.
CONCLUSIONS
OF THE
FINANCIAL CRISIS INQUIRY COMMISSION
The Financial Crisis
Inquiry Commission has been called upon to examine the financial and
economic crisis that has gripped our country and explain its causes to the
American people. We are keenly aware of
the significance of our charge, given the economic
damage that America has suffered in the wake of the greatest financial crisis
since the Great Depression.
Our task was first to
determine what happened and how it happened so that we could understand why it
happened. Here we present our conclusions. We encourage the
American people to join us in making their own assessments based on the
evidence gathered in our inquiry.
If we do not learn from history, we are unlikely to fully recover
from it. Some on Wall Street and in Washington with a stake in the status quo
may be tempted to wipe from memory the
events of this crisis, or to suggest that no one
could have foreseen or prevented them. This report endeavors to expose the
facts, identify responsibility, unravel
myths, and help us understand how the crisis could
have been avoided. It is an attempt to record history, not to rewrite it, nor
allow it to be rewritten.
To help our fellow
citizens better understand this crisis and its causes, we also present specific
conclusions at the end of chapters in Parts III, IV, and V of this report.
The subject of this report
is of no small consequence to this nation. The profound events
of 2007 and 2008 were
neither bumps in the road nor an accentuated dip in the
financial and business cycles we have come to expect in a free market economic
system. This was a fundamental disruption—
financial upheaval, if you will—that wreaked
havoc in communities and neighborhoods across this country.
As this report goes to
print, there are more than 26 million Americans who are out
of work, cannot find full-time work, or have given up looking for work. About
four million families have lost their
homes to foreclosure and another four and a half million
have slipped into the foreclosure process or are seriously behind on their
mortgage payments. Nearly $11 trillion in household wealth has vanished, with
retirement accounts and life
savings swept away. Businesses, large and small, have felt the
sting of a deep recession. There is much anger about what has transpired, and
justifiably so. Many people who
abided by all the rules now find themselves out of work and
uncertain about their future prospects. The collateral damage of this crisis
has been real people and real
communities. The impacts of this crisis are likely to be felt for
a generation. And the nation faces no easy path to renewed economic strength.
Like so many Americans, we
began our exploration with our own views and some preliminary
knowledge about how the world’s strongest financial system came to the
brink of collapse. Even at the time of our
appointment to this independent panel, much
had already been written and said about the crisis. Yet all of us have been
deeply affected by what we have learned in
the course of our inquiry. We have been at various
times fascinated, surprised, and even shocked by what we saw, heard, and
read. Ours has been a journey of
revelation.
Much attention over the
past two years has been focused on the decisions by the federal
government to provide massive financial assistance to stabilize the financial
system and rescue large financial
institutions that were deemed too systemically important to
fail. Those decisions—and the deep emotions surrounding them—will be
debated long into the future. But our
mission was to ask and answer this central question: how
did it come to pass that in 2008 our nation was
forced to choose between two stark
and painful alternatives—either
risk the total collapse of our financial system and
economy or inject trillions of taxpayer dollars into the financial system and
an array of companies, as millions
of Americans still lost their jobs, their savings, and their
homes?
In this report, we detail
the events of the crisis. But a simple summary, as we see it,
is useful at the outset. While the vulnerabilities that created the potential
for crisis were years in the
making, it was the collapse of the housing bubble—fueled by low
interest rates, easy and available credit, scant regulation, and toxic
mortgages—that was the spark that
ignited a string of events, which led to a full-blown crisis in the
fall of 2008. Trillions of dollars in risky
mortgages had become embedded throughout
the financial system, as mortgage-related securities were packaged, repackaged,
and sold to investors around the world. When the bubble burst, hundreds
of billions of dollars in losses in
mortgages and mortgage-related securities shook
markets as well as financial institutions that had significant exposures to
those mortgages and had borrowed heavily
against them. This happened not just in the
United States but around the world. The losses were magnified by derivatives
such as synthetic securities.
The crisis reached seismic
proportions in September 2008 with the failure of
Lehman Brothers and the impending collapse
of the insurance giant American International Group
(AIG). Panic fanned by a lack of transparency of the balance sheets of major
financial institutions, coupled with a
tangle of interconnections among institutions perceived
to be “too big to fail,” caused the credit markets to seize up. Trading
ground to a halt. The stock market
plummeted. The economy plunged into a deep recession.
