve Rotella

described Long Beach as “terrible” and

“a mess,” with default rates that were

“ugly.” WaMu’s high risk lendingoperation was also problem-plagued.WaMu management was provided withcompelling evidence of deficient lendingpractices in internal emails, auditreports, and reviews Internal reviews oftwo high volume WaMu loan centers, forexample, described “extensive fraud” by

circumvented bank policies A WaMureview of internal controls to stopfraudulent loans from being sold to

“ineffective.” On at least one occasion,

delinquency-prone loans to investors

Aside from Long Beach, WaMu’sPresident described WaMu’s primehome loan business as the “worstmanaged business” he had seen in hiscareer.

launched its high risk lending strategyprimarily because higher risk loans andmortgage backed securities could besold for higher prices on Wall Street.They garnered higher prices, becausehigher risk meant the securities paid a

comparably rated securities, andinvestors paid a higher price to buythem Selling or securitizing the loansalso removed them from WaMu’s books

and appeared to insulate the bank fromrisk.

indicates that unacceptable lending andsecuritization practices were notrestricted to Washington Mutual, butwere present at a host of financialinstitutions that originated, sold, andsecuritized billions of dollars in highrisk, poor quality home loans thatinundated U.S financial markets Many

of the resulting securities ultimatelyplummeted in value, leaving banks andinvestors with huge losses that helpedsend the economy into a downwardspiral These lenders were not thevictims of the financial crisis; the highrisk loans they issued were the fuel that