The financial system we
examined bears little resemblance to that of our parents’ generation. The
changes in the past three decades alone have been remarkable. The financial
markets have become increasingly globalized. Technology has transformed
the efficiency, speed, and complexity of
financial instruments and transactions. There is
broader access to and lower costs of financing than ever before. And the
financial sector itself has become
a much more dominant force in our economy.
From 1978 to 2007, the
amount of debt held by the financial sector soared from $3
trillion to $36 trillion, more than doubling as a share
of gross domestic product. The very
nature of many Wall Street firms changed—from relatively staid private
partnerships to publicly traded
corporations taking greater and more diverse kinds of risks.
By 2005, the 10 largest U.S.
commercial banks held 55% of the industry’ assets,
more than double the level held in 1990. On the eve of the crisis in
2006, financial sector
profits constituted 27% of all corporate profits in the
United States, up from 15% in 1980. Understanding this transformation has
been critical to the Commission’ analysis.
Now to our major findings
and conclusions, which are based on the facts contained in
this report: they are offered with the hope that lessons may be learned to
help avoid future catastrophe.
•We
conclude this financial crisis was avoidable.
The crisis was the result
of human action and inaction, not
of Mother Nature or computer models gone haywire. The captains
of finance and the public stewards of our financial system ignored warnings
and failed to question, understand, and
manage evolving risks within a system essential to
the well-being of the American public. Theirs was a big miss, not a stumble.
While the business cycle
cannot be repealed, a crisis of this magnitude need not have occurred.
To paraphrase Shakespeare, the fault lies not in the stars, but in us. Despite
the expressed view of many on Wall Street and in Washington that the crisis
could not have been foreseen or avoided, there were warning signs. The tragedy
was that they were ignored or discounted.
There was an explosion in risky subprime lending
and securitization, an unsustainable rise in housing prices, widespread
reports of egregious and predatory
lending practices, dramatic increases in household mortgage
debt, and exponential growth in financial firms’ trading activities,
unregulated derivatives, and
short-term “repo” lending markets, among many other red flags.
Yet there was pervasive permissiveness; little meaningful action was taken to
quell the threats in a timely manner.
The prime example is the
Federal Reserve’s pivotal failure to stem the flow of toxic mortgages,
which it could have done by setting prudent mortgage-lending standards.
The Federal Reserve was the one entity
empowered to do so and it did not. The record
of our examination is replete with evidence of other failures: financial
institutions made, bought, and sold
mortgage securities they never examined, did not care to
examine, or knew to be defective; firms depended on tens of billions of
dollars of borrowing that had to be
renewed each and every night, secured by subprime mortgage securities;
and major firms and investors blindly relied on credit rating agencies as
their arbiters of risk. What else could one expect on a highway where there
were neither speed limits nor
neatly painted lines?
•
We conclude widespread failures in financial regulation and
supervision proved devastating to the stability of
the nation’s financial markets.
The sentries
were
not at their posts, in no small part due to the widely accepted faith in the
self-correcting nature of the
markets and the ability of financial institutions to effectively police
themselves. More than 30 years of deregulation and reliance on self-regulation
by financial institutions, championed by
former Federal Reserve chairman Alan Greenspan
and others, supported by successive administrations and Congresses, and
actively pushed by the powerful financial
industry at every turn, had stripped away key
safeguards, which could have helped avoid catastrophe. This approach had
opened up gaps in oversight of critical
areas with trillions of dollars at risk, such as the
shadow banking system and over-the-counter derivatives markets. In addition,
the government permitted financial firms
to pick their preferred regulators in what became
a race to the weakest supervisor.
Yet we do not accept the
view that regulators lacked the power to protect the financial system.
They had ample power in many arenas and they chose not to use it.
To give just three
examples: the Securities and Exchange Commission could have required more
capital and halted risky practices at the big investment banks. It did not.
The Federal Reserve Bank of New York and
other regulators could have clamped down
on Citigroup’s excesses in the run-up to the crisis. They did not. Policy
makers and regulators could have
stopped the runaway mortgage securitization train. They did
not. In case after case after case, regulators continued to rate the
institutions they oversaw as safe
and sound even in the face of mounting troubles, often downgrading them
just before their collapse. And where regulators lacked authority, they could
have sought it. Too often, they lacked the
political will—in a political and ideological environment
that constrained it—as well as the fortitude to critically challenge the
institutions and the entire system they
were entrusted to oversee.
Changes in the regulatory
system occurred in many instances as financial markets evolved.
But as the report will show, the financial industry itself played a key
role in weakening regulatory constraints
on institutions, markets, and products. It did
not surprise the Commission that an industry of such wealth and power would
exert pressure on policy makers and
regulators. From 1999 to 2008, the financial sector
expended $2.7 billion in reported federal lobbying
expenses; individuals and political
action committees in the sector made more than $1 billion in
campaign contributions. What
troubled us was the extent to which the nation was deprived of the
necessary strength and independence of the oversight necessary to safeguard
financial stability.
•We
conclude dramatic failures of corporate governance and risk management
at many
systemically important financial institutions were a key cause of this crisis.
There was a view that
instincts for self-preservation inside major financial firms would
shield them from fatal risk-taking without the need for a steady regulatory
hand, which, the firms argued, would
stifle innovation. Too many of these institutions acted
recklessly, taking on too much risk, with too little capital, and with too
much dependence on short-term funding. In
many respects, this reflected a fundamental
change in these institutions, particularly the large investment banks and bank
holding companies, which focused their
activities increasingly on risky trading activities that
produced hefty profits. They took on enormous exposures in acquiring and
supporting subprime lenders and creating,
packaging, repackaging, and selling trillions of
dollars in mortgage-related securities, including synthetic financial
products. Like Icarus, they never
feared flying ever closer to the sun.
Many of these institutions
grew aggressively through poorly executed acquisition and
integration strategies that made effective management more challenging. The
CEO of Citigroup told the Commission that
a $40 billion position in highly rated mortgage
securities would “not in any way have excited my attention,” and the
cohead of Citigroup’ investment
bank said he spent “ a small fraction of 1%”of his time on
those securities. In this instance, too big to fail meant too big to manage.
Financial institutions and credit rating
agencies embraced mathematical models as
reliable predictors of risks, replacing judgment in too many instances. Too
often, risk management became risk
justification.
Compensation systems—designed
in an environment of cheap money, intense competition,
and light regulation—too often rewarded the quick deal, the short-term
gain—without proper consideration of
long-term consequences. Often, those systems encouraged
the big bet—here the payoff on the upside could be huge and the downside
limited. This was the case up and down the
line—from the corporate boardroom to
the mortgage broker on the street.
Our examination revealed
stunning instances of governance breakdowns and irresponsibility. You
will read, among other things, about AIG senior management’ ignorance
of the terms and risks of the company’s
$79 billion derivatives exposure to mortgage-related
securities; Fannie Mae’s quest for bigger market share, profits, and bonuses,
which led it to ramp up its exposure to risky loans and securities as the
housing market was peaking; and the
costly surprise when Merrill Lynch’s top management realized
that the company held $55 billion in “super-senior” and
supposedly “super-safe”
mortgage-related securities that resulted in billions of dollars in losses.
•We
conclude a combination of excessive borrowing, risky investments, and lack
of transparency put
the financial system on a collision course with crisis.
Clearly, this
vulnerability was related to failures of corporate governance and regulation,
but it is significant enough by
itself to warrant our attention here.
In the years leading up to
the crisis, too many financial institutions, as well as too many
households, borrowed to the hilt, leaving them vulnerable to financial
distress or ruin if the value of
their investments declined even modestly. For example, as of 2007,
the five major investment banks—Bear Stearns, Goldman Sachs, Lehman Brothers,
Merrill Lynch, and Morgan Stanley—were operating with extraordinarily
thin capital. By one measure, their
leverage ratios were as high as 40 to 1, meaning for
every $40 in assets,
there was only $1 in capital to cover losses. Less than a 3% drop in asset
values could wipe out a firm. To make matters worse, much of their borrowing
was short-term, in the overnight market—meaning
the borrowing had to be renewed each
and every day. For example, at the end of 2007,
Bear Stearns had $11.8 billion in equity
and $383.6 billion in liabilities and was
borrowing as much as $70 billion in the
overnight market. It was the equivalent of a small business with $50, in equity
borrowing $1.6 million, with $296,750 of that due each and every day. One can't really
ask “What were they thinking?” when it seems that too many of them were
thinking alike.
And the leverage was often
hidden—in derivatives positions,
in off-balance-sheet entities, and
through “window dressing” of financial reports available to the investing
public.
The kings of leverage were
Fannie Mae and Freddie Mac, the two behemoth government-sponsored enterprises
(GSEs). For example, by the end of 2007, Fannie's and
Freddie's combined leverage ratio, including loans they owned and guaranteed,
stood at 75 to 1.
But financial firms were
not alone in the borrowing spree: from 2001 to 2007, national mortgage
debt almost doubled, and the amount of mortgage debt per household rose
more than 63% from $91,500 to $149,500, even while wages were essentially
stagnant. When the housing downturn hit, heavily indebted financial firms
and families alike were walloped.
The heavy debt taken on by
some financial institutions was exacerbated by the risky
assets they were acquiring with that debt. As the mortgage and real estate
markets churned out riskier and
riskier loans and securities, many financial institutions loaded
up on them. By the end of 2007, Lehman had amassed $111 billion in commercial
and residential real estate holdings and
securities, which was almost twice what
it held just two years before, and more than four times its total equity. And
again, the risk wasn’t being taken on
just by the big financial firms, but by families, too.
Nearly one in 10 mortgage borrowers in 2005 and 2006 took out “option ARM”
loans, which meant they could choose to make payments so low that their
mortgage balances rose every month.
Within the financial
system, the dangers of this debt were magnified because transparency
was not required or desired. Massive, short-term borrowing, combined with
obligations unseen by others in the market, heightened the chances the system
could rapidly unravel. In the early part
of the 20th century, we erected a series of protections—the Federal Reserve
as a lender of last resort, federal deposit insurance, ample regulations—to
provide a bulwark against the panics that had regularly plagued America’s
banking system in the 19th century. Yet, over the past 30-plus years, we
permitted the growth of a shadow banking
system—opaque and laden with short-term debt—hat
rivaled the size of the traditional banking system. Key components of
the market—for example, the multitrillion-dollar repo lending market,
off-balance-sheet entities, and the use of over-the-counter derivatives—were
hidden from view, without the
protections we had constructed to prevent financial meltdowns. We had
a 21st-century financial system with 19th-century safeguards.
When the housing and
mortgage markets cratered, the lack of transparency, the extraordinary
debt loads, the short-term loans, and the risky assets all came home to
roost. What resulted was panic. We had
reaped what we had sown.
•We
conclude the government was ill prepared for the crisis, and its inconsistent
response added to the
uncertainty and panic in the financial markets.
As part of our
charge, it was appropriate to review government actions taken in response to
the developing crisis, not just
those policies or actions that preceded it, to determine if any
of those responses contributed to or exacerbated the crisis.
As our report shows, key
policy makers—he Treasury Department, the Federal Reserve
Board, and the Federal Reserve Bank of New York—who were best positioned
to watch over our markets were ill
prepared for the events of 2007 and 2008. Other
agencies were also behind the curve. They were hampered because they did
not have a clear grasp of the financial
system they were charged with overseeing, particularly as
it had evolved in the years leading up to the crisis. This was in no small
measure due to the lack of transparency in
key markets.
They thought risk had been
diversified when, in fact, it had been
concentrated. Time and again, from the spring of
2007 on, policy makers and regulators were caught
off guard as the contagion spread,
responding on an ad hoc basis with specific programs to put fingers in the
dike. There was no comprehensive and
strategic plan for containment, because they lacked
a full understanding of the risks and interconnections in the financial
markets. Some regulators have
conceded this error. We had allowed the system to race ahead
of our ability to protect it.
While there was some
awareness of, or at least a debate about, the housing bubble, the
record reflects that senior public officials did not recognize that a bursting
of the bubble could threaten the
entire financial system. Throughout the summer of 2007, both
Federal Reserve Chairman Ben Bernanke and Treasury Secretary Henry Paulson
offered public assurances that the turmoil
in the subprime mortgage markets would
be contained. When Bear Stearns’ hedge funds, which were heavily invested
in mortgage-related securities, imploded
in June 2007, the Federal Reserve discussed
the implications of the collapse.
Despite the fact that so
many other funds were exposed to
the same risks as those hedge funds, the Bear Stearns funds were thought to
be “relatively unique.” Days before
the collapse of Bear Stearns in March 2008, SEC
Chairman Christopher Cox expressed “comfort
about the capital cushions” at the big investment
banks. It was not until August 2008, just weeks
before the government takeover of
Fannie Mae and Freddie Mac, that the Treasury Department understood the
full measure of the dire financial conditions of those two institutions. And
just a month before Lehman's
collapse, the Federal Reserve Bank of New York was still seeking
information on the exposures created by Lehman’s more than 900,000 derivatives contracts.
In addition, the
government’s inconsistent handling of major financial institutions during
the crisis—the decision to rescue Bear Stearns and then to place Fannie Mae
and Freddie Mac into conservatorship,
followed by its decision not to save Lehman Brothers
and then to save AIG—increased uncertainty and panic in the market.
In making these
observations, we deeply respect and appreciate the efforts made by
Secretary Paulson, Chairman Bernanke, and Timothy Geithner, formerly president
of the Federal Reserve Bank of New York
and now treasury secretary, and so many
others who labored to stabilize our financial system and our economy in the
most chaotic and challenging of
circumstances.
•We
conclude there was a systemic breakdown in accountability and ethics.
The integrity
of our financial markets and the public’s trust in those markets are
essential to the economic
well-being of our nation. The soundness and the sustained prosperity of
the financial system and our economy rely on the notions of fair dealing,
responsibility, and transparency.
In our economy, we expect businesses and individuals to
pursue profits, at the same time that they produce products and services of
quality and conduct themselves
well.
Unfortunately—as has
been the case in past speculative booms and busts—we witnessed
an erosion of standards of responsibility and ethics that exacerbated the
financial crisis. This was not
universal, but these breaches stretched from the ground level
to the corporate suites. They resulted not only in significant financial
consequences but also in damage to
the trust of investors, businesses, and the public in the financial
system.
For example, our
examination found, according to one measure, that the percentage of
borrowers who defaulted on their mortgages within just a matter of months
after taking a loan nearly doubled from
the summer of 2006 to late 2007. This data indicates
they likely took out mortgages that they never had the capacity or intention
to pay. You will read about mortgage
brokers who were paid “yield spread premiums” by lenders to put borrowers
into higher-cost loans so they would get bigger fees, often never
disclosed to borrowers.
The report catalogues the
rising incidence of mortgage fraud,
which flourished in an environment of collapsing lending standards and lax
regulation. The number of suspicious activity reports—reports of possible
financial crimes filed by
depository banks and their affiliates—related to mortgage fraud grew
20-fold between 1996 and 2005 and then more than doubled again between 2005
and 2009. One study places the losses resulting from fraud on mortgage loans
made between 2005 and 2007 at $112
billion.
Lenders made loans that
they knew borrowers could not afford and that could cause
massive losses to investors in mortgage securities. As early as September 2004,
Countrywide executives recognized that
many of the loans they were originating could
result in “catastrophic consequences.” Less than a year later, they noted
that certain high-risk loans they
were making could result not only in foreclosures but also
in “financial and reputational catastrophe” for the firm. But they did not
stop.
And the report documents
that major financial institutions ineffectively sampled loans
they were purchasing to package and sell to investors. They knew a significant
percentage of the sampled loans did not
meet their own underwriting standards or those
of the originators. Nonetheless, they sold those securities to investors. The
Commission’ review of many prospectuses
provided to investors found that this critical information
was not disclosed.
THESE CONCLUSIONS must be
viewed in the context of human nature and individual and
societal responsibility. First, to pin this crisis on mortal flaws like greed
and hubris would be simplistic. It
was the failure to account for human weakness that is relevant
to this crisis.
Second, we clearly believe
the crisis was a result of human mistakes, misjudgments, and
misdeeds that resulted in systemic failures for which our nation has paid
dearly. As you read this report, you will
see that specific firms and individuals acted irresponsibly.
Yet a crisis of this magnitude cannot be the work of a few bad actors, and
such was not the case here. At the same time, the breadth of this crisis does
not mean that “everyone is at
fault”; many firms and individuals did not participate in the excesses
that spawned disaster.
We do place special
responsibility with the public leaders charged with protecting our
financial system, those entrusted to run our regulatory agencies, and the
chief executives of companies whose
failures drove us to crisis. These individuals sought and accepted
positions of significant responsibility and obligation. Tone at the top does
matter and, in this instance, we were let
down. No one said “no.”
But as a nation, we must
also accept responsibility for what we permitted to occur.
Collectively, but certainly not
unanimously, we acquiesced to or embraced a system, a
set of policies and actions, that gave rise to our present predicament.
* * *
THIS REPORT DESCRIBES THE
EVENTS and the system that propelled our nation toward crisis.
The complex machinery of our financial markets has many essential gears—some
of which played a critical role as the crisis developed and deepened.
Here we render our
conclusions about specific components of the system that we believe contributed
significantly to the financial meltdown.
•We
conclude collapsing mortgage-lending standards and the mortgage securitization
pipeline lit and spread
the flame of contagion and crisis.
When housing prices
fell and mortgage borrowers defaulted, the lights began to dim on Wall Street.
This report catalogues the corrosion of
mortgage-lending standards and the securitization pipeline
that transported toxic mortgages from neighborhoods across America to
investors around the globe.
Many mortgage lenders set
the bar so low that lenders simply took eager borrowers’ qualifications on
faith, often with a willful disregard for a borrower’s ability to pay.
Nearly one-quarter of all mortgages made in the first half of 2005 were
interest only loans. During the
same year, 68% of “option ARM” loans originated by Countrywide and
Washington Mutual had low- or no-documentation requirements.
These trends were not
secret. As irresponsible lending, including predatory and fraudulent
practices, became more prevalent, the Federal Reserve and other regulators
and authorities heard warnings from many
quarters. Yet the Federal Reserve neglected
its mission “to ensure the safety and soundness of the nation’s banking
and financial system and to protect
the credit rights of consumers.” It failed to build the retaining
wall before it was too late. And the Office of the Comptroller of the Currency
and the Office of Thrift Supervision,
caught up in turf wars, preempted state regulators
from reining in abuses.
While many
of these mortgages
were kept on banks’ books, the bigger money came from
global investors who clamored to put their cash into newly created
mortgage-related securities.
It appeared to financial institutions, investors, and regulators alike that
risk had been conquered:
the investors held highly rated securities they thought were sure
to perform; the banks thought they had taken the riskiest loans off their
books; and
regulators saw firms making profits and borrowing costs reduced.
But each
step in the
mortgage securitization pipeline depended on the next step to keep demand
going. From the
speculators who flipped houses to the mortgage brokers who scouted the
loans, to the lenders who issued the mortgages, to the financial firms that
created the
mortgage-backed securities, collateralized debt obligations (CDOs), CDOs
squared, and synthetic
CDOs: no one in this pipeline of toxic mortgages had enough skin
in the game. They all believed they could off-load their risks on a moment’s
notice to the next
person in line.
They were
wrong. When borrowers stopped making mortgage
payments, the losses—amplified by derivatives—rushed through the pipeline.
As it turned out, these losses were concentrated in a set of systemically
important financial
institutions.
In the
end, the system that created millions of mortgages so efficiently has proven
to be difficult to unwind.
Its complexity has erected barriers to modifying mortgages so
families can stay in their homes and has created further uncertainty about the
health of the housing
market and financial institutions.
•
We
conclude over-the-counter derivatives contributed significantly to this
crisis.
The
enactment of legislation in 2000 to ban the regulation by both the federal
and state governments of
over-the-counter (OTC) derivatives was a key turning point
in the march toward the financial crisis.
From
financial firms to corporations, to farmers, and to investors, derivatives
have been used to hedge
against, or speculate on, changes in prices, rates, or indices or
even on events such as the potential defaults on debts. Yet, without any
oversight, OTC
derivatives rapidly spiraled out of control and out of sight, growing to $673
trillion in
notional amount.
This report explains the uncontrolled leverage; lack of
transparency, capital, and
collateral requirements; speculation; interconnections among
firms; and concentrations of risk in this market.
OTC
derivatives contributed to the crisis in three significant ways.
First, one
type of derivative—credit
default swaps (CDS)—fueled the mortgage securitization pipeline.
CDS were sold to investors to protect against the default or decline in value
of mortgage-related
securities backed by risky loans. Companies sold protection—to the tune
of $79 billion, in AIG’s case—to investors in these newfangled mortgage
securities, helping
to launch and expand the market and, in turn, to further fuel the housing
bubble.
Second,
CDS were essential to the creation of synthetic CDOs. These synthetic CDOs were
merely bets on the performance of real mortgage-related securities. They
amplified the losses from
the collapse of the housing bubble by allowing multiple bets on
the same securities and helped spread them throughout the financial system.
Goldman
Sachs alone packaged and sold $73 billion in synthetic CDOs
from July 1, 2004,
to May 31, 2007. Synthetic CDOs created by Goldman referenced more than
3,400 mortgage securities,
and 610 of them were referenced at least twice. This is apart from how many
times these securities may have been referenced in synthetic CDOs
created by other firms.
Finally,
when the housing bubble popped and crisis followed, derivatives were in
the center of the storm.
AIG, which had not been required to put aside capital reserves as
a cushion for the protection it was selling, was bailed out when it could not
meet its obligations. The
government ultimately committed more than $180 billion because
of concerns that AIG’s collapse would trigger cascading losses throughout
the global financial
system.
In
addition, the existence of millions of derivatives contracts of
all types between systemically important financial institutions—unseen and
unknown in this
unregulated market—added to uncertainty and escalated panic, helping
to precipitate government assistance to those institutions.
•We
conclude the failures of credit rating agencies were essential cogs in the
wheel of
financial destruction.
The three
credit rating agencies were key enablers of the
financial meltdown.
The mortgage-related securities at the heart of the crisis
could not have been
marketed and sold without their seal of approval. Investors relied on
them, often blindly. In some cases, they were obligated to use them, or
regulatory capital
standards were hinged on them. This crisis could not have happened without
the rating agencies. Their ratings helped the market soar and their downgrades
through 2007 and 2008
wreaked havoc across markets and firms.
In our
report, you will read about the breakdowns at Moody’s, examined by the
Commission as a case
study. From 2000 to 2007, Moody’ rated nearly 45,000 mortgage-related
securities as triple-A. This compares with six private-sector companies
in the United States that
carried this coveted rating in early 2010. In 2006 alone,
Moody's put its triple-A stamp of approval on 30 mortgage-related securities
every
working day. The results were disastrous: 83% of the
mortgage securities rated triple-A
that year ultimately were downgraded.
You will
also read about the forces at work behind the breakdowns at Moody’s,
including the
flawed computer models, the pressure from financial firms that paid for
the ratings, the
relentless drive for market share, the lack of resources to do the job despite
record profits, and the absence of meaningful public oversight. And you will
see that without the
active participation of the rating agencies, the market for mortgage-related
securities could not have been what it became.
* * *
THERE ARE
MANY COMPETING VIEWS as to the causes of this crisis. In this regard, the
Commission has endeavored
to address key questions posed to us. Here we discuss three:
capital availability and excess liquidity, the role of Fannie Mae and Freddie
Mac (the GSEs), and
government housing policy.
First, as
to the matter of excess liquidity: in our report, we outline monetary policies
and capital flows during
the years leading up to the crisis.
Low interest rates, widely
available capital, and international investors seeking to put their money in
real estate assets
in the United States were prerequisites for the creation of a credit bubble.
Those conditions created
increased risks, which should have been recognized by market
participants, policy makers, and regulators. However, it is the Commission’s
conclusion that excess
liquidity did not need to cause a crisis. It was the failures outlined above—including
the failure to effectively rein in excesses in the mortgage and financial
markets—that were
the principal causes of this crisis. Indeed, the availability of
well-priced capital—both foreign and domestic—is an opportunity for
economic expansion
and growth if encouraged to flow in productive directions.
Second, we
examined the role of the GSEs, with Fannie Mae serving as the Commission’s
case study in this area.
These government-sponsored enterprises had a deeply
flawed business model as publicly traded corporations with the implicit
backing of and
subsidies from the federal government and with a public mission. Their $5
trillion mortgage exposure and market position were significant. In 2005 and
2006, they decided to ramp
up their purchase and guarantee of risky mortgages, just as
the housing market was peaking. They used their political power for decades to
ward off effective
regulation and oversight—spending $164 million on lobbying from 1999
to 2008. They suffered from many of the same failures of corporate governance
and risk management as the
Commission discovered in other financial firms. Through
the third quarter of 2010, the Treasury Department had provided $151 billion
in financial support to
keep them afloat.
We
conclude that these two entities contributed to the crisis, but were not a
primary cause.
Importantly, GSE mortgage securities essentially maintained their value
throughout the crisis and
did not contribute to the significant financial firm losses that
were central to the financial crisis.
The GSEs
participated in the expansion of subprime and other risky mortgages, but
they followed rather than led Wall Street and other lenders in the rush for
fool’s gold. They
purchased the highest rated non-GSE mortgage-backed securities and their
participation in this market added helium to the housing balloon, but their
purchases never
represented a majority of the market. Those purchases represented 10.5%
of
non-GSE subprime mortgage-backed securities in 2001, with the share rising to
40% in 2004, and falling back to 28% by 2008. They relaxed
their underwriting standards to
purchase or guarantee riskier loans and related securities in order to meet
stock market analysts’
and investors’ expectations for growth, to regain market share, and
to ensure generous compensation for their executives and employees—justifying
their activities on the
broad and sustained public policy support for homeownership.
The
Commission also probed the performance of the loans purchased or guaranteed
by Fannie and Freddie.
While they generated substantial losses, delinquency rates
for GSE loans were substantially lower than loans securitized by other
financial firms.
For example, data compiled by the Commission for a subset of borrowers with
similar credit scores—scores
below 660—show
that by the end of 2008, GSE mortgages were
far less likely to be seriously delinquent than were non-GSE securitized
mortgages: 6.2% versus
28.3%.
We also
studied at length how the Department of Housing and Urban Development's (HUD’s)
affordable housing goals for the GSEs affected their investment in risky
mortgages. Based on the evidence and interviews with dozens of individuals
involved in this
subject area, we determined these goals only contributed marginally to Fannie’s
and Freddie’s participation in those mortgages.
Finally,
as to the matter of whether government housing policies were a primary cause
of the crisis: for decades, government policy has encouraged homeownership
through a set of
incentives, assistance programs, and mandates. These policies were put
in place and promoted by several administrations and Congresses—indeed, both
Presidents Bill Clinton
and George W. Bush set aggressive goals to increase homeownership.
In
conducting our inquiry, we took a careful look at HUD’s affordable housing
goals, as noted above, and
the Community Reinvestment Act (CRA). The CRA was enacted
in 1977 to combat “redlining” by banks—the
practice of denying credit to individuals and
businesses in certain neighborhoods without regard to their creditworthiness.
The CRA requires banks and
savings and loans to lend, invest, and provide services
to the communities from which they take deposits, consistent with bank safety
and soundness.
The
Commission concludes the CRA was not a significant factor in subprime lending
or the crisis. Many
subprime lenders were not subject to the CRA. Research indicates only
6% of high-cost loans— proxy for subprime loans—had any
connection to the
law. Loans made by CRA-regulated lenders in the neighborhoods in which they
were required to lend were
half as likely to default as similar loans made in the same neighborhoods
by independent mortgage originators not subject to the law.
Nonetheless,
we make the following observation about government housing policies—they
failed in this respect: As a nation, we set aggressive homeownership goals
with the desire to extend
credit to families previously denied access to the financial markets.
Yet the government failed to ensure that the philosophy of opportunity was
being matched by the
practical realities on the ground. Witness again the failure of the
Federal Reserve and other regulators to rein in irresponsible lending.
Homeownership peaked
in the spring of 2004 and then began to decline.
From that point on, the
talk of opportunity was tragically at odds with the reality of a financial
disaster in the
making.
* * *
WHEN THIS
COMMISSION began its work 18 months ago, some imagined that the events
of 2008 and their consequences would be well behind us by the time we issued
this report. Yet more than
two years after the federal government intervened in an unprecedented
manner in our financial markets, our country finds itself still grappling
with the after effects of
the calamity. Our financial system is, in many respects, still
unchanged from what existed on the eve of the crisis. Indeed, in the wake of
the crisis, the
U.S. financial sector is now more concentrated than ever in the hands of a
few large, systemically
significant institutions.
While we
have not been charged with making policy recommendations, the very purpose
of our report has been to take stock of what happened so we can plot a new
course.
In our inquiry, we
found dramatic breakdowns of corporate governance, profound
lapses in regulatory oversight, and near fatal flaws in our financial system.
We also found that a
series of choices and actions led us toward a catastrophe for which
we were ill prepared. These are serious matters that must be addressed and
resolved to restore faith
in our financial markets, to avoid the next crisis, and to rebuild a
system of capital that provides the foundation for a new era of broadly
shared prosperity.
The
greatest tragedy would be to accept the refrain that no one could have seen
this coming and thus
nothing could have been done. If we accept this notion, it will happen
again.
This
report should not be viewed as the end of the nation’s examination of this
crisis. There is still
much to learn, much to investigate, and much to fix.
This is
our collective responsibility. It falls to us to make different choices if we
want different results.